Question

Modern Monetary Theory points out that banks in the real world are not constrained by the level of their deposits but rather by their level overall risk based on their capitalization or "leverage ratio". Suppose a bank balance sheet looked like this with a 5% required reserve ratio. a. How would this balance sheet change if the bank provided a $1,000 loan to one of its depositors who deposited this loan back in the bank? b. What would this do the bank's capitalization or "leverage ratio"? c. Would the bank still be in reserve requirement compliance? One way to get back into compliance would be to sell some of its other investments to raise reserve cash. What would the bank balance sheet than look like? d. Now suppose $1,500 of the bank's $2,000 in loans had to be written off as they were "nonperforming" (borrowers could not pay them back). What would the bank's balance sheet then look like? What would be the bank's net worth? e. What does the balance sheet in d) imply about the relationship between bank created money. leverage, and risk?

Answer 1

In Modern Monetary Theory, banks are not constrained by their deposits, but by their overall risk based on capitalization or leverage ratio. If a bank provides a loan to a depositor who deposits it back, the balance sheet changes. Selling investments can help a bank comply with reserve requirements. Nonperforming loans can decrease a bank's net worth and highlight the relationship between bank-created money, leverage, and risk.

Step-by-step explanation:

According to Modern Monetary Theory (MMT), banks in the real world are not constrained by the level of their deposits but rather by their overall risk based on their capitalization or leverage ratio. Let's address each part of the question:

a. If the bank provides a $1,000 loan to one of its depositors who deposits this loan back in the bank, the balance sheet would change as follows:

• Assets: Loans increase by $1,000
• Liabilities: Deposits increase by $1,000

b. Providing the loan and depositing it back in the bank would not directly affect the bank's capitalization or leverage ratio. However, it could indirectly impact the ratio if the loan becomes nonperforming.

c. If the bank needs to comply with a reserve requirement, it can sell some of its other investments to raise reserve cash. In this case, the bank balance sheet would change as follows:

• Assets: Investments decrease
• Liabilities: Reserves increase

d. If $1,500 of the bank's $2,000 in loans becomes nonperforming and needs to be written off, the bank's balance sheet would change as follows:

• Assets: Loans decrease by $1,500
• Liabilities: Deposits remain the same

The bank's net worth would be calculated by subtracting its liabilities from its assets: Net Worth = Assets - Liabilities = $2,000 - $1,500 = $500

e. The balance sheet in part d implies that there is a relationship between bank-created money, leverage, and risk. When loans become nonperforming, it increases the risk for the bank and can lead to a decrease in net worth. Additionally, leverage, which is the ratio of a bank's loans to its capital, can impact the bank's ability to absorb losses and maintain solvency.