Exercises: The financial system and money creation

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?

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 $\text{€}\ 1,000$ 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.

What is the Deposit Guarantee Scheme and up to what amount does it cover per account holder and bank in Ireland ($€100,000$)? Explain why the existence of that guarantee means customers do not rush to withdraw their money when a rumour of a banking crisis spreads.

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?

What is the reserve ratio (the share of deposits that the bank must keep liquid)? Explain what that legal requirement exists for and what would happen if it were $0\ \%$.

"Banks lend out their depositors' money." Explain why that is legal and useful for the economy (it finances homes and businesses), and reason what would happen to credit and activity if banks were required to keep all deposits without lending them out.

With a reserve ratio of $10\ \%$, an initial deposit of $\text{€}\ 2,000$ can end up creating up to $\text{€}\ 20,000$ 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.

The figure shows the bank money creation chain: Aoife deposits, the bank lends to Seán, Seán pays Niamh, and Niamh deposits again.

1. a) Identify at what point new money is "created" and who creates it.
2. b) What would happen to the chain if Niamh kept the banknotes under her mattress? Justify your answer.

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.

With a reserve ratio of $5\ \%$, an initial deposit of $\text{€}\ 5,000$ 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.

A bank's simplified balance sheet is: customer deposits $8,000$, own funds (equity) $2,000$, cash in reserve $1,000$ and loans granted $9,000$.

1. a) Explain why the bank cannot return all the deposits at once even though it is solvent.
2. b) If $20\ \%$ of the loans are not repaid, how much does the bank lose and who absorbs that loss first (own funds, shareholders, depositors)? Reason about the importance of the bank's capital.

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.

A $\text{€}\ 20$ note is just paper, but everyone accepts it as if it were worth $\text{€}\ 20$.

1. a) Explain what fiat money is and what its value is based on (trust and general acceptance, the backing of the monetary authority).
2. b) What happens when that trust breaks down (historical hyperinflation, restrictions on withdrawing deposits)? Describe the consequences for daily life.

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?

In an economy, mortgage credit granted by banks is growing at a rate of 14 % per year, housing prices are rising by 11 % year-on-year, and headline consumer inflation stands at 2.1 %, very close to the central bank's target.

1. a) Explain the procyclical feedback loop: how do rising property prices increase borrowers' collateral, what role does the creation of bank money play in this process, and why do financial institutions not curb lending on their own initiative?
2. b) Faced with this situation, the central bank hesitates between two measures:

1) Raising policy interest rates by 250 basis points (2.5 percentage points).

2) Keeping interest rates stable and imposing macroprudential measures on banks: capping the loan-to-value (LTV) ratio at a maximum of 70 % of the appraised value and requiring an additional countercyclical capital buffer of 2.5 %.

Predict and justify the asymmetric effects of both options on: households that already hold a variable-rate mortgage, young people seeking to access their first home, and non-real estate industrial companies.

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.

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?

During several years of stagnation, the European Central Bank implemented massive bond purchases in the secondary market (quantitative easing or QE), acquiring public and corporate debt worth trillions of euros.

1. a) Trace in detail the economic transmission chain of QE: how does the central bank ensure that buying bonds in financial markets translates into lower financing costs for an SME applying for a loan or for a family taking out a mortgage?
2. b) Analyze the distributive effect of this policy: while interest rates remained at 0%, the price of stock market shares and housing in large cities rose sharply, whereas the real wages of middle- and low-income workers stagnated. Justify the causal relationship between the massive purchase of financial assets and the increase in wealth inequality.
3. c) Predict what dilemma the central bank faces when inflation skyrockets to 8% and it must implement quantitative tightening (selling bonds and raising rates) in an environment where several Member States have a public debt exceeding 110% of their GDP.

Two commercial banks operate with an identical volume of total assets (1 000 million euros each), but with different financial structures:

• Banco Prudente: Own funds (shareholders' equity) = 120 million euros; Total debt liabilities (deposits and debt) = 880 million euros.

• Banco Palanca: Own funds = 30 million euros; Total debt liabilities = 970 million euros.

1. a) In a year of economic expansion, both banks obtain a net return of 2% on their total assets (20 million euros net). Calculate the financial return for shareholders (ROE = Profit / Own funds) for each institution. Based on the result, justify why the free market creates perverse incentives for bank managers to reduce capital to a minimum in the absence of regulation.
2. b) Suppose a crisis strikes and both banks suffer defaults that reduce the real value of their assets by 4% (a loss of 40 million euros). Numerically demonstrate what happens to each bank's Equity and explain who would bear the financial loss in each case if the institutions had to be liquidated.
3. c) Analyze the regulatory dilemma («trade-off»): if requiring high capital levels provides maximum stability and protects the taxpayer, what negative side effects does it cause on the total volume of credit granted and on the financing costs of firms?

An innovative SME needs €150 000 to expand its facilities. Its long-standing bank denies the loan, claiming that it lacks sufficient mortgage collateral. The company then turns to a digital crowdfunding platform («crowdlending»), where 300 individuals contribute €500 each in exchange for an agreed annual interest rate of 8.0%, assessed using a predictive creditworthiness algorithm.

1. a) Compare the position of the individual saver who places €500 in this loan with that of someone who deposits that same €500 in a fixed-term deposit at a bank at 2.5% per annum. Analyze the key differences in terms of expected return, immediate liquidity, and legal protection in the event of the debtor's bankruptcy.
2. b) If millions of similar transactions begin to take place off the balance sheets of traditional banks (in the so-called shadow banking system), predict what difficulties the central bank will face in cooling down or stimulating aggregate demand through the control of official interest rates and reserve requirements.
3. c) Design two proportionate regulatory requirements that financial authorities (such as the CNMV) should impose on these digital platforms to protect small retail investors without stifling technological innovation or restricting access to funding for SMEs that cannot secure traditional bank credit.

Analyze and compare the functioning of two alternative banking models under the same macroeconomic scenario:

• Model 1 (100% Reserve Banking): Banks act as custodians of demand deposits, charging maintenance fees and with no possibility of lending them out. Loans to businesses can only be granted using funds from fixed-term savings previously locked in by clients who accept the risk without early withdrawal.

• Model 2 (Conventional Fractional-Reserve Banking): Banks maintain only a 1% legal reserve requirement on demand deposits and create bank money by lending the rest over the long term.

1. a) Predict how the implementation of Model 1 would affect the speed of economic growth, the cost of credit for new business investments, and the capacity for maturity transformation (short-term savings converted into long-term productive investment) compared to Model 2 during a period of stability.
2. b) Suppose a military conflict breaks out, driving up energy prices and triggering widespread mistrust. Explain why Model 2 is vulnerable to a violent credit contraction and a deleveraging spiral with a bank run, while Model 1 remains immune to bank runs.
3. c) In light of both extremes, evaluate the current tools of the Basel III international framework (countercyclical capital buffers, short-term LCR liquidity ratios, and stress tests). Justify whether these rules manage to preserve the money-creating dynamism of Model 2 while minimizing the risk of systemic contagion.