The financial system and the creation of money

Explain what the financial system is and who its main participants are. What role does it play in the economy by connecting them with one another?

What is bought and sold in financial markets? Distinguish, at a basic level, between a share (a piece of ownership of a company) and a bond (a loan you make to whoever issues it): who pays you and what risk do you take on in each case?

Distinguish between cash and bank money. When you pay by card, what type of money do you use and where does that money "exist"?

A bank receives $1.000\ \text{€}$ in deposits and, by law, is only required to keep $10\ \%$ in reserves.

1. a) How much does it keep in reserve and how much can it lend?
2. b) Explain why the bank does not keep all the money in reserve: what would it gain and what would it lose?

From the bank's point of view, your account is a debt: the bank owes you that money. Explain the difference between a deposit (a liability of the bank) and a loan the bank grants (an asset of the bank), and why the bank profits from the difference between what it pays on one and what it charges on the other.

With a reserve ratio of $10\ \%$, an initial deposit of $2.000\ \text{€}$ can end up creating up to $20.000\ \text{€}$ of bank money.

1. a) Calculate the money multiplier ($1$ divided by the reserve ratio) and check the final figure.
2. b) Explain step by step how this multiplication occurs: who deposits, who lends, and who redeposits.

With a reserve ratio of $5\ \%$, an initial deposit of $5.000\ \text{€}$ can, in theory, turn into much more bank money.

1. a) Calculate the money multiplier and the maximum amount of bank money it can give rise to.
2. b) What assumptions does that model make (all the money returns to the banks, banks lend out everything they can, there is demand for credit)? Reason why the real multiplier is smaller.

The central bank carries out a liquidity injection of 500 million euros through the purchase of government bonds from commercial banks. The minimum reserve requirement set by the monetary authority is 2 % (0,02). However, the economy is going through a recession with high uncertainty:

• Commercial banks decide to retain an additional 8 % of deposits as voluntary excess reserves as a precaution against potential defaults.

• Individuals and firms decide to hold the equivalent of 10 % of their bank deposits in cash.

1. a) Calculate the theoretical potential money multiplier (assuming there is no cash drain or voluntary reserves) and compare it with the effective multiplier that occurs under the actual behaviour described.
2. b) An analyst states on television: «The central bank has injected 500 million; therefore, banks are going to flood households with credit and will multiply the money supply fiftyfold immediately». Technically refute this statement using the calculations from the previous section and distinguishing between the supply of credit and the creditworthy demand for it.
3. c) Predict what would happen to the money supply and inflation risk if the economy suddenly regains confidence and both banks and households reduce their excess reserves and cash holdings to a minimum.

Explain what the European Central Bank is and how it differs from a local commercial bank. Mention at least two functions that only the central bank performs.

The European Central Bank lowers its interest rates to almost zero.

1. a) What is it trying to achieve with that decision?
2. b) Describe the transmission chain to the real economy: from the official rate to the rates on bank loans, and from there to the decision of an SME wondering whether to buy a new van.

"If a bank knows the State will rescue it because it is too big to fail, it will tend to take more risks."

1. a) Explain the reasoning (moral hazard): who wins if the bet goes well and who pays if it goes wrong?
2. b) What do regulators do to prevent this (requiring more capital, supervision, orderly resolution plans)? Explain how each measure works.

What is the Deposit Guarantee Fund and up to what amount does it cover per account holder and bank in Spain ($100.000\ \text{€}$)? Explain why the existence of that guarantee means customers do not rush to withdraw their money when a rumour of a banking crisis spreads.

The commercial bank «Banco Sureste» presents the following simplified balance sheet:

• Assets: Liquid cash reserves and central bank deposits: 10 million euros; Mortgage loans and corporate loans maturing in 15 years: 90 million euros.

• Liabilities and Equity: Demand deposits of its clients: 85 million euros; Equity capital contributed by shareholders: 15 million euros.

1. a) Following a piece of fake news that goes viral on social media, clients arrive to withdraw 18 million euros within 24 hours. Prove numerically whether the bank faces a liquidity problem, a solvency problem, or both at that moment.
2. b) A parliamentary group proposes: «To end bank runs forever, let us require banks by law to keep a 100 % reserve requirement, keeping all deposit money in a safe». Economically refute this proposal by analysing its impact on the creation of bank money, on credit available for productive investment, and on the account maintenance costs for households.
3. c) If the central bank decides to act as a «lender of last resort» to bail out this institution, under what prior balance sheet requirement must it do so and what «moral hazard» problem would be generated if it bailed out banks that are genuinely insolvent?

The simplified balance sheet of «InmoBank» before a crisis is as follows:

• Assets: 20 million euros in government debt securities and 80 million euros in loans to real estate developers.

• Liabilities: 70 million in deposits from small savers (all below €100 000) and 15 million in bonds issued by the bank held by institutional investors.

• Equity: 15 million in own funds contributed by shareholders.

A drop in land prices causes the recoverable value of loans to developers to fall by 25% (20 million euros are lost all at once).

1. a) Reconstruct the balance sheet after recording this loss: calculate the new Equity and determine whether the bank is solvent or technically bankrupt.
2. b) To resolve the situation, two alternatives are considered:

1) External bailout with public money («bail-out»): the State injects the missing 20 million euros.

2) Internal resolution («bail-in», under the European directive): absorption of losses by the bank's own creditors.

Determine exactly which investors would lose their money in the «bail-in» option, respecting the legal order of priority (shareholders, bondholders, depositors), and compare both approaches from the perspective of public deficit and moral hazard.

1. c) Why does the existence of the Deposit Guarantee Fund (up to €100 000) curb panic among small depositors, but cannot on its own clean up the losses of the institution's assets?