The origin of the banking system emerges in two functions
(1) money changes
it
becomes convenient for money exchangers to accumulate a lot of coins
denominated in different currencies and then they started the warehouse
bank (it is more convenient for them to set up a place to change the money)
(2) payment system
save keeping and protect people's asset
Warehouse banks (100% reserve "banks")----custodian of savers
Assets Liabilities
gold 200$ Rachel 10$
Mike 10$
Other 180$
in this case, the warehouse bank is the bailee of the savers
there is no liability for warehouse to depositors
How for warehouse bank to make money? Charge a rent
The origin of fractional reserve banks
The money deposited there is never all withdrawn. Huge cost for all money to stay in the warehouse.
What makes fractional reserve banks feasible
(1) money is fungible
(2) law of large number
Fractional reserve banks
Asset Liabilities
gold 40$ Rachel 10$
loans 160$ Michael 10$
others 180$
the bank becomes a debtor to lenders, and savers are now investors
Banks make profits from this system and thus they begin to look for more depositors. Interest payment on deposits emerges. The effective money supply increases. When banks are able to loan out, depositors become more valuable to them.
The emerge of fractional reserve banking system creates a synergy between having banks serve only as places to execute payments and as places where intermediation process to happen. The reason is that the deposited funds that are not needed as reserves and possibly be lent out.
The synergy makes the financial system unstable. That is the reason why it needs to be regulated.
Some people may say that fractional reserve bank is fraudulent, when would that be true?
Answer: when depositors are led to believe that banks do hold all of their money.
Why would people put money in fractional reserve banks?
Answer: they get benefit (interest on their depositors, or free checks. Both of these are possible only when the banks are fractional.
Innovation in the payment system:
At first the reserve ratio is high, because every time a person wants to execute a payment, he goes to the bank and withdraw the deposits.
How to discourage the withdrawn? The creation of the money itself by the banks
(1) bank notes
anybody who has them can get base money at anywhere that accepts them
issued by the bank, payable to the bearer
(2) checks (demand deposit)
Two people who have accounts in the same bank. Person A write a check to order the bank to move a certain amount of money to B's account.
They are called bank money or inside money. They are used to reduce the reliance on species of payment, and they only work when people accept them. When they are widely accepted, they can become money.
How do they improve the efficiency of the payment system?
Before we had inside money, it is really costly to engage in transaction.
For example:
Rachel sells chairs, Mike wants to buy it. Mike goes to bank with his deposit slip to get money. Then he gives money to Rachel for the chair. Then Rachel goes to bank to deposit the money.
Bank's sheet
Assets Liabilities
gold - 10 Mike - 10
gold +10 Rachel +10
net=0 net = 0
One way to make it cheaper is to let them meet in the bank. It can lower the transaction cost.
If Mike gives Rachel a check, and Rachel goes to the bank, transaction is even lower.
But Rachel still has to go to the bank!
Electronic funds transfer (telegraph and electronic devices)
Bank money are not feasible without fractional reserve banks system
For payment by account transfer, FRB offers a more economic way of
providing payment services. A money warehouse or 100% reserve
institution could also offer payments by account transfer, but its
services would be significantly more expensive. The other bank payment
instrument, redeemable banknotes circulating in round denominations,
simply cannot exist without fractional reserves. Banknotes are feasible
for a fractional-reserve bank because the bank doesn’t need to assess
storage fees to cover its costs. It can let the notes can circulate
anonymously and at face value, unencumbered by fees, and cover its costs
by interest income. An issuer of circulating 100% reserve notes would
need to assess storage fees on someone, but would be unable to assess
them on unknown note-holders. There are no known historical examples of
circulating 100% reserve notes unemcumbered by storage fees
Loans are still given out as actual coins rather than bank notes. Why?
A lot of loans are given out to merchants that trade all around the world, and foreign bankers may not accept the bank notes.
Fractional reserve bank expand money supply. (loaning in the form of notes and checks expand the money supply)
A L
gold 0 R 10
loan 200 M 10
Other 180
i= 10%
profit 20$ peryear
A L
gold 40 R 5
loan 160 M 5
new loans O 90
100000 note $100
new loans 100000
If you can convince people not to come to bank, you can issue bank notes to make profits. (Inflation can occur) Overconfidence in financial industry can lead to high price level
Bank can create bank note (private money), or issue new loans
(google that)
Difference between checks and notes
Notes are payable to anyone who bears it, checks are payable to the person whose name is on it.
Risks with checks
(1) does the person who wrote you the check have that amount of money in his account? (Creditor risk)
(2) even if the person who writes the check has the money, does the bank have that amount of money? (Institutional risk)
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