How does the financial system work

how does the financial system work

How the U.S. Banking System Works

The United States banking system is a “fractional reserve” system. This began in the 1800s when the courts declared that money on deposit in banks was no longer the property of the depositor, but rather was a debt owed by the bank to the depositor in the amount of the deposit. This meant that the money deposited became the property of the banks to do with as they pleased, which opened the way for lending “their” money. It wasn’t long before they realized that only a small fraction of depositors wanted to withdraw “their” money at one time. Thereafter, banks began lending a large percentage of the money depositors placed with them and keeping only a small “reserve” to meet depositors demands for cash. This gave rise to two potential problems for banks: 1. a solvency problem (if the bank’s liabilities exceeded its assets. creditors/depositors were not all able to withdraw “their” deposits and the bank went bankrupt), 2. a liquidity problem (even though a bank might have assets in excess of its liabilities, it might not be able to convert enough of its assets to cash to meet the current demand for cash [from depositors’ withdrawals]).

When enough banks had liquidity problems simultaneously, there were banking panics (1857, 1873, 1893, 1896, and 1907). These panics were characterized by sharp rises in short-term interest rates, making it more difficult to borrow short-term funds and/or get one’s money out of the bank. The lack of liquidity occurring during these panics generally resulted in significant economic downturns afterwards.

In 1913, the Federal Reserve Bank (the U.S. central bank, also known as “the Fed”) was established, and given monopoly powers over member-bank policies and U.S. monetary policies with the intended purpose of stabilizing short-term interest rates and preventing economic downturns by providing as much liquidity as necessary to avoid these panics. With regard to banking policies, the Fed uses two tools to accomplish their purposes: 1. member-bank reserve requirements and 2. loans to member-banks.

Bank reserve requirements.

The Fed sets bank reserve requirements. These requirements can be met with either cash in the bank’s vault, or as non-interest bearing deposits with the regional Federal Reserve Bank. If the reserve requirement is 20% of the bank’s deposits, then, for each new $100 deposited and held in reserve, the bank can lend an additional $400. It does this by simply entering $400 in new demand deposits (checking accounts) into their books for customers to whom they lend this newly created money. Thus, for each new $100 deposited, a total of $500 is added to the money and credit system by the banks. Now, let’s compare this with what happens with a 10% reserve requirement. For each new $100 deposited, the bank can increase its lending by $900 by booking $900 in new demand deposits lent out to loan customers. Here, for each new $100 deposited, a total of $1,000 is added to the money and credit system. Thus, fractional reserve banking effectively creates money. The lower the reserve requirement, the greater the quantity of money banks can create.

To help member-banks meet their reserve requirements, the Fed lends money to member-banks in two ways: discounts and advances. Discounts were primarily used during the early days of the Federal Reserve System. They are purchases of loans owed to a bank by the Fed. These purchases are made at the Discount Window of the Fed and put more cash into the banks, thus increasing their reserves and allowing them to meet their minimum reserve requirements. More recently, banks receive advances (loans) from the Fed based on U.S. government securities owned by the bank that are used as collateral. This also puts cash into banks, thus increasing their reserves to meet their minimum reserve requirements. The discount rate is set by the Fed as part of its monetary policy (see next section).

U.S. monetary policies.

The Fed also influences the U.S. economy with its monetary policies. It does this by setting the discount rate and through the expansion and contraction of the money supply. The Federal Open Market Committee (FOMC), which is part of the Fed, conducts meetings regularly throughout the year. At each meeting, the FOMC targets the fed funds rate. which, in turn, determines the primary and secondary credit rates (discount rate) for loans from the Federal Reserve bank to its member banks. By raising/lowering the discount rate, the Fed makes it more difficult/easier for member banks to borrow money from the Fed.

Beginning in December, 2007, because borrowing through the discount window was viewed by many as a sign of financial weakness thereby reducing its effectiveness, the Fed established a new program of auctions for 28-day money through its Term Auction Facility (TAF). Banks that qualify for primary credit rates may participate in bi-weekly auctions for available money with the interest rate to be determined by market action. This program was established to supply credit to member banks when they were unable to borrow funds from each other because of their reduced creditworthiness resulting from the sub-prime debacle.

To meet the fed funds rate target, the Fed, through its open market desk, buys/sells U.S. Treasury securities in the market. To lower the fed funds rate, the Fed buys U.S. Treasury securities. To pay for these purchases, it simply cuts a check (or makes a computer entry) for the desired amount, thus creating the money it needs to purchase the securities. There is no limit to the amount that can be purchased in this fashion. By doing this, the Fed infuses cash into the banking system (monetizing the debt ), increasing the supply of bank reserves and thereby lowering the fed funds (interbank) rate. This increase in the supply of money is inflationary. Conversely, to raise the fed funds rate, the Fed sells U.S.

Treasury securities. The money it receives is removed from the banking system, thereby reducing the supply of bank reserves and raising the fed funds rate.

This practice of buying/selling U.S. Treasury securities in the open market is known as “open market operations.” When the federal government wants more money, more debt is monetized, thus increasing the nation’s money supply. This is inflationary. Because the public’s expectations for inflation can influence its spending and wage demands, it becomes important for the Fed to tell the public that inflation is under control. The FOMC report issued after each meeting does this. By reinforcing the public’s belief that inflation is relatively low, the Fed avoids an inflationary spiral in the short run.

Unfortunately, manipulating the economy through money supply and interest rate changes is not a precise science. What’s more, as the money supply grows, the Fed’s influence weakens. Its ability to inflate its way out of a recession or depression diminishes. More money is needed to gain the same effect as lesser quantities used to have. As more money is expected, more money is needed. Who doesn’t expect the Fed to supply the U.S. government with the money it needs to fight wars in Iraq and Afghanistan (and possibly Iran and/or China ), and against terrorism, drugs, enemy combatants, and tax evaders?

There is a limit to what the Fed can do to influence the economy. The Fed can expand or contract the money supply. The Fed can raise or lower the discount rate. The Fed can influence the fed funds rate, but the Fed can’t stop an inflationary (or deflationary) spiral once it starts in earnest.

This brings us to the Fed’s biggest fear—losing control of the economy, especially on the downside (deflationary spiral). It is commonly believed that during the 1930s, the Fed didn’t do enough to prevent the Great Depression. Most economists believe that it should have expanded the money supply and extended credit (loans) to its member banks. They believe that lowering the interest rates and increasing liquidity could have prevented the many bank runs and bank failures that occurred. In short, they believe that the Fed could have prevented the Great Depression and that Americans don’t ever want to experience another depression like it. Consequently, many people believe that the Fed currently has a bias against deflation and in favor of inflation. In fact, Ben Bernanke, the current Fed chairman, made a speech about making sure deflation doesn’t happen here, which you can view here. It was this speech that earned him the nickname of “Helicopter Ben” because he believes he can prevent a deflationary spiral, even if short-term interest rates reach zero, by expanding the money supply (dropping money from helicopters, if necessary—an option not available to the French in the 1790s and the Germans in the 1920s! Don’t you just love technology!).

Federal Deposit Insurance Corporation.

Another result of the Great Depression of the 1930s and the numerous bank runs in the United States was the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933. In the short run, this put a halt to bank runs by “insuring” all deposits (up to a limit). It also gives the FDIC, a government “corporation,” power over the banking industry. The FDIC has the power to require a change in bank management, and make other “corrective” changes to improve its risk-based capital ratio. In the long run, the federal government may have to use its power to tax and to print money to bail out the U.S. banking industry if enough banks fail. This is inflationary. It also destroys the banks’ incentive to act prudently with depositors’ funds. This can be seen with the way banks lend out “their” money to sub-prime borrowers. Sub-prime borrowers pay a higher interest rate on their borrowed funds. In short, banks try to maximize their revenue by lending to risky, high-interest paying customers. This works well until interest rates go up and money becomes scarcer. At that point, the sub-prime borrowers start having difficulty paying their bills and ultimately default on their loans. If there are enough defaults, the banks, in turn, may become insolvent, requiring a bailout or merger. If enough banks fail, the entire banking system is endangered. This may be more than the FDIC and/or the Fed can handle.

When banks’ incentive to act prudently is reduced, they may also pursue riskier investments; i.e. derivatives.

A banking industry crisis similar to the one the U.S. experienced during the 1980s with the Savings & Loan (S&L) industry would be much larger in scope were it to occur today. For more information about the S&L bailout, click here.

The U.S. Banking System Today.

During the fall of 2007, the U.S. banking system (and the European banking system as well), experienced a “shortage” of lending, in part because banks didn’t trust one another’s balance sheets due to the sub-prime lending fiasco. In short, banks’ debtor’s risk premiums were high because it wasn’t clear which banks would fail (or require a government bailout) because they had made bad loans to debtors with high debtor’s risk premiums.

During recent years in the United States, real estate prices have been continually rising. Loans have been made based on ever higher valuations of the underlying collateral. In an attempt to slow the inflationary bubble, the Fed raised interest rates, making it more difficult to borrow additional funds and to service adjustable rate mortgages. Consequently, more homeowners/real estate speculators have defaulted on their loans and the values of the underlying collaterals have dropped substantially in many locations. Bankruptcies are on the rise, giving the Fed the impetus to “do something;” i.e. print more money and lower interest rates. Of course, that’s the Fed’s response to every crisis. More inflation is on its way.

© 2008 Libertarian Press, Inc.


Category: Personal Finance

Similar articles: