201003124 Management of Financial Intermediation, Professor Lee Jang Woo, Week3 , Essential Material

Chapter 3 . The What, How and why of financial Intermediaries.

 1) The Macroeconomic Implications of Fractional Reserve Banking : The Fixed Coefficient Model.

 The Fixed Coefficient Model emphasizes the asset-transformation function of financial intermediaries. The bank’s effort to maximize its profit is captured only implicitly.

 Reserves of the bank + M(The bank’s earning assets) = Deposit liability + Equity

 Moreover, R=r(Requirement rate)X D, with 0 < r ≤ 1.

 The fixed coefficient, r(Requirement rate) , can be interpreted either as a legal reserve requirement or a voluntary behavioral parameter. Actually, it should be interpreted as the greater of the two. In any case, the parameter relates to liquidity or withdrawal risk.

 Equity = e(default risk)X L(loan), with 0<e ≤ 1

 The parameter e can be interpreted as a regulatory capital

 2) An Illustration of the FCM

 We shall further assume a 20 % effective legal reserve requirement(r=0.2). The assumption that e=0 is an extreme representation of the assumption that the capital requirement is not binding.

 Now suppose Bank A receives a $1,000 deposit from Fedral Reserve.

 Bank A = Requirement Reserves 200 + Excess Reserves 800 = 1000 Deposits

 Bank A = Requirement Reserves 200 + Excess Reserves 800 + Loan 800 = 1000 Deposits + 800 deposit

 If the loan to bank B

 Bank B = Required Reserves 160 + Excess Reserves 640 = 800 Deposits

And Bank B now lends away its away it excess reserves, so that :

 Bank C = Required Reserves 128 + Excess Reserves 512 = 640 Deposits

However, the deposit expansion does not affect the level of reserves in the banking system. In fact, deposit expansion absorb reserves.

 The FCM and Monetary Policy

 There are three major tools of monetary policy : 1) open market operations, 2) reserve requirement changes, and 3) discount rate changes

 Open market operations are sales and purchases of government securities by a special committee of the Federal Reserve. This means that the initial open market operation of purchasing Treasuries leads to an increase in lending by banks. The open market operation of selling government securities has the opposite effect.

 Reserve requirement changes affect bank lending. Any increase in reserve requirements will reduce the amount of deposits available for lending, and any reduction in reserve requirements will increase the amount of deposits available for lending.

 Finally, the discount rate, which is the rate charged by the Fed to member banks for short-term borrowings from the Federal Reserve, also affects monetary expansion/contraction. This reduces lending. Likewise, a lowering of the discount rate facilitates increased lending.