The Role of Financial Intermediaries and Financial Markets2009Financial intermediaries play the role of connecting real and financial sectors. The most important financial intermediaries are banks that provide checking accounts to the public. Commercial banks are fundamentally businesses that earn profits for their owners by providing certain services for customers in return of payments from them. In contrast to other businesses, the balance sheet of a commercial bank has reserves on the assets of its balance sheet. These are cash on hand or funds deposited by the bank with the central bank.
Some reserves are held for day-to-day business needs, but most serve to meet legal reserve requirements. In most countries, a fixed fraction of the banks’ checking deposits, or bank money, is kept as reserves. The central bank determines the quantity of reserves of the banking system. Using those reserves as an input, the banking system transforms them into a much larger amount of bank money. The currency plus this bank money is the money supply, created through multiple expansion of bank deposits, or money multiplier. Assuming that the central bank, or Federal Reserve, buys a $1000 government bond from an individual who deposits $1000 in her checking account at Bank 1.
The modern commercial bank does not keep the entire amount in reserves but only a reserve requirement, say 10 percent, as reserves that do not earn interest. So, the bank now has $900 that it can lend out. The borrower deposits this money in Bank 2, creating a checking account of the borrower in Bank 2. Hence, the total amount of money supply becomes $1900. Bank 1’s activity has created $900 of new money in second-generation bank, Bank 2.
Thus, a chain of bank activity is set in motion. The process will come to an end once every bank in the system has reserves equal to 10percent that is equal to the new reserves. For every additional dollar in reserves provided to the banking system, banks create $10 of additional deposits of bank money. The money supply multiplier is the ratio of new money created to the change in reserves. This summarizes how the banking system creates money.
The entire banking system transforms an initial increase in reserves into a multiplied amount of new deposits or bank money. Fractional reserve banking has the advantage of creating money, thus stimulating business activity, but it also has great risks. The fact that banks cover only a fraction of their deposits opens up the possibility of “bank panics” or “a run on the banks”. Since a bank has only a small portion of money that it owes to its depositors, there is usually no problem. Only a small number of people will want to withdraw their money at one time.
But when too many people want their money at once, then there can be a frenzy that is known as “bank run”. In the modern financial system, bank runs are rarer and less dangerous. This is because the federal government ensures that all but the largest depositors will get their money back no matter what happens. Besides, the Federal Reserve takes an active role in being the “lender of the last resort”, providing funds to healthy banks with temporary liquidity problems and making sure that sick banks get liquidated in an orderly way.