Banks use leverage by borrowing money from depositors and other lenders to fund loans and other assets. This allows banks to earn profits on amounts much larger than the capital invested by its owners. However, it also subjects the owners to greater risk if asset values decline. Central banks like SAMA can influence the money supply through three main tools: open market operations, the discount or official repo rate, and required reserve ratios. Lowering the reserve ratio increases the money multiplier and thus the money supply. Deposit insurance aims to prevent bank runs but may also encourage banks to take on more risk.

1. Chapter 30
Part 2
The Monetary System

2. Bank Capital
The money the bank’s
shareholders have put in
to the bank

3. Leverage
OPM
Using other people’s
money

4. Leverage
1. I have 10
2. I borrow 90 from you
3. I buy something for 100
4. I resell the item for 150
5. I pay back your 90
6. I keep the 60
7. I earned 50 profit on my 10

5. Leverage Ratio
The ratio of assets to
bank capital
Assets
Bank Capital

6. Bank Balance Sheet
Assets
Liabilities and
Owner Equity
Reserves 200 Deposits 800
Loans 700 Debt 150
Securities 100 Capital 50
Total 1000 Total 1000
Totals must balance or be equal

7. What is the leverage ratio?
Assets
Liabilities and
Owner Equity
Reserves 200 Deposits 950
Loans 800 Capital 50
Total 1000 Total 1000
Assets ÷ Capital
1000 ÷ 50 = 20

8. Leverage Ratio of 20
Owners put up 1
Depositors put up 19

9. Leverage is Risky!
If leverage ratio is 20,
5% increase in asset value
= 100% return to owners
5% decrease in asset value
= 100% loss to owners

10. Capital Requirement
Government rule on
minimum amount of
bank capital

11. Insolvent
Liabilities are more than
the assets
You owe more
than you own

12. Three Tools
of Central Banks
Open-Market Operations
Discount Rate
Reserve Ratio

13. Open-Market Operations
Purchase and sale of
government bonds
Buy bonds increases supply
Sell bonds decreases supply

14. Banks
now have
more cash to
loan
Central Bank
Public Banks
Increase Money Supply?
Buy bonds for cash

15. Banks
now have less
cash to loan
Central Bank
Public Banks
Decrease Money Supply?
Sell bonds for cash

16. Discount Rate
The rate the central bank
charges to make loans to
member banks
Called the Official Repo Rate
or ORR rate in Saudi Arabia

17. Official Repurchase Rate
or Discount Rate
2.0%
Dropped from 2.5% on
January 19, 2009

18. SAMA Official Repo Rate
Dropped from
5.5% October 2008
to 2.0% by January 2009
3 month period of
global financial crisis
Rate increased
as economy
heated up

19. Reserve Ratio
Increase reserve ratio will
reduce money multiplier
Decrease reserve ratio will
increase money multiplier

20. 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1 2 4 6 8 10 12 14 16 18 20
Reserve
Ratio
Money Multiplier
The Power of the Reserve Ratio to Multiply Money

21. Reserve Ratio
Not changed very often
What is the current reserve
ratio in Saudi Arabia? 7%
What is the Money Multiplier?
1÷7% = 14.28

22. Bank Deposit Insurance
Protects against bank runs
Moral Hazard to take more
risk because government
will pick up losses

24. Bank Run
Customers all want their
money at the same time
Many banks runs at once
Bank Panic

25. Quiz 5 Name______________ ID_________
1.What is financial leverage?
2. How do you calculate a bank’s leverage?
3.What are the three tools that SAMA can use to manage the money supply?
4. If SAMA buys bonds, what happens to the money supply?
5. If SAMA lowers the ORR what happens to the money supply?
6. If SAMA lowers the reserve requirement what happens to the money supply?
7. Does deposit insurance make bankers more or less risky?

27. Zimbabwe, Nov. 2008 Highest monthly inflation: 79,600,000,000%
Prices doubled every: 24.7 hours

35. The Meaning of Money
Three Functions of Money
Medium of Exchange
Unit of Account
Store ofValue
Two Kinds of Money
Commodity
Fiat
Money in the Economy
Currency
Demand Deposits
Central Banks
SAMA
Banks and the Money Supply
100-Percent Reserve Banking
Fractional-Reserve Banking
Reserve Ratio
Money Multiplier
Leverage
Capital Requirement
Tools of Monetary Control
Open-Market Operations
Discount Rate - ORR
Reserve Ratio
Bank Runs and Deposit Insurance