We all require the service that banks provide because of the role money plays in today's society. There is arguably no other social construct as important as money, playing an even more pivotal role than race, language and gender norms but to name a few other constructs. Having already discussed banks from the interbank and bank run perspective, this article will discuss fractional reserve banking, and the role it plays in money creation.
Definitions and History
In the past, before the existence of governmental monetary authorities, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit. As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw an opportunity to invest their coin reserves in interest-bearing loans and bills.
A process was started that altered the role of goldsmiths from passive guardians of valuable commodities, charging fees for storage, to interest-paying and interest earning banks. Thus fractional reserve banking was born.
Fractional Reserve Banking(or FRB) entails banks accepting deposits from customers and making loans to borrowers while holding in reserve an amount equal to a fraction of the banks deposit liabilities. In so doing, commercial banks like FNB and Absa create money through a mechanism known as the money multiplier.
The country's central bank (SARS in the case of South Africa) determines the minimum account balance that banks must hold in liquid assets, this minimum amount being called the reserve ratio. Banks usually hold more than the minimum amount, keeping excess reserves. Having provided a definition of FRB, what follows is an example illustrating how this process functions, by focusing on the money multiplier mentioned above.
Money Creation: Example
Suppose that R100 is deposited in a bank with a reserve ration of 20%. The bank will keep R20 of that R100 on reserve and provide R80 to someone who needs a loan. That person spends the R80, and she/he who receives the R80 will deposit that sum in a bank. This bank holds 20% of the R80(which is equal to R16) and lends the remainder just as the first bank did. The process repeats and can be seen in more detail in the table provided below.
Below another graph is given, This particular graph illustrates the importance of the reserve ratio by showing the impact of different reserve ratios. These graphs asymptotically approach the geometric sum which is equal to: original deposit/reserve ratio.
Netlogo Simulation
The example provided above helps in building an understanding or FRB, but fails to provide a wholistic picture because it is static. The final building block that will complete our understanding of FRB is, as was previously, simulation. This time around, we will make use of Netlogo to study the money creation process.
Netlogo is both an integrated development environment and a programmable language used for agent based modelling. As I explained in a previous article, an agent based model is a class of computational models for simulating the actions and interactions of autonomous agents with the view of assessing their effects on the system as a whole. The Netlogo model we will make use of is called Bank Reserves.
The model allows us to set two parameters(without us having to change the code). These parameters are the number of people in our economy, and the reserve ratio. By keeping the people variable constant, we see that there is a negative correlation between the reserve ratio variable and Money-Total. Likewise by keeping reserve ratio constant, we can see that there is a positive correlation between people and Money-Total. If you don't believe me, you should download the modelling software and try experimenting with it yourself. The bank reserves model presented below brings the example we discussed earlier to life.
As the model demonstrates, the amount of money in this simulated economy has a limit, which was explained by the second graph we discussed. Another interesting thing to notice would be that when we increase the reserve ratio to 100, the amount in the economy falls to zero. And this makes sense. If banks hold the full amount that is given to them by depositors, they would not be able to loan out money, as the money multiplier function would not be able to operate under such a reserve ratio regime. We only discussed a few features of the Bank Reserve Model. Other features like the Income Distribution and Wealth Distribution Histogram might be discussed in future articles.
Conclusion
Banking is a fascinating topic which has been discussed in some depth in other articles on this blog. By thoroughly going through the money creation process, I aim to contribute to aiding readers understand how banks functions, which in turn contributes to the conversation that analyses whether banks add to an economy's efficiency, or if they are unnecessary rent-seeking agents. As you can guess, this conversation still requires additional presentations... Complement this article with the following video.
References
Wilensky, U. (1998). NetLogo Bank Reserves model. http://ccl.northwestern.edu/netlogo/models/BankReserves. Center for Connected Learning and Computer-Based Modeling, Northwestern University, Evanston, IL
Wilensky, U. (1999). NetLogo. http://ccl.northwestern.edu/netlogo/. Center for Connected Learning and Computer-Based Modeling, Northwestern University, Evanston, IL.
Fractional Reserve Banking, princeton.edu
Fractional Reserve Banking, wikipedia.com
Agent Based Modelling and The Stock Market, creativeafricanprojects.com
creativeafricanprojects: banking and markets, creativeafricanprojects.com
How peer to peer lending works, fundingknights.com
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