Jeffrey Timmermans Global Economic Journalism Class 8: The Banking System

Measuring the money supply ✤ M1: Currency + Demand Deposits + Traveler’s Checks + Other Checkable Deposits ✤ M2: M1 + Savings Deposits + Retail Money Market Mutual Funds

U.S. Money Supply Currency M1 SavingsDeposits Time Deposits billions of U.S. dollars Source: U.S. Federal Reserve Money Mkt Funds

Structure of the Banking System ✤ Commercial banks borrow from each other to meet short-term (overnight) needs in the interbank market ✤ The overnight interbank rate is typically influenced by changes in the money supply made by central banks (open-market operations) ✤ Commercial banks take deposits from individuals and lend out some of those deposits ✤ The role of the banking system is channel savings to those who need funds/capital (financial intermediation

The Banking System Central Bank Commercial Bank Discount window Interbank market Deposits Home/car Loans Business loans Interbank rate Base/discount rate Prime rate Deposit rate Commercial lending rate +$ –$

Key interest rates ✤ Interbank rates ✤ Overnight, 1-wk, 1-mth, 3-mth ✤ Deposit rates ✤ interest rate banks pay for funds ✤ Prime (lending) rate ✤ interest rate banks charge for (some) loans LOW HIGH

Interbank rates ✤ U.S.: Fed Funds target rate ✤ H.K.: Hong Kong Interbank Offer Rate (Hibor) ✤ U.K.: London Interbank Offer Rate (Libor) ✤ Fed sets Fed Funds target rate; supply/demand determine Hibor & Libor ✤ Banks’ lending rates often based on local interbank rate

Commercial Banks ✤ Take deposits ✤ Deposits are banks’ liabilities ✤ Pay depositors interest (deposit rate) ✤ Make loans ✤ Loans (& reserves) are assets ✤ Banks keep some reserves, lend out the rest ✤ Earn interest from borrowers

Reserve Ratio ✤ Typically set by the central bank ✤ Indicates the percentage of deposits a bank must keep as reserves ✤ In U.S., reserve ratio is now 10% for deposits above $55.2 million ✤ In China, the reserve ratio is now 21% for large banks ✤ An increase in the reserve ratio forces banks to curtail lending, a decrease leads to more lending and an expansion of the money supply

Jeff’s Bank (100% reserve ratio) AssetsLiabilities Reserves$100Deposits$100

Jeff’s Bank (10% reserve ratio) AssetsLiabilities Reserves$10Deposits$100 Loans$90

The Money Multiplier 1 reserve ratio

How the multiplier works Original deposit$100 Jeff’s Bank lending$90 (.9 x $100)$190 Masato’s Bank lending$81 (.9 x $90)$271 Diane’s Bank lending$72.90 (.9 x $81)$ etc. Total money supply$1,000 $90 $81

Definition of Capital (Basel III) ✤ Common equity (core) Tier 1 capital: equity ✤ Tier 1 capital: equity + disclosed reserves ✤ in other words: share capital + retained earnings (shareholders’ funds) ✤ Tier 2 capital: undisclosed reserves + revaluation reserves + general provisions/loan-loss reserves + hybrid instruments (equity look-alikes) Source: Bank for International Settlements

Basel III capital requirements ✤ Minimum capital requirement: 8.0% ✤ Of which: ✤ at least 4.5% is core Tier 1 ✤ at least 6% is Tier 1 ✤ PLUS conservation buffer: 2.5% (entirely core Tier 1) ✤ PLUS counter-cyclical buffer: 0-2.5%(entirely core Tier 1) Source: Bank for International Settlements