The Banking System and Money Supply

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1Summary 重點摘要

Hong Kong's authorised institutions comprise licensed banks, restricted licence banks and deposit-taking companies; central banking functions are shared by the HKMA and others. Banks create credit by taking deposits and lending: maximum credit creation equals initial excess reserves times the banking multiplier, whose ceiling is one over the reserve ratio.

2Vocabulary cards Vocabulary

3Step by step Steps

1. Step 1: Hong Kong's three-tier banking systemHong Kong's authorised institutions come in three tiers. Licensed banks, the highest tier, offer full banking services including current, savings and time deposits — the banks ordinary people use. Restricted licence banks mainly do merchant banking and capital-market business, taking mostly large deposits. Deposit-taking companies are the smallest tier with stricter limits on deposits. For example, your payroll account sits with a licensed bank; all three tiers are licensed and supervised by the Monetary Authority.
2. Step 2: Functions of a central bankA traditional central bank has five functions: issuing currency and managing the money supply; serving as banker to the government; serving as banker to the banks, settling between banks and providing liquidity at the last moment — the lender of last resort; managing official reserves such as foreign exchange reserves; and supervising the banking system. For example, in a crisis the lender of last resort lends to a bank short of funds, stopping panic from spreading.
3. Step 3: How central banking works in Hong KongHong Kong has no traditional central bank; the functions are shared. The HKMA supervises banks, manages the Exchange Fund (official reserves) and acts as lender of last resort; banknotes are issued by HSBC, Standard Chartered and Bank of China (Hong Kong) under the Monetary Authority's authorisation; government accounts are kept by the Treasury. For example, your thousand-dollar note may carry any one of the three note-issuing banks' names — never write that the HKMA prints the notes.
4. Step 4: Definitions of the money supplyHong Kong's money supply is defined in tiers of liquidity. M1 is currency held by the public (notes and coins) plus customers' demand deposits with licensed banks; M2 is M1 plus customers' savings and time deposits with licensed banks; M3 is M2 plus customers' deposits with restricted licence banks and deposit-taking companies. For example, switching a demand deposit into a time deposit keeps the money inside licensed banks: M1 falls while M2 is unchanged — a classic examination point.
5. Step 5: The process of credit creationCommercial banks create money by taking deposits and lending. They keep reserves at the required reserve ratio and lend the rest; borrowers spend the loans, and the proceeds are deposited back into the banking system as new deposits, which are partly reserved and partly lent again — total deposits expand by a multiple. For example, with a 25 percent ratio and a new deposit of 10,000 dollars, the bank keeps 2,500 and lends 7,500; the recipient deposits it, and 5,625 is lent on, and so on.
6. Step 6: The banking multiplier and maximum credit creationThe banking multiplier equals one over the required reserve ratio (ceiling 1/r), the multiple by which an initial deposit can support total deposits. Maximum total deposits equal the initial deposit times the multiplier; maximum credit creation equals maximum total deposits minus the initial deposit — i.e. initial excess reserves times the multiplier. The syllabus requires only this ceiling formula, with no cash-deposit ratio. For example, at 25 percent the multiplier is 4: a 10,000-dollar deposit supports at most 40,000 of deposits and 30,000 of credit.
7. Step 7: Money demand and the determination of interest ratesMoney demand has two parts. Transactionary demand, for everyday payments, rises mainly with income. Asset demand treats money as an asset and moves inversely with the nominal interest rate, because the rate is the opportunity cost of holding money — the higher the rate, the more interest forgone. In the money market, the intersection of money demand and money supply determines the equilibrium rate. For example, when the rate rises from 1 to 3 percent, holding cash costs more interest forgone, so asset demand for money falls.

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8Recap Recap

• Hong Kong's authorised institutions come in three tiers: licensed banks, restricted licence banks and deposit-taking companies
• Central banking functions are shared by the HKMA, three note-issuing banks, the Treasury and others
• M1 is currency held by the public plus licensed banks' demand deposits; M2 and M3 add time and other institutions' deposits
• The banking multiplier is one over the reserve ratio; maximum credit creation equals initial excess reserves times the multiplier
• The interest rate is set by money demand and supply: income drives transactionary demand, and the nominal rate moves asset demand inversely