3.3 Banks and the creation of money

Time deposits:Deposits which can be withdrawn from a bank only after a specied

period of time.

Because of the dangers of insufcient liquidity, some monetary authorities impose

a minimum reserve ratio. Where this happens, the ratio is said to be mandatory. In the

UK the ratio is a matter of choice for banks themselves (though the Bank of England

must be informed in advance of any proposed change). In the UK case, therefore,

the ratio is said to be prudential. A glance at Table 3.3 shows that for UK banks as a

whole the ratio of reserves to total liabilities is just over 0.2 per cent (0.17 0.035).

This looks astonishingly (dangerously?) low. But remember that Table 3.3 is the con-

solidated balance sheet for the wholebanking system and we know that banks vary

greatly in their activities.

A mandatory reserve ratio:A ratio of reserves to customer deposits, which banks are

required by lawto maintain.

A prudential reserve ratio:A ratio of reserves to deposits which banks can choose for

themselves in the light of their own experience.

For some banks in the system deposits are only a small proportion of the balance

sheet, and sight deposits (where the risk of unforeseen withdrawal is greatest) are

virtually zero. If we calculate the reserve ratio strictly using deposit liabilities (only) in

the denominator, the ratio rises to 0.3 per cent, and if we calculate it solely on sterling

sight deposits, the ratio jumps to 1.2 per cent. Be that as it may, availability of reserves

couldobviously set a potential limit to the expansion of loans and deposits.

In most monetary systems however, including that of the UK, the quantityof

reserves is not a binding constraint. Reserves can always be obtained from the central

bank, albeit at a price. In section 3.4.1 we look at how the priceof reserves may be

a constraint on monetary expansion and in 3.4.3 we look at why the authorities

do not try to control the quantity. For the moment, we merely wish to see how the

authorities’ creation of reserves permits banks to expand their lending, and deposits

and the money supply.

Box 3.4 sets out a simplied version of the Bank of England’s balance sheet,

following the simplied style that we adopted for commercial banks above.

Box 3.4	The Bank of England’s balance sheet
	Assets	Liabilities

Loans to	commercial banks	CBL	Commercial banks’ deposits	D
		b		b
Loans to	government	CBL	Government deposits	D
		g		g
Holdings	of government debt	B	Notes and coin in circulation	C
		g		p

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Chapter 3 • Deposit-taking institutions

Flows of funds through this balance sheet have very similar effects to those

that we saw with commercial banks. For example, if the central bank extends loans

to its customers, those who receive payments from those customers will nd their

deposits increase. Imagine, for example, that the central bank extends loans to

the government. As the loans are drawn, CBLincreases, but the government makes

g

purchases from the private sector so that Dat the commercial banks must increase

p

by the same amount. When the M4 private sector receives these funds, commercial

banks’ own deposits at the central bank are also credited. The end result (looking

at both sets of balance sheets) reads: CBL(), D(), D(). Notice that Dappears

gpbb

twice: in the commercial banks’ balance sheet (as an asset) and in the central bank’s

balance sheet (as a liability). Notice also that the balance sheets still balance: there

is a () on each side of both balance sheets. Most importantly, notice that commer-

cial bank reserves, D, have increased. Much the same sequence occurs if the central

b

bank lends to commercial banks. As commercial banks draw on the loan facility,

CBLincreases. But this can happen only when banks make payments to someone.

b

Again the recipients must be the M4 private sector (‘the general public’). Thus D

p

increases and the Bank of England credits commercial banks with the corresponding

deposits, D.

b

If the central bank buys government debt (bills or bonds), the ows are different,

but the results are the same: Bincreases by the amount of the purchase. If the debt

g

was bought from banks, then CBLin Box 3.3 falls by the same amount. (The bills

g

and bonds appear under ‘bills’ and ‘investments’ in Table 3.3.) When the central

bank purchases the debt, it credits the commercial banks with funds equal to the

amount of the transaction. Thus, while CBLfalls, Dincreases by the same amount.

gb

(Check again that the two balance sheets still balance. B() and D() expand the

gb

balance sheet at the central bank. L() is offset by D() at the commercial banks.)

gb

Commercial banks have more reserves.

If the government debt is bought from the general public, CBLincreases as before.

g

But this is matched by payments to the M4PS, so Dalso increases. The addition to

b

Dis matched when the central bank credits commercial banks with the amount

b

of the purchase (D). This time then we have: CBL(), D(), D(). Once again,

bgpb

commercial banks have additional reserves.

Notice one further possibility. The central bank can always make additional reserves

available to commercial banks by short-term loans, secured on ‘investments’ held by

the commercial banks. This is done through what is known as a ‘repurchase agreement’

or ‘repo’. This is now common practice, and we explain it in more detail when we

discuss the functioning of money markets in Chapter 5. A repurchase agreement

involves a temporary sale of securities (most probably government bonds) from

commercial banks to the central bank. At the time of sale, both parties make an

agreement that the seller will buy back the securities in the near future at a price

which is more than that of the original sale. The difference is the ‘price’ of the loan.

In Chapter 5 we shall see that this price can be expressed as a rate of interest. In terms

of balance sheets, these events give us: CBL() and D().

bb

Thus, there are many ways in which the central bank can make reserves available

to commercial banks. Remember, we emphasised earlier that in practice central banks

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