Banking - Class 1

What is the main function of banks in the economy?

Banks are primarily financial intermediaries that take deposits and grant loans, helping to move funds from savers to borrowers.

What are the two main types of money used in the modern financial system?

M0 (Central Bank Money): Currency and bank reserves. M1 (Commercial Bank Money): Deposits (created by banks).

How do banks create money?

Banks create deposit money (M1) when they grant a loan. The loan amount is credited to the borrower's deposit account.

What is the reserve requirement and what is its role?

The reserve requirement is the minimum percentage of deposits a bank must hold as reserves (cash or Central Bank balance). It limits the amount of money a bank can create through lending.

Define the Money Multiplier (M).

The money multiplier is the ratio of the total money supply (M1) to the monetary base (M0). It represents the maximum amount of commercial bank money that can be created per unit of reserves.

What are the three main components on the Assets side of a bank's balance sheet?

1. Reserves (cash/Central Bank balance); 2. Loans (to clients); 3. Securities (e.g., government bonds).

What are the main components on the Liabilities side of a bank's balance sheet?

1. Deposits (client funds); 2. Interbank Liabilities (borrowing from other banks); 3. Owe to Central Bank; 4. Equity (owner's capital, counted as a liability from the bank's perspective).

What is the primary difference between Reserves and Loans on a bank's balance sheet?

Reserves are the most liquid asset (cash, readily available), while Loans are the most illiquid asset, representing future cash flow.

What fundamental imbalance leads to Liquidity Risk for banks?

Banks finance illiquid assets (loans) with liquid liabilities (deposits), making them vulnerable to unexpected and large deposit withdrawals.

If a customer's deposit increases, how does this immediately affect a bank's balance sheet?

Reserves (Asset) increase and Deposits (Liability) increase by the same amount.

If a bank grants a loan, how does this immediately affect its balance sheet (assuming the funds are credited to the borrower's account)?

Loans (Asset) increase and Deposits (Liability) increase by the same amount.

If a customer withdraws cash, how does this affect a bank's balance sheet?

Reserves (Asset) decrease and Deposits (Liability) decrease by the same amount.

What is a liquidity shortfall?

A situation where a bank has insufficient Reserves to meet its immediate payment obligations (like deposit withdrawals or settling interbank liabilities).

List two options a bank can use to manage a liquidity shortfall in the market (not involving the Central Bank).

1. Interbank Borrowing (asking for a short-term loan from another bank). 2. Selling assets (like securities or loans) or using them for Repo agreements.

How does a bank's balance sheet change when it borrows from another bank (Interbank Borrowing)?

Reserves (Asset) increase and Interbank Liability (Liability) increase by the same amount.

What are the potential drawbacks of relying on Interbank Borrowing during a liquidity crisis?

The interbank market can freeze up (banks stop lending to each other) if there are doubts about a bank's solvency, leaving the bank stranded.

List one long-term option a bank can use to prevent future liquidity problems

Issue long-maturity securities (like bonds or equity) or attract more client deposits (e.g., through marketing or higher interest rates).

What is the Discount Window?

It is the facility offered by the Central Bank for commercial banks to borrow cash (reserves), usually when other market options fail.

According to Bagehot's Dictum, how should a Central Bank lend through the discount window?

Lend whatever amount (unlimited money) at a high price (incentive to use the market) against good collateral (to avoid supporting insolvent banks).

Why does the Central Bank charge a high price (interest rate) for discount window borrowing?

To incentivize banks to find a solution in the market first, using the discount window only as a last resort.

Why must banks provide good collateral when borrowing from the Central Bank?

To ensure the Central Bank is not financially supporting insolvent banks (banks whose liabilities exceed their assets)

How does a bank's balance sheet change when it borrows from the Central Bank (using the discount window)?

Reserves (Asset) increase and Owe to Central Bank (Liability) increase by the same amount.

When the Central Bank lends cash to a commercial bank, what kind of money is created?

M0 (Central Bank Money / Monetary Base) is created, specifically in the form of reserves.

What is the difference between a bank that is illiquid and one that is insolvent?

An illiquid bank lacks cash reserves but has positive net worth (Assets > Liabilities). An insolvent bank has a negative net worth (Liabilities > Assets). The Central Bank should only lend to the illiquid bank.

The Banking Union (mentioned in your slides) coordinates work on crisis management. What is a primary goal of this framework?

To ensure the stability of the banking system, often by handling bank failures and coordinating supervision and resolution across member states.