This lesson provides an overview of basic banking concepts, illustrating how deposits turn into required reserves and excess reserves. It also covers how a bank accounts for these items on its balance sheet.
Deposits and Loans
Margie the cake baker comes into the lobby of the First National Bank of Ceelo to deposit a check for $20,000 into her savings account. Margie trusts that her money is safe at the bank, and she knows that at any time, she can return to the bank and withdraw her money. As she deposits the check, she sees Bob the business owner sitting in an office with an officer of the bank. Bob is talking to a loan officer about borrowing money to buy a new ginormous commercial mower with heated seats, gold plating and anti-lock brakes.
The bank serves an important purpose by connecting savers like Margie, who want to earn a return on their money, with borrowers like Bob, who are willing to pay a price for the use of that money in their businesses. The bank pays a relatively low interest rate to customers like Margie who deposit money into savings, and the bank loans out most of this money to borrowers like Bob at a higher interest rate, keeping the difference. That's how the bank makes money.
Although Margie may not realize it, two things will happen with the $20,000 she's depositing. A fraction of this deposit, say 10%, will be set aside by the bank as a reserve. The rest of this money, or 90% in this case, will get loaned out to borrowers like Bob the business owner, who wants to invest into his business.
In this lesson, we're talking about the fractional reserve banking system, which is a fancy way of saying that banks loan out most, but not all, of the money that gets deposited into accounts. Most modern economies are based on this system. Let's take a look at Margie's deposit and Bob's loan from the bank's perspective and see how the fractional reserve banking system works in banks across the economy. First, a little history.
When a deposit is made, banks place a little in the reserve and loan the rest out.
The History of Fractional Reserve Banking
The fractional reserve banking system is a system in which banks hold back a small fraction of their deposits in a reserve and loan out the rest of their deposits to borrowers. This whole idea started in the Middle Ages, when people used gold as money and needed a place to store it. The bankers, called goldsmiths at the time, agreed to hold onto a customer's gold for a small fee. Every person who deposited gold with the goldsmiths was given a gold receipt that they could hold onto and return whenever they wanted to redeem the gold.
Eventually, people started using these gold receipts as money to buy goods and services. Then the goldsmiths observed that most people deposited their gold but only withdrew a small part of it. So, they came up with the idea to loan out some of this gold and charge interest, and that's where we get the fractional reserve banking system. The fractional reserve banking system legally permits banks to hold less than 100% of their deposits as a reserve.
Banking serves as the foundation of the economy because entrepreneurs and businesses borrow money to invest, and their investment produces economic growth. The fractional reserve idea was designed to ensure that while they are loaning out money, they have enough reserves on hand to cover any withdrawals that consumers want to make from their accounts.
Of course, the danger of this strategy is that when people become fearful, they sometimes show up to the bank and demand all of their money at the same time, in which case, there isn't enough money to give everyone. That's what economists call a run on the banks, and it's one of the reasons that the central bank was created - to lend money to banks if they run out of reserves.
When Margie deposited $20,000 into her account at the bank, the bank calls that a demand deposit because she can place a demand on that money and withdraw it at any time. Her $20,000 deposit increased the bank's demand deposits by $20,000. In accounting, we describe this as a liability, because it is money that the bank owes to Margie. It's also considered an asset, and according to accounting, assets must always equal liabilities.
The fractional reserve system requires banks to reserve a portion of every deposit as a safety precaution. Banks call this required reserves. How do they know what to reserve? There is a required reserve ratio for all banks in the economy. Who decides what this number is? The central bank. The required reserve ratio is the percentage of deposits that banks are required to reserve.
Calculating Required Reserves for a Bank
Now let's talk about calculating required reserves. Required reserves cannot be loaned out. For example, a required reserve ratio of 10% means that 10% of all demand deposits must be set aside on reserve. To figure out how much a bank has to reserve, you simply multiply the amount of their deposits by the required reserve ratio.
For example, with a required reserve ratio of 10%, and demand deposits of $20,000, the required reserves would be 10% x $20,000, which is $2,000. These reserves will not be held in the bank, they'll be held at the Federal Reserve Bank.
Whatever is left after reserving this amount can be loaned out, something that banks call excess reserves. Excess reserves are bank reserves above and beyond the reserve requirement set by a central bank. Excess reserves may be loaned out by the bank in order to generate profits.
For example, when the required reserve ratio is 10%, and a demand deposit of $20,000 is made at the First National Bank of Ceelo, required reserves of $2,000 would first be set aside. That means $20,000 minus $2,000, or $18,000, is considered excess reserves and can be loaned out to borrowers like Bob. In the fractional reserve banking system, when a bank lends to a customer, this increases the money supply.
Accounting for Deposits and Reserves
Okay, it's time to take off your economics hat, and put on your accounting hat for a minute. When a consumer deposits money into a bank checking or savings account, this demand deposit is considered a liability to the bank because they owe this money to the customer. Just think about that - when you deposit money in your bank, you can decide to take this money out if you need it or want it. The bank owes this money to you. You didn't give it to them; you allowed them to hold it for you.
From their perspective, the bank's reserves and loans are both considered assets. In accounting, we have what's called a T-account, with reserves and loans on the asset side of their balance sheet and demand deposits on the liability side of the bank's balance sheet. The assets and liabilities always have to balance. That's why we call it a balance sheet.
Let's review Margie's deposit of $20,000 and Bob's loan of $18,000, this time wearing our accounting hat, so we can look at it from the bank's perspective. Here's how we account for it:
First National Bank of Ceelo
Balance Sheet as of Dec 22, 2020
As you can see, Margie's $20,000 deposit is on the right side, under demand deposits, while the required reserves, as well as Bob's loan of $18,000, is on the left side. Notice that both sides of this balance sheet total $20,000.
Now suppose that Bob has a great year, and he gets the White House as a lawn customer. How awesome is that? Each month he mows the White House lawn, he earns a $100,000 in a paycheck. Wow, that must be a really big lawn. Anyway, Bob takes one of his $100,000 checks and deposits it into the First National Bank of Ceelo. As a result, not only does the bank president take Bob to the Ruth's Sally Steak House, but excess reserves go up by $80,000. What we want to know is: how much is the required reserve ratio? You can probably see already that $20,000 would be left over, and out of $100,000, $20,000 represents 20%. However, it is more tricky when we're not using $100,000 as an example.
So let's look at this one step at a time. To find the answer, remember what excess reserves mean. Excess reserves is money that the bank has available to loan out. In other words, excess reserves are not required reserves.
Here's the formula we need to answer this question:
Required reserves = deposit amount x required reserve ratio
In this situation, required reserves = $100,000 minus $80,000, which is $20,000.
Plugging the numbers we know into the formula gives us:
$20,000 = $100,000 x the required reserve ratio.
Now we solve for the required reserve ratio by dividing each side by $100,000, and get:
$20,000 / $100,000 = required reserve ratio, or 20%.
Let's summarize what we've learned in this lesson. The fractional reserve banking system is a system in which banks hold back a small fraction of their deposits in a reserve and loan out the rest of their deposits to borrowers.
The fractional reserve banking system legally permits banks to hold less than 100% of their deposits as a reserve. The required reserve ratio is the percentage of deposits that banks are required to reserve. To figure out how much a bank has to reserve, you simply multiply the amount of new deposits by the required reserve ratio.
Excess reserves are bank reserves above and beyond the reserve requirement set by a central bank. Excess reserves may be loaned out by the bank in order to generate profits. In the fractional reserve banking system, when a bank lends to a customer, this increases the money supply.
When a customer deposits money into a bank checking or savings account, this demand deposit is considered a liability to the bank, because they owe this money to the customer.
After watching this lesson, you should be ready to:
- Explain how the fractional reserve banking system works
- Define demand deposits, excess reserves and required reserves
- Calculate the required reserve ratio for a bank deposit