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      Commercial Banking as a deposit financial institutions not only serve as saving intermediary in the flow of funds from surplus spending units to deficit spending units but also offer transaction deposits (unlimited check-writing deposits) which are used as a medium of exchange. This chapter investigates the creation of transaction deposits by deposit intermediaries, theories of asset and liability management for commercial banks, and the regulatory environment for commercial banks. The discussion focuses on commercial banks because of their historical role as the principal issuers of check-writing deposits.





      The definition of M1 money is currency and transaction deposits (check-writing deposits). A check-writing deposit [demand deposit, NOW account, ATS account, or a credit union share draft (CUSD) account] permits the owner of a deposit to transfer funds to another party through check writing or wire transfer. Because currency is a bearer instrument, check writing is a safer medium of exchange, with the result that transaction deposits in the United States are about three times that of currency outstanding.


Example 1.  Funds in transaction deposit can be transferred from one party to another by writing a check. By issuing a check payable to corporation Z for $100, individual A instructs the commercial bank to transfer $100 from A’s transaction account to corporation Z. Corporation Z, upon receiving the check, endorses it and deposits it in the commercial banking system; when the check has cleared, the accounts of individual A and corporation Z appear as follows:



                    ∆ Assets                                                                                                      ∆ Liabilities 


Transaction deposit of

individual A                                   -$100

Transaction deposit of

corporation Z                                 +$100



      Because transaction deposits are a safer medium of exchange for large transactions, deficit spending units prefer receiving a credit to their transaction account rather than currency when borrowing from a deposit intermediary. Deposit financial intermediaries therefore normally create a medium-of-exchange balance (a transaction deposit) when lending (example 2). Because the quantity of M1 affects the level of employment and prices, the money-creating ability of deposit intermediaries is regulated by the Federal Reserve.


Example 2. Suppose corporation A approaches commercial bank D for a $500,000 loan. The application is approved by commercial bank D, and corporation A’s transaction deposit (e.g., A’s demand deposit account with D) is credited $500,000. The T-account entries for these transactions appear below. Note that as a result of the loan commercial bank D’s assets (loans) and liabilities (transaction deposits) have increased; D has not parted with an asset in lending but rather has created a liability.



                    ∆ Assets                                                                                                      ∆ Liabilities 

Loan to corporation A        +$500,000

Transaction deposits               +$500,000




                    ∆ Assets                                                                                                      ∆ Liabilities 

Transaction deposits           +$500,000

Loan from commercial

bank D                                     +$500,000






      The Federal Reserve regulates transaction deposits by imposing  a reserve requirement on transaction balances and by controlling the volume of reserves held by deposit intermediaries. The Federal Reserve, imposing a reserve requirement on transaction deposits, specifies that deposit intermediaries must keep a minimum ratio between designated assets, currency plus deposits at the Federal Reserve, and the bank’s transaction deposits. A 0.12 reserve requirement on transaction deposits requires that a deposit intermediary hold $0.12 in cash items (currency plus deposits at the Federal Reserve) for each $1.00 in a transaction deposit liability. Because the Federal Reserve fines intermediaries not meeting the reserve requirement, some deposit intermediaries hold excess reserves. Excess reserves exist when reserve assets held exceed those that are required.


Example 3. Suppose commercial bank D has the following balance sheet, currency plus deposits at the Federal Reserve is the reserve asset, 0.20 is the reserve requirement on transaction deposits, and there is no reserve requirement on savings deposits. The reserves of commercial bank D equal $100,000,000, and $84,000,000 is the amount of reserves it is required to hold because of $420,000,000 in transaction deposits [(0.20)$420,000,000 = $84,000,000]. Commercial bank D has $16,000,000 in excess reserves; i.e., reserves held ($100,000,000) exceed those required ($84,000,000).



               Assets                                                                                           Liabilities + Net Worth

Currency                             $100,000,000

Government securities            50,000,000

Loans                                    300,000,000

Other investments                125,000,000     

Fixed assets                            20,000,000


Total assets                        $595,000,000

Transaction deposits           $420,000,000

Savings and time deposits    100,000,000

Net worth                                75,000,000




Liabilities + net worth         $595,000,000








      It is generally assumed that deposit intermediaries seek to maximize profits. Because cash items (currency plus deposits at the Federal Reserve) earn no interest income, deposit intermediaries expand transaction deposit liabilities when they have excess reserves (example 4). It is highly probable, though, that newly created transaction deposits will be transferred to someone whose account is in another deposit intermediary. Since transaction balances are transferred from one bank to another through reserves, transaction deposit creation will most likely result in a reserve loss. Loans are made even though reserves may be lost because earning assets replace nonearning assets (reserves). But, because reserves may be transferred to another bank in lending, the amount of the loan should not exceed the deposit intermediary’s holdings of excess reserves.


Example 4. Commercial bank D in example 3 has $16,000,000 in excess reserves. Currency (reserves) generates no interest return. If the average annual return on loans is 12 percent, commercial bank D increases its annual interest income $1,920,000 by expanding loans and transaction deposits $16,000,000 [(0.12)$16,000,000 = $1,920,000].


Example 5. Suppose that (a) the reserve requirement on transaction deposits is 0.20; (b) currency and deposits at the Federal Reserve are the designated reserve asset; and (c) deposit intermediaries do not wish to hold excess reserves. Suppose further that (1) individual A makes a $1,000 currency deposit in commercial bank D; (2) commercial bank D lends $800 (a sum equal to its excess reserves) to individual B; (3) Individual B pays for an $800 purchase of goods from the ABC Corporation with a check drawn on commercial bank D; (4) the ABC Corporation deposits B’s check in commercial bank E, where ABC has its account; (5) in the check-clearing process, commercial bank D transfers $800 of its reserves to commercial bank E.

      Transactions (1) through (5) are presented in the T accounts below. Note that, as a result of the outflow of newly created transaction deposits, commercial bank D no longer has excess reserves; it has substituted an earning asset (loan +$800) for its excess reserves (currency -$800).




                   ∆ Assets                                                                                                      ∆ Liabilities 

(1)  Currency                           -$1,000

(1)  Transaction deposit          +$1,000





                     ∆ Assets                                                                                                      ∆ Liabilities 

(1)  Currency (reserves)         +$1,000

(2)  Loans                               +$   800

(3)  Currency (reserves)          -$   800

(1)  Transaction deposit               +$1,000

(2)  Transaction deposit               +$   800

(3)  Transaction deposit                -$   800




                     ∆ Assets                                                                                                      ∆ Liabilities 

(2)  Transaction deposit            +$800

(3)  Transaction deposit             -$800

(3)  Goods                                 +$800

(2)  Loan from commercial

       bank D                                    +$800





                     ∆ Assets                                                                                                      ∆ Liabilities 

(3)  Goods                                 -$800

(3)  Check from individual B   +$800

(4)  Check from individual B    -$800

(4)  Transaction deposit at

      commercial bank E             +$800




                     ∆ Assets                                                                                                      ∆ Liabilities 

(4)  Check drawn on

       commercial bank D           +$800

(5)  Check drawn on

       commercial bank D            -$800

(5)  Currency (reserves)           +$800

(4)  Transaction deposit

      of ABC                                   +$800






      Through the deposit-creating activity of each deposit intermediary, transaction deposit expansion for the banking system is a multiple of any increase in reserve (example 6). When it is viewed in the aggregate and it is assumed that deposit intermediaries hold no excess reserves ΔR, where d is the reciprocal of the reserve requirement 1/r. That is, ΔD = d ΔR. (See Example 7).


Example 6. Assume that banks expand loans and transaction deposits by the amount of excess reserves held. Continue the situation in Example 5 where commercial bank D (a) receives $1,000 in reserves, (b) increases loans and transaction deposits $800, and (c) loses $800 in reserves to commercial bank E because the ABC Corporation has its deposit account with commercial bank E. Suppose further that (1) commercial bank E increases its loans $640 as a result of the receipt of $800 in reserves from commercial bank D; (2) the $640 transaction deposit created in (1) is transferred to commercial bank F as a result of check writing; (3) commercial bank F increases loans and transaction deposits $512 upon the receipt of $640 in reserves; (4) the $512 transaction deposit created in (3) is transferred to commercial bank G; (5) commercial bank G with a $512 increase in reserves expands loans and transaction deposits $409.60; (6) the $409.60 transaction deposit created in (5) is transferred to commercial bank H; (7) commercial bank H with a $409.60 increase in reserves expands loans and transaction deposits $327.68; and (8) the $327.68 transaction deposit created in (7) is transferred to commercial bank I. These transactions result in a net change in transaction deposits for commercial banks D through H of $3,361.60 (see Table-1). Note that the $1,000 increase in reserves is dispersed throughout the banking system, and the increase in transaction deposits (the sum of the net increase in transaction deposit of commercial banks D through H) is a multiple of the $1,000 increase in reserves.




Net Change in Transaction Deposit

Commercial Bank D

Commercial Bank E

Commercial Bank F

Commercial Bank G

Commercial Bank H



       640.00 Color






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