BANKING

SECTOR AND INTEREST RATES1

Vipul Mathur

In our previous classes, we first introduced Money as helicopter drops on the real economy,
and then later developed the idea into a more sophisticated exchange of bonds and money
between the central bank and the real economy. In that process, we discovered that the
central bank amasses currency as its liability and government debt/bonds/securities as its
assets. Now, we introduce one more layer to this arrangement. The exchange of money and
bonds is facilitated by an intermediate sector, the economic entities of which are more
generally referred to as financial intermediaries. A financial intermediary is literally an
intermediary – a middlemen – that acts to serve the two parties in a financial transaction.
These intermediaries take the shape of modern variants of commercial bank, investment
banks, mutual funds and pension funds, etc. The two parties in a financial transaction could
be a lender and a borrower, the households and the central bank or the markets.

The financial intermediary we will focus on is the commercial bank. As always, when we want
to start we will assume that there is only one representative commercial bank, but to be sure,
the framework we discuss can always be extended to include multiple heterogeneous banks,
and therefore facilitate a inter-banking sector. To begin with the modern banking structure,
we first take a look at the underlying basis of fractional reserve banking.

Fractional Reserve Banking

Fractional reserve banking is a system in which only a fraction of bank deposits are backed by
actual cash on hand. What this does is that it frees some money for lending. The central bank
of an economy decides this fraction – also called as cash reserve ratio (crr).
Why does the central bank do it this way? When banks take deposits from us, their primary
objective is to lend so that they can earn a ‘spread’ between the lending rate and the deposit
rate. Left to themselves, banks may like to maximize their lending and keep their idle cash at

1
Prepared for the Macroeconomics course; for any typos please mail to vipul@iimcal.ac.in
a minimum, so that the profits are higher. But if much of the funds are lent out and there’s a
sudden rush to withdraw, banks will struggle to meet the repayments. It is to avoid this
situation that the central bank specifies2 both a CRR (and an SLR (Statutory Liquidity Ratio))
for banks. The CRR requires banks to maintain reserves with the central banks with liquid
cash. The SLR requires banks to invest in safe and quickly liquefiable assets such as
government bonds.

How much fraction to keep? This is an empirical question really. Can vary across countries.
One way to get around this number is to realize that not all the deposits made by the
households are withdrawn at any point. As a matter of fact – empirically – only a little fraction
is ever withdrawn at any point in time. Typically, it’s a number around 10%. Which means
about 90% of the deposit capital is available with the banks to lend to the private sector and
to the government (via the government bonds).

Where do banks keep these reserves? With the central bank. It shows up as an asset on the
balance sheet of the banks and on the liabilities of the Central Bank. If it is an asset for banks,
do the banks earn interest income on it, or in other words, does the central bank pays interest
on these reserves? Typically, no. The reserves are regulatory requirement3 and the Central
bank is not obligated to pay any service cost on it.

As with every economic agent we have analyzed, when it comes to understanding the choices
of the bank, will adopt our usual lens of quantities and prices. Banks deal with the commodity
of money (whether cash or electronic), so the quantity is simply the quantity of money they
deal in. What about the price of this commodity? As we have said before the price of money
is in terms of the real commodity. Interest rate is not the price of money, but it is surely a
good enough candidate to capture the opportunity cost of money. We will use interest rates
in the spirit of prices. As a first act of simplification - let’s get prices out of our way - by
assuming we are in a perfectly competitive banking environment and hence, banks are price

2
CRR (4 per cent of Net Demand and Time Liabilities (NDTL) and SLR is 18.75 per cent of NDTL. This means that
roughly 22.75 – a fourth – of the deposits with Indian banks remain secure, even if banks make poor lending
decisions.
3
Importantly, the CRR can sometimes also act as an instrument of monetary policy. In unconventional times,
the central bank may change this drastically and even pay interest on it.
takers. Put simply, we assume that banks just take the prevailing interest rates (on
government bonds, deposit accounts, loan accounts) as given. Not much action to explain
there. Move onto quantities. The best way to understand the dynamics of quantities is to look
at the balance sheet of a bank. This is how the balance sheet of a bank looks like:

Balance Sheet of a Commercial Bank
Assets Liabilities
Reserves (kept with the central bank) Deposits
To government (bonds)
Loans
To private sector (firms & households)

Money Multiplier

When a commercial bank accepts deposits, say !, it keeps a fraction of it as reserves. Say that
fraction – the CRR – is ". Then Reserves will be "!. The rest of it (1 − ") fraction will be loans.
These loans could either be to the government or the private sector. Regardless of who it
eventually loans out, the loaned money will ultimately travel back to the banking system –
and in this case since there is one bank – it is easy to see that the new deposits made out from
these loans would be 1 − " !. Again, on this, the central bank would regulate banks to keep
some reserves as before; the additional reserves on these new deposits would be " 1 − " !;
and as before, a fraction (1 − ") of the new deposits would be available for fresh lending.
This process will continue and by the end of it, the total deposits with the banking system
would be
!
! + 1 − " ! + 1 − " *! + ⋯ =
"
Since the cash reserve ratio, " < 1, starting from an original money value of !, the banking
seems to have “multiplied” the money in the economy by a factor of 1/". This is called as the
money multiplier. The implications are straightforward: lower the value of CRR, higher is the
amount of money created by the Banking sector.
0
Now, interestingly, the total reserves of the banking system would simply be ! (" ∗ ). These
1

reserves are kept with the central bank. Let’s us now take a look at the balance sheet of
Central Bank.
Central Bank Operations with the Banking Sector

The central bank essentially prints currency. A part of this currency is being used to settle
transactions in cash (currency in circulation, say, 2) and a part of it is kept as reserves
(!, 45 678 9:;7<). The total liabilities are simply 2 + !. This is referred to as high powered
money or sometimes even the reserve money of the central bank. Traditionally, this monetary
aggregate is called as => . There are other monetary aggregates4 also, which include the
money created by the banking sector, and money with other financial intermediaries.

Balance Sheet of a Central Bank
Assets Liabilities
Net Domestic Assets High- Currency in circulation
powered Reserves of commercial banks
Money

Net Foreign Assets

On the asset side, the central bank has domestic government bonds and also foreign assets.
We will focus on the domestic government bonds. Now, as we have seen before in our
discussion of money and bonds, if the central bank wanted to increase money supply in the
economy, it would buy bonds from the economy and the corresponding cash associated with
this transaction would get “pushed” in the economy. With a banking sector in place, this
transaction is now more technical as following.

Say the central bank wants to increase money supply. Then it will buy bonds from the banks
(or the representative bank in our example). Say the total bonds that have been bought are
worth a value of ∆=. On the bank’s side, the following would happen: the loan portfolio of
the government would get diminished by ∆=. But this is just one leg of the transaction. The
central bank will be transferring money ∆= to the bank. This is where it become interesting.

4
Depending upon which monetary aggregate is used, simply plugging that value in the quantity equation would
give the corresponding velocity of that monetary aggregate. The historical patterns of these velocities are of
interest to researchers who attempt to understand the structure of money flow in the economy.
The central bank would simply increase the reserve balances of the bank which it maintains
at its end by the amount ∆=. The central bank’s balance sheet would then look the following:

Balance Sheet of a Central Bank
Assets Liabilities
Net Domestic Assets plus ∆@ High- Currency in circulation
powered Reserves of commercial banks
Money plus ∆@

Net Foreign Assets

Both the asset and the liability side would get augmented by Δ=. The increase in reserves will
also in parallel reflect in the bank’s balance sheet. The intermediate state of the bank’s
balance sheet would look the following:

Balance Sheet of a Commercial Bank
Assets Liabilities
Reserves ! plus ∆@ Deposits !/"
To government (bonds)
B minus ∆=
Loans − C !
1
To private sector (firms &
households)

The net change on the asset side would be zero. However, the composition between the
reserves and the loans would have changed. The liabilities side would be unaffected by this
operation. Now, since the liabilities side has not changed – and the reserve requirement is
purely on the liability side - the commercial bank would find itself to be in excess of the
regulatory requirement of reserves. Now remember, the reserves pay no interest – so a
profit-maximizing bank would not be happy with these idle reserves which won’t be earning
the bank any income. The only way the commercial bank could live with this is when the
liability side gets augmented such that the extra reserves just meet the regulatory
requirement on the extra liability. This would mean that the extra liability which would justify
these extra reserves should be Δ=/". And this is where the beauty of the banking system
comes in: every loan entry, is essentially a parallel deposit entry. The bank will start making
out private sector loans which will ultimately amount to Δ=/". After all these operations are
exhausted, the final state of the balance sheet of the banking sector would be

Balance Sheet of a Commercial Bank
Assets Liabilities
Reserves ! plus ∆@ Deposits !/" + New Deposits Δ=/"
To government (bonds)
minus ∆=
B
Loans − C ! To private sector (firms &
1
households)
+ New loans Δ=/"

Take a moment to think what has eventually happened: The central bank aimed to increase
its high-powered money by Δ= but the banking sector ended up multiplying this intent, and
finally the total money in the economy has increased by Δ=/". Is that a good thing or bad
thing? Neither. It is intentional. The central bank would have come at the estimate of Δ= in
the first place, not on a whim, but rather based on a careful assessment of the impact of such
an operation on the (desired) policy rate. And this brings us to the prices - the placeholder
for which in our world is the interest rates.

Interest rates

Why would the central bank want to increase the money supply in the first place? Because
we know it will have an impact on the interest rates. Which interest rate? Well, since the
operation is directly on government bonds and high-powered money, the interest rate
relevant for this transaction is the yield on the government bonds. Our previous analysis of
the money supply and money demand diagram would remain intact except that we have to
note that the money in this transaction is the high-powered money. And as before, since the
money supply curve here would shift to the right, the interest rate on the government bonds,
will drop. Let’s denote this interest rate as 4 D .


What happens to other rates? For this, let’s look at the bank’s profit maximization problem.
Say the interest rate on the private, commercial loans is 4 E and on the deposit side is 4 F .
The bank is looking to maximize its profits. Profits are simply revenues minus costs. Revenues
is the interest inflow on the Loans (the reserves pay no interest). And the cost is the interest
outflow on deposits.

Typically, the commercial loans are riskier than the government loans. The banks would
demand to be compensated for this extra risk they would be taking by loaning out to private
sector vis-à-vis he government. This compensation is referred to as the risk-premium. Say the
risk premium is G > 0 (phi). Then the two rates can then be related such that

4E = 1 + G 4D
Also suppose the SLR is some fraction J of the total deposits – and say the banks loan out to
the government at exactly this value. Then the profit function for a bank can be written as

K86L4;5 = 4 D J! + 4 E 1 − " ! − J! − 4 F !

In perfect competition, the profits would be zero. After substituting for the relation of
4 E N5O 4 D we get
4 F = J + 1 + G 1 − " − J 4 D or,
J
4F = 1 + G 1 − " + J + 4D
1+G
Recall that
4E = 1 + G 4D
Few observations can be made:
One, that both the commercial loan rate and the deposit rate are related to government rate.
If the central bank changes the government rate, then in a perfect world, all other rates
should mimic this change. This is the monetary policy transmission through the banking
sector. In a perfect world, it would be immediate and complete. By just changing the policy
rate the central bank should ideally be able to change the interest rates across the markets.

5
The !, deposits here is the final cumulative deposits prevailing at the banking sector equilibrium. This is
different from the ! used in the balance sheet discussion.
In a world with banking sector frictions (such as the NPAs, departure from perfect competition
market structure, etc.) such a transmission would be impeded. And this is also something we
have been witnessing in India.

Second, the rates depend upon the SLR, CRR and the risk premium. All these three essentially
capture some kind of “liquidity”. CRR is the cash liquidity – the highest form of liquidity. SLR
is the next one. Risk premium entails the liquidity associated with private sector. Bottom-line
is that the liquidity across markets have a bearing on the rates which prevail across the
markets.

Third, notice that
J
1− "+J + < 1
1+G

so, clearly 4 E > 4 F . This simple view of the banking sector is able to explains our natural view
of the world too in terms of how the loan rates are always greater than the deposit rates.

Now, all this while we have been discussing the nominal interest rates. They are nominal
because they represent a transaction of monetary commodities. No real commodity has been
exchanged. But we know that if there is some nominal variable, there will exist a real
counterpart to it. This brings us to the discussion on real interest rates.

Real Interest Rate and Fisher equation

So far we have discussed the borrowing and lending of money. While it is true that the
borrowing and lending mostly happen through money, the purpose of borrowing or lending
is mostly real. Consumers borrow to say buy a car or invest in a house. Firms borrow to buy
machinery, set up a plant, expand operations. To the extent that the underlying purpose is
for real consumption or investment, it is only kosher that these decisions have to be made on
the assessment of real trade-offs: the comparison of real benefit and real cost. Nominal
interest rates are a depiction of the nominal costs. To get to the real costs, we do the
following: Legitimate
Let’s say that the price level of goods and services is KP at time ;. If you want to consume QP
amount of goods and services today, you will have to borrow KP QP . Let’s say you are borrowing
this money at the nominal interest rate 4P – and this is known to you at time ;, so that the
next time period ; + 1 your pay back amount in nominal terms will simply be (1 + 4P )KP QP .

Since you have to pay back this money in period ; + 1; your real consumption in period ; + 1
will be dented by this payment. Let’s say that you expect the price level in period ; + 1 as
S
KPRB ; so the amount of real consumption which you will have to “sacrifice” away because of
(BRTU )VU WU
these payments will be Z ; this is your real cost of borrowing when you want to
VUXY

consume QP today.
So, the (expected) real interest rate – denoted by 8PS - that you are essentially expecting to
pay, in terms of the forgone goods and services is

1 + 4P KP QP
S − QP
KPRB
[\]P ^_` g_cc_[ Tb cS]d PScef
[\]P ^_` a]^ Tb cS]d PScef
8PS =
QP

Now also note that by definition, inflation is the proportional increase in price levels, i.e.

KPRB − KP
hPRB =
KP
In this case, when the borrowing is happening at time ;, we don’t know KPRB . We can only
S
have some "expectations" for the price level, as denoted by KPRB . Consequently, the ratio

KP 1
S = S
KPRB 1 + hPRB

S
where hPRB is expected inflation for time period ; + 1. Substituting this in the relation above,

and rearranging the terms we will get

1 + 4P
1 + 8PS = S
1 + hPRB
This equation is called as the Fisher equation. Upon a first order approximation, we can
rewrite it as
S
8PS ≈ 4P − hPRB

The real rate which we deduce from the RHS of this equation is an expected real rate. It is
expected, because we will only be able to arrive at the actual real cost once the inflation for
the next period has been realized. Since this assessment is before the actual cost is incurred,
it is also called as ex-ante real rate. Once we enter into the next period, we will know for sure
how many goods we have foregone and that will tell us the actual real cost we have paid after
the nominal interest payment. That real interest rate is called as ex-post real interest rate,
and it would simply be 8P = 4P − hPRB . A couple of observations are in order.

First, by definition the real rate is being measured in the cost of foregone opportunities to
consume in real terms. The exact price would depend upon the price of commodity in
question. Since people borrow for a variety of goods and services, it is really not possible to
nail down one real interest rate. This is unlike the case with nominal interest rate, where
money being the underlying commodity is the same for everyone. Thus, deduction of real
rates would depend upon the inflation metric (consumer price index, wholesale price index,
gdp deflator, etc).

Second, in the derivation of fisher equation, we have not used the assumption of sticky prices.
It is a derivation that is pretty much axiomatically arrived at by the construction of the interest
rate. Therefore, it will hold for all time frames.

Third, however since inflation is sticky in the short-run, when we are dealing with the fisher
equation in the short-run we will often take the expected value of inflation in the next period
to be simply the current period’s inflation value.




Zero Lower Bound and Liquidity Trap

What does the interest rate really represent? It represents the price of time. If you’re keeping
your money in cash and not investing in say a government bond – you lose out on interest
income over time. You lose out value over time. The amount of value you lose out per unit of
time is nothing but the price, the interest rate. Prices are always positive, and hence, the
interest rate – the nominal interest rate – will always have to be positive. At best, it can be
zero (equivalent to something with a zero price – free). Unsurprisingly therefore, for the
longest time6, it was believed that the nominal interest rates could not go below zero – or
equivalently, there exists a zero lower bound on the nominal interest rates.
Does a similar bound exit for real interest rates? Well, in principal, if the borrowing or lending
was happening in real terms, then one can make a similar argument. But that is not the case.
The real interest rate is a deduced variable, and depending upon how the inflation turns out,
atleast the ex-post real interest can – and it does often enough – venture into the negative
territory.
What does a zero interest rate mean in our model? In our setup the principal interest rate is
the interest rate on government bonds. Recall that we motivated the holdings of government
bonds by enticing the households to give up on their cash holdings in return for some positive
interest income. If this interest income is zero, the household will be indifferent between
holding the money in cash or bonds. As a matter of fact, since the cash at least have a
transaction utility, the household may marginally prefer to hold the entire money in cash.
How does one reach zero interest rates anyway? Well, it happens when the central bank has
been incessantly increasing the money supply, in order to cut the interest rates (to revive
investments as we will see in the short-run model) and suddenly finds itself at a remote corner
of the money supply-demand diagram where increases (or decreases) in money supply have
no impact on interest rates. That situation is called as liquidity trap. Conventional monetary
policy stops being effective. And this makes the central bank desperate enough to pursue
unconventional measures – and experimenting with negative interest rates is one example of
it, done with the hope that the money demand function would shift outwards, and the
economy would get back to the conventional realm.

6
Japan, Switzerland, Denmark, Sweden have witnessed negative rates at different points in time over the last
few decades.