The Fractional Reserve System and the Current Debt Crisis

[skating101]

I am relatively new to economics and after reading a significant amount of information on the net I have some probably pretty basic questions:

1. A bank gets money either from a central bank, depositors or other banks (or all three).
Under the fractional reserve system the bank then lends out 10x the money it recieves.
The profit of the bank is determined by the amount of interest it receives from these loans.
If 90% of these loans no longer pay interest (default) the bank still has the same amount of money it had to begin with.
Does this mean than the bank needs more than 90% of its loans to default for the bank to actually LOSE money?

2. Why did the government need to purchase the toxic debt that these banks owned when these banks had just created the money to issue these loans?

 

[Knobby22]

I am relatively new to economics and after reading a significant amount of information on the net I have some probably pretty basic questions:

1. A bank gets money either from a central bank, depositors or other banks (or all three).
Under the fractional reserve system the bank then lends out 10x the money it recieves.
The profit of the bank is determined by the amount of interest it receives from these loans.
If 90% of these loans no longer pay interest (default) the bank still has the same amount of money it had to begin with.
Does this mean than the bank needs more than 90% of its loans to default for the bank to actually LOSE money?

2. Why did the government need to purchase the toxic debt that these banks owned when these banks had just created the money to issue these loans?

1. 10% only as the capital of the bank is gone, (actually less but it would take too long to explain it). Someone else might like to.

2. See 1 above. Another question is why they saw it fit to effectively bankrupt the state against taxpayers wishes.

The answer is manifold but mainly to stop the rich taking a bath. Look at what Iceland did compared to Ireland, a much better solution.

 

[skating101]

1. 10% only as the capital of the bank is gone, (actually less but it would take too long to explain it). Someone else might like to.

2. See 1 above. Another question is why they saw it fit to effectively bankrupt the state against taxpayers wishes.

The answer is manifold but mainly to stop the rich taking a bath. Look at what Iceland did compared to Ireland, a much better solution.

Thanks for the reply

I thought they havent loaned out their capital, they have just created new capital in the form of loans and kept the base capital as the reserve for the loans?

 

[McLovin]

I am relatively new to economics and after reading a significant amount of information on the net I have some probably pretty basic questions:

1. A bank gets money either from a central bank, depositors or other banks (or all three).
Under the fractional reserve system the bank then lends out 10x the money it recieves.
The profit of the bank is determined by the amount of interest it receives from these loans.
If 90% of these loans no longer pay interest (default) the bank still has the same amount of money it had to begin with.
Does this mean than the bank needs more than 90% of its loans to default for the bank to actually LOSE money?

The bank has $100m in deposits. It then lends out $90m in the form of loans and keeps the rest (the fraction) in reserves in the form of cash and highly liquid marketable securities (read government paper). If 90% of it's loans go bad then that means the bank has lost 90% ($81m) of it's depositors money. Without raising equity it will be insolvent.

The equity in a bank provides a solvency buffer, the fractional reserve provides a liquidity buffer (ie no bank runs).

 

[skating101]

The bank has $100m in deposits. It then lends out $90m in the form of loans and keeps the rest (the fraction) in reserves in the form of cash and highly liquid marketable securities (read government paper). If 90% of it's loans go bad then that means the bank has lost 90% ($81m) of it's depositors money. Without raising equity it will be insolvent.

The equity in a bank provides a solvency buffer, the fractional reserve provides a liquidity buffer (ie no bank runs).

What about if the deposits were in the form of government bonds and the bank could lend out 9 x the amount of the bond? Then the 90% was just money that the bank had created out of thin air?

 

[McLovin]

What about if the deposits were in the form of government bonds and the bank could lend out 9 x the amount of the bond? Then the 90% was just money that the bank had created out of thin air?

I think you're getting the two sides of the balance sheet confused. The government bonds a bank holds in its reserves are on the asset side of the BS. A deposit is a liability. Why would a bank accept a government bond on deposit, they can't do anything with it. All it will do is increase their liabilities.

 

[skating101]

I think you're getting the two sides of the balance sheet confused. The government bonds a bank holds in its reserves are on the asset side of the BS. A deposit is a liability. Why would a bank accept a government bond on deposit, they can't do anything with it. All it will do is increase their liabilities.

I suspect I was incorrect in stating government bond but with the deposit they can lend out 9 x the deposit value correct? So their asset is the loan (9 x deposit value and created out of thin air by the bank) and technically they could write off the loan and still retain the deposit?

 

[McLovin]

I suspect I was incorrect in stating government bond but with the deposit they can lend out 9 x the deposit value correct?

No, incorrect. They can lend out 90% (ie less the 1x) of the deposits they receive (or whatever the reserve requirements dictate). Banks can't lend out money they don't have, they'd require a printing press to do that.

 

[basilio]

No, incorrect. They can lend out 90% (ie less the 1x) of the deposits they receive (or whatever the reserve requirements dictate). Banks can't lend out money they don't have, they'd require a printing press to do that.

I don't believe that is true McLovin and in fact the actual creation of huge amounts of extra money by banks in the form of loans is largely the reason for the current den crisis.

There is an excellent presentation which outlines how banks create money. ( It has been used as a basis for teaching curriculums so it is on the ball.) Worth a look.

Money as debt. http://video.google.com/videoplay?docid=-2550156453790090544

http://paulgrignon.netfirms.com/MoneyasDebt/disputed_information.html

 

[McLovin]

I don't believe that is true McLovin and in fact the actual creation of huge amounts of extra money by banks in the form of loans is largely the reason for the current den crisis.

That's a pretty long presentation. Note, I'm not denying that banks play a part in creating money through the credit creation process, but I am saying banks cannot just click their fingers and get a 9:1 exchange of money.

Here's the 2010 WBC balance sheet. http://westpac2010.reportonline.com.au/anr/balance_sheet_review/

Have a look at the loans under assets and deposits under liabilities. Does it look like they are creating money and lending 9x their deposits?

Here's a bad bank, Northern Rock. Same thing they're not lending 9x their deposits. Although note how levered they are GBP101m in assets on GBP3m of equity.

The issue for banks was that credit quality had deteriorated because they were trying to increase their loan book without using extra equity. In the case of Northern Rock <3% bad loans would wipe out equity.

I just noticed on the second link you provided this paragraph:

However, if it is interpreted to mean that this is all the cash the bank has, the ratio of cash ($1111.12) to total credit issued ($100,000) would be 1.1 %. This has been criticized as a ten-fold exaggeration. However, on the Wikipedia page http://en.wikipedia.org/wiki/Fractional-reserve_banking there is a bank balance sheet for ANZ National Bank Limited that shows the bank to have cash reserves of just 0.79%. So my implication is within the range of real life possibilities.

This makes me think whoever made the film has very little understanding of banking. Certainly he seems unable to distinguish between cash and other liquid assets. And equity and deposits.

 

[skating101]

http://video.google.com/videoplay?docid=-2550156453790090544

I just watched this video which explains the fractional reserve system and have a question:

Banks can only lend 90% of their deposits so for example

Bank receives $100 deposit bank has to pay 10% on this deposit in interest ($10)

The bank lends out $90 of the $100 (leaving only $10 reserve in the bank) and for this $90 the bank receives 10% interest from the borrower ($9).

So how do banks make any money if they have to pay more money in interest to the depositors than they receive in interest from the borrowers? And why would banks bother with this system?

 

[Tyler Durden]

I can't remember where, but I have read somewhere that banks can 'create' money, by lending out money it doesn't have. That is, if it receives $10 in deposits, it can then lend out 9 times that.

http://video.google.com/videoplay?docid=-2550156453790090544

I just watched this video which explains the fractional reserve system and have a question:

Banks can only lend 90% of their deposits so for example

Bank receives $100 deposit bank has to pay 10% on this deposit in interest ($10)

The bank lends out $90 of the $100 (leaving only $10 reserve in the bank) and for this $90 the bank receives 10% interest from the borrower ($9).

So how do banks make any money if they have to pay more money in interest to the depositors than they receive in interest from the borrowers? And why would banks bother with this system?

The interest rates paid and receive are different. For example, banks may pay you 5% interest for your money, but if you were to borrow from them, the interest they charge you is 12%, and therein lies the gain.

 

[skating101]

I can't remember where, but I have read somewhere that banks can 'create' money, by lending out money it doesn't have. That is, if it receives $10 in deposits, it can then lend out 9 times that.



The interest rates paid and receive are different. For example, banks may pay you 5% interest for your money, but if you were to borrow from them, the interest they charge you is 12%, and therein lies the gain.

So in that case the interest rates must get progressively higher and higher as the money gets lent using the fractional reserve system

As per the table on this Wikipedia page http://en.wikipedia.org/wiki/Money_multiplier

Bank A receives a deposit of $100 and pays interest to this depositor of 1% ($1)
Bank A lends $90 to bank B
Bank B has to pay maybe 2% ($1.80) interest to bank A to provide a profit to bank A
Bank B lends $81 to bank C
Bank C has to pay maybe 4% ($3.22) interest to bank B to provide a profit to bank B
Bank C lends $73 to bank D
Bank D has to pay maybe 6% ($4.38) interest to bank C to provide a profit to bank C
Bank D lends $65 to bank E
Bank E has to pay maybe 8% ($5.20) interest to bank D to provide a profit to bank D
Bank E lends $58 to bank F
Bank F has to pay maybe 10% ($5.80) interest to bank E to provide profit to bank E
etc

and the interest would get exponentially higher

 

[McLovin]

http://video.google.com/videoplay?docid=-2550156453790090544

I just watched this video which explains the fractional reserve system and have a question:

Banks can only lend 90% of their deposits so for example

Bank receives $100 deposit bank has to pay 10% on this deposit in interest ($10)

The bank lends out $90 of the $100 (leaving only $10 reserve in the bank) and for this $90 the bank receives 10% interest from the borrower ($9).

So how do banks make any money if they have to pay more money in interest to the depositors than they receive in interest from the borrowers? And why would banks bother with this system?

Banks don't borrow and lend at the same price (interest rate). The whole business of banking is pooling lenders and matching them with borrowers for a fee.

 

[McLovin]

I can't remember where, but I have read somewhere that banks can 'create' money, by lending out money it doesn't have. That is, if it receives $10 in deposits, it can then lend out 9 times that.

The banking system can create more money through the credit creation/money multiplier process but the level of reserves will remain at 10% of total liabilities (deposits). It's not lending money it doesn't have, it's lending money than may already have been lent.

 

[nomore4s]

https://www.aussiestockforums.com/forums/showthread.php?t=7108

The above thread has some discussions on banks and creating money in the form of loans. The posts by lakemac make interesting reading.

 

[McLovin]

https://www.aussiestockforums.com/forums/showthread.php?t=7108

The above thread has some discussions on banks and creating money in the form of loans. The posts by lakemac make interesting reading.

Deary me, more misinformation.

This...

Now for any entity ASSETS - LIABILITIES equals the "value" of a entity. For a bank this means LOANS - DEPOSITS equals the "value" of a bank.

How is it that LOANS are bigger than DEPOSITS?

Banks manufacture credit out of thin air.
Let me repeat that: Banks manufacture credit out of thin air

Is rubbish. The difference between assets and liabilities is like in any other business, ie it's the equity that shareholders have put into the business, either through capital raisings or through retained earnings. By the logic of that post, every business can create cash out of thin air, because every decent business has more assets than liabilities.

As I've been saying banks are highly leveraged (ie they are funded mainly by debt, in the form of deposits) businesses, but they cannot, on their own, create money out of thin air.

So what happened in the GFC? Banks started trying to gain more market share, in order to do this they had to sacrifice interest margin, which meant that they weren't earning as much on their loan book as they previously had, but they continued to aggresively grow their loan book albeit at lower margins. If you grow your loan book at 20%pa but you're only increasing your profit at 10%pa then, unless you raise fresh equity, your business is going to becoming increasingly levered, which is what happened. That's all well and good until you realise that you probably weren't lending to prime borrowers and because you might be low levered 50x a 2% writedown of the loan book will wipe out shareholders equity.

 

[skating101]

My example was incorrect

B1 = Bank 1
P1 = Person 1

Deposits and Lending
P1----> B1---> P2---> B2---> P3----> B3---> P4---> B4
___$10____$9____$9____$8.1___$8.1___$7.3___$7.3

Interest Payments
P1 <----B1 <---P2 <---B2 <---P3 <----B3 <---P4 <---B4
____10%___15%___10%___15%___10%___15%___10%
____$1___$1.35___$0.9__$1.20__$0.81___$1.1___$0.73

So if this example is correct then why do banks need to keep loaning out money? Is it because people keep making deposits?

 

[McLovin]

My example was incorrect

B1 = Bank 1
P1 = Person 1

Deposits and Lending
P1----> B1---> P2---> B2---> P3----> B3---> P4---> B4
___$10____$9____$9____$8.1___$8.1___$7.3___$7.3

Interest Payments
P1 <----B1 <---P2 <---B2 <---P3 <----B3 <---P4 <---B4
____10%___15%___10%___15%___10%___15%___10%
____$1___$1.35___$0.9__$1.20__$0.81___$1.1___$0.73

So if this example is correct then why do banks need to keep loaning out money? Is it because people keep making deposits?

Banks make money by lending money. Ideally, they want to be able to lend as much money as they can for a given reserve ratio.

 

[skating101]

Banks make money by lending money. Ideally, they want to be able to lend as much money as they can for a given reserve ratio.

The banks could in theory stop lending and stop getting deposits and still be very profitable, they only NEED to make more loans cause people are making deposits and because they want to increase their profits