Commercial and Central Banking

Commercial and Central Banking

I. Introduction:

Probably the most important industry to any economy is the commercial banking industry. Commercial banks act as financial intermediaries, taking in deposits from one group in society and making loans to another group in society. Most commercial banks are corporations and are therefore in business to make profits. However, because banks are so important to the economy, and because the element of public trust is so crucial to their well being, the banking industry is usually highly regulated by the government. Whenever the public loses confidence in the solvency of a bank, they will rush to the bank and attempt to withdraw their deposited money. We call this a "bank run". If there are widespread bank runs in the economy, there will be a severe recession, with many bankruptcies and rising unemployment. This is precisely what bank regulators want to avoid.

Like all businesses, commercial banks have both assets and liabilities. The major liabilities of commercial banks are the various deposits which they offer to their customers. In Taiwan, these include checking deposits, savings deposits, passbook savings accounts, time deposits, and time saving deposits. Banks can also issue bonds (sometimes called financial bonds) and borrow funds, both of which act as liabilities to the banks. On the asset side of the ledger there are three principal items. These include the reserves of the banks, the securities which they hold, and the various loans which they make to borrowers. The difference between the assets and liabilities of a bank represents its net worth or owners equity.

Commercial banks are important to the economy because they reduce the cost of transactions between savers and investors, and between consumers and producers. They also affect the amount of credit extended to borrowers. Finally, they provide a relatively safe and convenient means for savers to hold their wealth.

II. Asset Management of Banks

In order to earn a profit, banks must carefully manage the asset side of their balance sheet. Naturally, this involves two factors: (1) the amount of resources which the bank has available, and (2) the attitude which the bank has towards risk and return. The amount of resources which the bank has is determined by its capital invested, its retained earnings, and its deposits. The bank must decide how to allocate its resources among its reserves, securities, and loans -- that is, its assets.

A bank's reserves are defined as its vault cash plus its money deposited with the central bank. The central bank acts as a bank for commercial banks. Just as you have a deposit account with a commercial bank, your bank has a deposit account with the central bank. These deposits are called reserves. A bank must keep a minimum amount of reserves on deposit with the central bank. We call these the required reserves. Banks usually keep their total reserves above the required reserve amount. Excess reserves are defined as total reserves minus required reserves. Both excess and required reserves are deposited at the central bank.

Commercial banks do not earn interest on their reserves. Therefore, they will not want to hold a large amount of excess reserves. Required reserves are relatively easy to determine because they are a percentage of the bank's deposits. Each type of deposit will have a required percentage called the required reserve ratio. For example, if saving deposits are $100 and the required reserve ratio for saving deposits is 15%, then the required reserves on such saving deposits is $15. The required reserve ratios are determined by the central bank.

While it is easy to determine required reserves, it is not easy to determine excess reserves. If the outlook for the economy is good, then banks may decide to hold less excess reserves. However, if the economy goes into recession, banks may become more conservative and decide to hold greater excess reserves. Excess reserves can also be affected by changes in interest rates.

Commercial banks can also use their resources to purchase securities. Usually, these securities include government debt, but some countries such as Taiwan allow banks to buy corporate bonds and stock. Private securities often involve greater risk, but they also have greater returns to compensate for this higher risk. In Taiwan, banks often buy T-Bills and CD's issued by the Central Bank of China. They also buy government bonds issued by the Ministry of Finance, the provincial government, and the city governments. These carry little risk of default, but there is still the problem of price risk associated with changes in interest rates.

Commercial banks also earn interest by making loans. These include business loans, mortgage loans, and consumer loans. Consumer loans include credit extended by the bank for credit card purchases. Mortgages are long term loans taken out for the purchase of a house or land. The house or land acts to collateralize the loan. Firms often borrow funds to finance their inventories, and these inventories act to collateralize the loan. Loans which have collateral are called secured loans. Loans which do not have collateral are called unsecured loans. Unsecured loans will have higher interest rates associated with them due to higher risk premiums.

III. The Role of the Central Bank

The central bank of an economy is often called the banker's bank. It accepts deposits from commercial banks (which we call reserves), it buys securities from and sells securities to commercial banks, and it makes loans to banks which are short of funds. Moreover, it facilitates the transfer of funds between banks. The central bank also oversee the operation of banks, and it often helps to stabilize the foreign exchange markets.

The major goals of the central bank are to provide adequate funds to promote stable economic growth and a stable price level. It does this by regulating the amount of loanable reserves in the banking system. The central bank has three major tools which it can use to accomplish its goals. First, it can change the required reserve ratios. This will not change the overall level of reserves, but it will affect the amount of excess reserves that can be loaned out by banks. Second, it can change the interest rate charged banks for loans from the central bank. This interest rate is called the central bank discount rate (sometimes called the rediscount rate). Changes in the discount rate can affect the overall level of reserves in the banking system. Finally, it can buy or sell government securities. When it buys bonds from the banks, this is called an open market purchase. When it sell bonds to banks or the public, this is called an open market sale. We call this kind of buying and selling of securities open market operations. Open market operations can likewise change the overall level of reserves in the banking system. The central bank's monetary policy consists of decisions on how best to use these three tools.

The central bank has a balance sheet, although it is not a corporation. The assets of the central bank consists of foreign exchange reserves, loans to commercial banks, gold, and government bonds. It's liabilities consist of currency, reserves, and securities which it has issued and sold to banks. Economists are particularly concerned with changes in currency and reserves. The sum of these two items is called the monetary base (or high powered money). Small changes in the monetary base can lead to large changes in the money supply, which is defined as currency plus commercial bank deposits. The central bank can use its three tools of monetary policy to affect the level of the monetary base, and thus change the money supply.

IV. Money Supply and Money Demand

Each person in the economy has an amount of wealth. The division of wealth between money and non-money assets is the basic idea underlying the demand for money. When we talk about the demand for money, we are really discussing peoples' decision to hold a certain percentage of their wealth in the form of money.

There are many factors which can affect the demand for money, but usually we consider only two: income and interest rates. If incomes rise, then people will want to spend more of this income. Their demand for money will increase because they need the additional money with which to transact. If interest rates on non-monetary assets increase, then people will reduce their demand for money and will try to hold other assets instead.

In deciding how fast the money supply should grow, the central bank will take into consideration how fast the demand for money is expected to increase. Suppose that the money supply grows faster than the demand for money. Then people will find that they have too much of their wealth in the form of money. They will try to reduce their money holdings by purchasing goods and other assets. This creates an inflation in goods and asset prices. Conversely, if the supply of money grows slower than the demand for money, then the prices on goods and assets will fall. There will be deflation.

Discussion Questions:

#1. What functions do banks serve in the economy?

#2. What is a bank run and what causes it?

#3. What are the assets and liabilities of banks?

#4. What are total, required, and excess reserves?

#5. What are the three tools of monetary policy?

#6. What are the assets and liabilities of the central bank?

#7. What is the demand for money and why is it important to monetary policy?

#8. What is the difference between secured and unsecured loans?