Question

Suppose you decide to withdraw $\mathrm{\$}100$ in cash from your checking account. Draw a T-account that shows the effect of this transaction on your bank's balance sheet.

Short answer

After the $100 cash withdrawal, the bank's reserves and the checking deposits, both decrease by $100, this reflects the decrease in the bank's assets and liabilities respectively. The net worth remains the same and the balance sheet remains balanced.

Step-by-step solution

Set up the T-account

Set up the T-account as a simple table divided into three rows and two columns. The top row is for the name of the account, which in this case is 'Bank'. The middle row-left column is for the 'Assets' and the right column is for 'Liabilities'. The bottom row is for the 'Net Worth'.

Showing the effect of the transaction

On the assets side, decrease the 'Reserves' by $100 to show the cash withdrawal. Correspondingly, on the liabilities side, decrease the 'Checking Deposits' by $100. Write these as subtractions in this step as $-\mathrm{\$}100$ under 'Reserves' and 'Checking Deposits'.

Balancing the T-account

After completing the transaction, check if the T-account sums up to the same on both sides - 'Assets' and 'Liabilities + Net Worth'. Having the bank's assets equal to the bank's liabilities plus the bank's net worth means that the T-account is balanced and the transaction is valid.

Key concepts

Balance Sheet

In understanding the relationship between a bank's transactions and its financial position, the balance sheet plays a foundational role. A balance sheet is a financial statement that provides a snapshot of an entity's financial standing at a specific point in time. It is comprised of three main elements: assets, liabilities, and shareholders' equity.

For a bank, the assets include cash on hand, which is known as reserves, loans made to customers, and securities. Liabilities cover what the bank owes to others, such as customers' checking and savings deposits, and any debt it may have incurred. Shareholders' equity represents the net worth, which is the amount by which assets exceed liabilities.

When a customer withdraws cash, as in the exercise, the bank's balance sheet reflects this by a reduction in its assets—in this case, a decrease in reserves—and a simultaneous reduction in its liabilities through a decrease in checking deposits. The essence of the T-account exercise is about ensuring that the balance sheet remains balanced, meaning that the total assets equal the sum of total liabilities and the shareholders' equity after the transaction is complete.

Bank Reserves

Bank reserves are a vital component of a bank's financial health and regulatory compliance. They are the portion of depositors' balances that banks must hold on hand and not lend out or invest—essentially, the cash stored in the bank's vault or held at the central bank.

The purpose of reserves is multifaceted: they provide liquidity to meet the withdrawal needs of customers, such as the $100 withdrawal described in our exercise, they act as a buffer in times of financial strain, and they are also a regulatory requirement set by central banks to ensure systemic stability.

Central Bank's Influence on Reserves

Central banks, like the Federal Reserve in the United States, set reserve requirements, influencing how much cash a bank must keep relative to its deposit liabilities. This transaction of withdrawing cash directly depletes the bank's reserves, reflecting a lesser ability to further lend and a change in its immediate liquidity position.

Checking Deposits

Checking deposits account for money that customers have placed in the bank for safekeeping and everyday use. They are a bank's primary form of liability because the bank is obliged to return these funds on demand. When customers write checks or withdraw cash, they are drawing on these deposits.

In the context of the T-account, withdrawing cash reduces the checking deposit balance, as the bank hands over physical currency to the customer. This reduction is recorded as a debit in the bank's T-account, and is a direct decrease in the bank's liabilities, as they now owe less money to their depositors.

Impact on Money Supply

Checking deposits are also a critical part of the money supply in the economy since they are used for transactions. When customers withdraw money, this becomes part of the currency in circulation, while the remaining deposits contribute to the overall money supply through what is known as the money multiplier effect.