Question

Suppose Chemical Bank makes a loan of \(\$ 100,000\) to Mr. Gerard. Mr. Gerard uses the loan to buy a house from Ms. Furey, and Ms. Furey deposits Mr. Gerard's check into her account at Citibank. Show what happens at each stage of this process to the deposit liabilities and the reserves of each of the two banks.

Short answer

When Chemical Bank grants a $100,000 loan to Mr. Gerard, it increases its deposit liabilities by $100,000, with no change to its reserves or Citibank's balance sheet. Mr. Gerard buys a house from Ms. Furey, and she deposits the check into her Citibank account, increasing both Citibank's deposit liabilities and reserves by $100,000. Chemical Bank transfers $100,000 of its reserves to Citibank, decreasing its reserves and increasing Citibank's reserves. Final deposit liabilities and reserves are: Chemical Bank with +$100,000 deposit liabilities and -$100,000 reserves; Citibank with +$100,000 deposit liabilities and +$100,000 reserves.

Step-by-step solution

Granting the Loan to Mr. Gerard

When Chemical Bank grants a loan of \(100,000 to Mr. Gerard, it increases its deposit liabilities by \)100,000. At this stage, the balance sheets of the two banks look like this: Chemical Bank: - Deposit liabilities: +$100,000 (loan given to Mr. Gerard) - Reserves: No change Citibank: - Deposit liabilities: No change - Reserves: No change

Mr. Gerard Buys the House from Ms. Furey

Mr. Gerard uses the loan to buy a house from Ms. Furey. He writes a check for $100,000 and gives it to her. There are no changes in the deposit liabilities and reserves at this stage since the money has not yet been deposited into either bank.

Ms. Furey Deposits the Check into Citibank

Ms. Furey deposits the check of \(100,000 into her account at Citibank. This will increase the deposit liabilities of Citibank by \)100,000. After the check clears, Citibank's reserves will also increase by $100,000. Chemical Bank must now transfer \(100,000 of its reserves to Citibank to cover the check. Chemical Bank's reserves decrease by \)100,000, and Citibank's reserves increase by $100,000. The updated balance sheets are as follows: Chemical Bank: - Deposit liabilities: +$100,000 (loan given to Mr. Gerard) - Reserves: -$100,000 (reserves transferred to Citibank) Citibank: - Deposit liabilities: +$100,000 (Ms. Furey's deposit) - Reserves: +$100,000 (reserves received from Chemical Bank)

Final Deposit Liabilities and Reserves After the Transaction

After all stages of this process, the deposit liabilities and reserves of each bank are as follows: Chemical Bank: - Deposit liabilities: +$100,000 (loan given to Mr. Gerard) - Reserves: -$100,000 (reserves transferred to Citibank) Citibank: - Deposit liabilities: +$100,000 (Ms. Furey's deposit) - Reserves: +$100,000 (reserves received from Chemical Bank)

Key concepts

Loan Granting

When a bank grants a loan, it's essentially creating money within the financial system. This means when Chemical Bank granted a loan of $100,000 to Mr. Gerard, it didn't immediately hand over physical cash. Instead, it increased its deposit liabilities by this amount. This adjustment implies that Chemical Bank considers itself responsible for Mr. Gerard's new potential to withdraw up to $100,000. No physical reserves or cash were moved at this stage. It's an agreement for future possible withdrawals, reflecting in the bank's balance sheet. The process starts a cycle of financial activities that affect multiple banks and accounts.

Deposit Liabilities

Deposit liabilities refer to the total amount a bank owes to its depositors. These are recorded on the bank's balance sheet. When Mr. Gerard deposited his check into Ms. Furey's account at Citibank, it wasn't just a transaction for Ms. Furey's bank account. It also signified Citibank's promise to pay Ms. Furey that amount whenever she decides to withdraw it. Thus, Citibank's deposit liabilities increased by $100,000 at this moment. Deposit liabilities always grow with new deposits, reflecting the amount banks owe to their depositors.

Bank Reserves Transfer

The transfer of bank reserves is crucial. When Ms. Furey's deposit of Mr. Gerard's check increased Citibank's reserves by $100,000, Chemical Bank had to reconcile this by transferring an equivalent amount of reserves to Citibank. Bank reserves are the cash minimums that banks must hold onto rather than lend out or invest. It's what ensures banks can meet depositor withdrawals and other financial obligations. This reserve transfer helps balance the books between banks, ensuring one isn't left without the necessary capacity to handle its new liabilities.

Balance Sheets in Banking

Balance sheets are critical tools, showcasing the financial health of a bank. For both Chemical Bank and Citibank, the balance sheets illustrate their assets, liabilities, and bank reserves. In this example, we've seen how a straightforward transaction alters these sheets.
For Chemical Bank, the initial loan increased its deposit liabilities, but later its reserves decreased when transferred to Citibank. Conversely, Citibank experienced an increase in both deposit liabilities and reserves upon receiving the check and funds from Chemical Bank's reserves.

• Deposit liabilities reflect promises to depositors.
• Reserves ensure liquidity and financial integrity of banks each.

The careful monitoring of these figures ensures banks can operate smoothly, lend money, and provide for their depositors.