A Primer on Money and Banking

by William F Hummel

May 3, 2016

The Elusive Concept of Money

Money can be defined as whatever is widely accepted as a medium of exchange. Of course to be accepted, it must be seen as a store of value. However these basic properties do not explain how something gains status as money and how it is to be measured. Keynes held that the primary concept in the theory of money is the unit of account. Throughout history, States have established what is to serve as legal tender. They have done so by (1) giving a name to the unit of account; (2) declaring what token is legal tender measured in that unit; and (3) enforcing debts and contracts payable in that token. 

The point is that debts and contract prices must be expressed in terms of the unit of account while the token can be whatever the government chooses, and can be changed independent of the unit of account. In the U.S. the unit of account is the dollar, and the token is a dollar bill. When the U.S. established the dollar in 1792, the token was a silver and copper alloy coin weighing 27.0 grams, containing 24.1 grams of pure silver.

The Evolution of Fractional Reserve Banking

London goldsmiths, originally operating as money changers, accepted coins and other gold objects for safekeeping for a fee, and issued receipts to the depositors. This became known as warehouse banking. By the mid 17th century, people found it more convenient to exchange the receipts rather than the coins when making payments among themselves. This facilitated trade within the economy, and the receipts themselves gradually became the accepted form of money. 

The goldsmiths found that people would rarely redeem the deposited gold for their receipts. Consequently they began lending receipts, unbacked by gold deposits. Thus began the transition from warehouse banking to fractional reserve banking in England. Unbacked receipts evolved into notes loaned by banks, payable in gold coin to the bearer on demand. Fractional reserve banking was an attractive means of expanding the money supply and increasing profits. However the tendency toward over-lending by bankers created problems. When their notes could not be fully honored, bank runs often followed, sometimes with serious consequences for the local economy.

Transition to Fiat Money

As the US economy grew ever larger and more complex, precious metal coins as money became a perennial problem. The financial panics and depressions of the 19th  and early 20th century owe their origin to the  constraints of a metal-based monetary system in an economy that depends on the availability of ample credit. A major financial crisis in 1907 led to the creation in 1913 of a central bank known as the Federal Reserve or simply the Fed.  Its main purpose was to establish a flexible currency and act as a lender of last resort.

However the dependence of credit on gold remained in place for another twenty years. Bank deposits and dollar bills were convertible into gold coin on demand until 1933. It took a major financial crisis leading to the Great Depression for government to finally break the link to gold. With the end of the gold standard in the US, definitive money became credit issued by the Fed. We call that credit fiat money because it is money by government fiat.

Creating Fiat Money

The Fed creates fiat money by lending to banks or by purchasing securities in the open market and crediting the seller’s bank with a deposit at the Fed. The bank then credits the seller with an equal deposit in his own account. Private bank deposits are claims on fiat money, not actual fiat money. 

Fiat money exists in just two forms – as deposits at the Fed and as cash, i.e. notes and coins. Cash is simply the tangible form of fiat money, and the only form with which the non-bank public has direct contact. Deposits at the Fed are owned by financial institutions, mainly banks and the Treasury. Bank-owned deposits are known as Fed funds, and can be converted into cash on demand. A bank’s vault cash and its Fed funds comprise its most liquid assets, known as reserves.

Unlike a bank, the Fed can issue credit without limit. Banks can also issue credit, but they do so by lending and are limited by the capital ratio requirement. A bank lends by simply crediting the borrower with a deposit in his account. When a depositor makes a payment by check or electronic means, the payer's bank debits his transaction account and must surrender that amount of reserves to the payee’s bank, which then credits the payee with an equal deposit. 

The Monetary Base

Any sovereign State with the power to tax can establish its own currency by declaring what token is to be legal tender. All modern States have adopted intrinsically worthless tokens for their currencies. The State necessarily holds a monopoly on the issue of fiat money. Fiat money held by the private sector comprises the monetary base, which we will refer to as base money. Thus the reserves of banks and currency in circulation are base money.

Base money acquires value because that is what the Treasury requires in the payment of federal taxes. In effect base money is a tax credit. Those who have no tax liabilities will readily accept payment in base money because it is needed by so many others. Ultimately the viability of the monetary base depends on the government widely enforcing tax collection, and acting to maintain a modest rate of price inflation. 

The Dual Role of Banks

We will use the term banks to mean any financial institution that serves as a depository, such as commercial banks and thrifts. That does not include so-called investment banks  or bank holding companies, which cannot accept deposits but are permitted to engage in a variety of investment activities and to hold assets not allowed to banks themselves.

Banks play two distinct roles: as profit-seeking enterprises and as depositories. Their profit-seeking activities include a variety of services. We will focus on their service as intermediaries who provide a link between those with savings to invest and those in need of funds. For most banks, the main source of income is by lending at a markup over their cost of acquiring funds.

As depositories banks accept deposits, provide payment facilities, and issue cash on demand in exchange for debits against their deposit liabilities. They pay no interest on demand deposits and very modest interest on savings deposits. They also offer term deposits at higher interest rates because those deposits provide a more stable supply of funding to back their lending. 

The Money Supply

What is meant by the money supply? The term itself implies that a certain amount of money exists at any given time. However in a fractional reserve system, there can be no meaningful measure of the money supply, as will be explained.

The Fed has its own measures of the money supply which it once used to help guide its monetary policy decisions. It defines the money supply as the total cash in circulation and the deposit liabilities of banks and thrifts. At one time it set targets for the growth of the money supply. Now it largely ignores its own measures because it has found little correlation between them and its major policy objectives – limiting inflation and unemployment. 

The Fed's definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, are not included in the monetary aggregates, even though they are a part of the monetary base. That means when a bank makes payments to the public, it increases the money supply.  When a bank receives payments from the public such as interest on loans, the money supply decreases.

Lines of Credit

The Fed's definition of money ignores bank lines of credit which can be exercised at the discretion of the borrower. Some firms hold substantial lines of credit at their banks, which they can use on short notice. Likewise consumers hold lines of credit in their credit card accounts that are just as useful for purchases as checking accounts or the cash in their wallets. Lines of credit increase liquidity, which is important in terms of aggregate demand.

When someone uses a credit card in a purchase, he automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system – until the buyer pays off the loan. Consumers who roll over their credit card loans rather than paying them off have increased the money supply on their own initiative by hundreds of billions of dollars. Thus the effective money supply is substantially larger and less measurable than the Fed's definition.

The Role of the Fed 

Since base money is a monopoly of the State, the Fed must provide whatever reserves the banking system needs to ensure the liquidity of the payment system. When the Fed needs to increase aggregate reserves, it buys Treasury securities from the public and credits the sellers' banks with additional deposits at the Fed. Conversely the Fed sells Treasury securities to the public from its own portfolio when it needs to decrease aggregate bank reserves. Bank reserves are only a small part of the monetary base, but they play a key role because they are the grease that enables the bank credit system to function. 

These transactions by the Fed are designed to balance supply and demand for bank reserves at the Fed's target interest rate on overnight loans between banks, otherwise known as the Fed funds rate. The Fed funds rate is the benchmark for all short-term interest rates.  It has a significant influence on the amount of bank money issued, and thus the liquidity of the private sector. In controlling the Fed funds rate, the Fed necessarily relinquishes control of the amount of base money it issues. The private sector itself determines the net amount issued. 

Treasury Operations 

The Treasury spends out of its account at the Fed. It continually replenishes that account with transfers from its accounts in commercial banks where it deposits its receipts from taxes and the sale of bonds. These so-called Treasury Tax and Loan accounts, like all other bank transaction accounts, must be backed in accordance with the reserve ratio requirement. The Treasury targets a fixed balance in its Fed account in order to minimize disturbances to aggregate banking system reserves. The purpose is to facilitate the Fed's control of the interest rate on interbank loans, i.e. the Fed funds rate.

The Treasury maintains an approximate balance between total inflows and outflows in order to avoid significant disturbance in the aggregate transaction deposits of the private sector. It does so by selling securities as needed to cover its deficit spending. If it sold less than needed, its general fund would ultimately be depleted. It has no incentive to sell more than needed; that would unnecessarily increase its interest expenses. Thus on balance,  the government spending has no net effect on the money supply except when it needs to change the target  balance in its general fund. Normally it simply recycles the base money it has previously acquired.

Managing Inflationary Expectations 

The interest rate the Treasury must pay to borrow is a market rate which is influenced by Fed policy. The short-term rate closely tracks the Fed funds rate due to arbitrage. Longer-term rates include a premium over the Fed funds rate which varies with inflationary expectations. Although many diverse factors affect those expectations, the Fed itself has considerable influence through its monetary policy decisions. It is therefore up to the Fed to keep inflationary expectations within acceptable limits. By doing that well, it protects the purchasing power of money, and ensures that interest rates on long term borrowing will not become so burdensome as to hinder economic growth. 

The historical record shows no significant correlation between the amount of deficit spending and the inflation rate or interest rates. Most central banks now target a small positive inflation rate to provide a margin against a deflation trap. Deflation hurts aggregate demand by creating a money-hoarding psychology which is difficult to overcome, and may result in a prolonged recession. Under the gold-based system, the State's ability to counter inflationary and deflationary pressures was very limited.

The Role of Bank Reserves

The bulk of all money transactions involve the transfer of bank deposits and an equal amount of reserves. A bank must hold enough reserves to meet the cash withdrawals of its depositors and to cover the checks written against their accounts. When a depositor makes a payment out of his account, his bank must surrender that amount of reserves to the payee’s bank. Thus reserves move from one bank to another as payments are made and cleared. At the end of the day, some banks will be short of reserves and others long. Banks redistribute reserves among themselves by trading in the Fed funds market. Those long on reserves will normally lend to those short. The interest rate on interbank loans, known as the Fed funds rate, varies with supply and demand.

The reserve requirement applies only to a bank's transaction deposits, not its savings or term deposits. Thus when a bank depositor transfers funds in a transaction account to a savings or term account, he frees up reserves that were held against those transaction deposits. The bank can then use the free reserves in several ways. For example, it can hold them to back further lending, buy interest-earning Treasury securities, or lend them to other banks in the Fed funds market. The Fed funds rate is effectively the upper limit on the cost of reserves to banks, and thus determines the interest rate that banks must charge the public for loans.

Reserve Requirements

All depository institutions -- commercial banks and thrifts -- in the United States are subject to reserve requirements on customer deposits. The required reserve ratio depends on the amount of checkable deposits a bank holds. As of year-end 2015, no reserves are required on the first $15.2 million. Between $15.2 million and $110.2 million, deposits are subject to a 3% reserve. Above $110.2 million they are subject to a 10% reserve. These breakpoints are adjusted annually in accordance with money supply growth. No reserves are required against term deposits or savings accounts.

Reserves are figured as the average held over a 14-day period, ending every second Wednesday. On any single day, a bank needs only enough to cover its customer's withdrawals. A bank may hold its reserves in any combination of vault cash and deposits at the Fed.  As profit-seeking enterprises, banks try to keep their reserves close to the required minimum, since they earn no interest. 

Factors Affecting Aggregate Reserves

A bank loses reserves whenever it pays out cash or transfers funds by wire for its customers. Customer checks to pay out of town bills funnel back through the Fed and are charged against its reserves. A bank may also lose reserves when it advances loans or buys securities. Conversely a bank gains reserves when it receives new deposits. 

There are many factors outside of the Fed’s control that influence aggregate reserves. They include changes in currency holdings of the public, changes in the Treasury’s cash balances at the Fed, checking system float, and foreign central bank transactions. The Fed actively compensates for these variations by adding or draining system reserves as needed to avoid large fluctuations in their market price, i.e. the Fed funds rate. The growing demand for currency is the largest single factor requiring reserve injections.

An active market in reserves helps to redistribute reserves to those banks that need them. If a bank faces a reserve deficiency, it has several options.  It can try to borrow reserves for one or more days from another bank; sell marketable assets such as government securities; bid for funds in the money market such as large CDs or Eurodollars; or it can pledge collateral and borrow at the Fed’s discount window at a penalty rate. 

Bank Liquidity

Liquidity for a bank means the ability to meet its financial obligations as they come due. Commercial banks differ widely in how they manage liquidity.  A small bank derives its funds primarily from customer deposits, normally a fairly stable source in the aggregate. Its assets are mostly loans to small firms and households, and it usually has more deposits than it can find creditworthy borrowers for. Excess funds are typically invested in assets that will provide it with liquidity such as Fed funds loaned and U.S. government securities. The holding of assets that can readily be turned into cash when needed, is known as asset management banking.  

Large banks generally lack sufficient deposits to fund their main business -- dealing with large companies, governments, other financial institutions, and wealthy individuals. Most borrow the funds they need from other major lenders in the form of short-term liabilities which must be continually rolled over. This is known as liability management, a much riskier method than asset management. A small bank will lose potential income if it gets its asset management wrong. A large bank that gets its liability management wrong may fail. 

A bank's most vital asset is its creditworthiness. If there is any doubt about its credit, depositors can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest indication of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. With the advent of deposit insurance, bank runs by small depositors are largely a thing of the past. Insurance is currently limited to $250,000 per deposit, which provides complete coverage to about 99% of all depositors. But it covers only about three-fourths of the total amount of deposits because many accounts far exceed the insurance limits.  

Distortions due to the Recent Financial Crisis

The Fed's response to the financial crisis greatly distorted its balance sheet and altered some of its practices. As of 2014, banks still hold a large excess of reserves. That forces the Fed to use different methods of implementing monetary policy than outlined above. Since It is likely the Fed will gradually recapture the excess reserves and return to its pre-crisis mode of operaton, we have dealt only with the Fed's normal mode of operation.