Description                                  
The narrator examines the relationship between a bank's assets, liabilities, and net worth. The reserve requirement ratio that a bank is required to hold is also discussed. 

Narrator: 
When Marge decides she must expand her restaurant she is faced with the prospect of borrowing money from a commercial bank. 

Narrator: 
Commercial banks are financial intermediaries, which indirectly link savers in the economy to borrowers. A commercial bank's balance sheet shows the relationships between its assets, liabilities and net worth. 

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The sum total of all bank assets must be equal to the sum total of all liabilities plus its net worth. Bank assets usually include items such as loans, government securities and cash reserves. 

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Liabilities include checkable deposits, time deposits and large CD's. 

Narrator: 
Net worth is just another name for owner's equity or capital and is the difference between the bank's assets and liabilities. 

Narrator: 
Commercial banks typically receive funds from two sources. First, banks create liabilities by accepting various types of deposits from consumers, firms and government entities. The second source of funds is owner's equity. Banks are contractually responsible for the funds, which have been deposited in the institution and therefore, view these deposits as liabilities. 

Narrator: 
Banks use deposit liabilities to create earning assets such as loans. Consumers, firms and government entities take loans from banks and are contractually obligated to pay back the loan principal along with the interest. The outstanding loan obligation is an asset to the bank. 

Narrator: 
Although commercial banks hold many different types of deposits, we assume for simplicity that they hold only demand deposits or checkable deposits. The Federal Reserve Bank requires that banks hold some portion of their total deposits in reserve. In other words, a commercial bank cannot use all of its deposits to create earning assets. 

Narrator: 
The minimum portion of deposits that must be kept in reserve is determined by the reserve requirement ratio and this ratio is set by the Fed.  

Narrator:  
Because banks are required to hold only a portion of their deposits in reserve, the banking system is said to be a fractional reserve banking system. For example, if the reserve requirement ratio is 10% and the bank of Pleasantville has $1,000,000 in deposits, it must keep $100,000 in required reserves. This amount must be held in cash or as deposits at the Federal Reserve. It should be noted that neither of these holdings earns interest. 

Narrator: 
Any reserves over and above required reserves are referred to as excess reserves. Excess reserves can be used to create earning assets for the bank. Because excess reserves are idle, they do not earn interest. Therefore, banks continually sweep their accounts searching for excess reserves that can be used to create earning assets such as loans or interest earning government securities. 

Narrator: 
The Federal Reserve establishes different reserve requirements for different types of bank deposits. For simplicity, the reserve requirement on demand deposits is the only one we'll consider. 

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