Forum Post: A Question about Fractional-Reserve Lending
Posted 13 years ago on Oct. 30, 2011, 1:30 a.m. EST by AlternativeSynergy
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With fractional-reserve lending, when you walk into the bank and get a loan, 9/10 of the money you receive is newly created at that instant because they only have to hold 10 percent in reserve. Does the bank get to keep not only the interest and fees, but the principle after you pay it back? In other words, for every loan they make, is their profit 9/10 of the loan amount (plus fees and interest minus debt service and other costs)? TIA
This video series explains fractional reserve banking for dummies:
http://www.khanacademy.org/video/banking-1?playlist=Banking+and+Money
Thanks, I'll check it out.
Dalton's right. Commercial banks can't create money (loans) out of thin air, but can only loan either what has been deposited with them or what they have themselves borrowed. There are merely financial intermediaries. Their income (as banks) comes from the difference between the rate of interest they pay depositors (if at all) and the higher rate they charge borrowers. Their profit is what is left after they've paid all their expenses (buildings, computers, staff, etc). There is nothing mysterious or fraudulent about banking. What's wrong with the world is that its economy is currently based on competition between profit-seeking (and mostly non-banking) corporations.
There is one hell of a lot of misinformation on this subject - including many textbooks. But reading the first chapter of this free to download book http://www.smashwords.com/books/view/85595 should give you a better idea of how it works.
No ... that's not how it works.
The money isn't "created" when they lend it: what they're lending is money which has been deposited with them. When you pay it back, and indeed before you pay it back, they owe it (on demand) to the depositors. So when you pay it back to the bank it's not their profit because it's not their money. Their profit is the interest they're charging you minus the interest they're paying to the depositors ... and then fees and so forth, as you say.
not true,as the name fractional reserve banking explains.Fractional reserve banking means you create 10 what you have as reserves(deposits).Banks never touch their reserves unless paying back the nations central bank as this increases their resreves and enables them to increase the amount of fictional money they can then loan out.When you borrow money from a bank,the money you just borrowed never existed till you loaned it.You just loaned that money into exsistence.
See my further explanation below.
You are confused, loans are from actual deposits. The bank may then have to borrow from the central bank to maintain adequate cash reserves.
Yes the loans are from deposits, but they are able to loan out 10 times the amount needed for reserves. So they never have reserves to pay back their depositers on demand. When this is done over and over again by many transactions, it is still equivalent to multiplying the money supply by ten-fold even though the loans originate from deposits. This money multiplier isn't part of their profits, but they are in fact making profits from interest on ten times the amount of money they have in reserves. When you sit back and think about it. it's ridiculous that this system has been legal for hundreds of years. It's really a recipe for disaster and it's no surprise why we have financial disasters every 10 to 20 years.
Then you are saying no portion of the loan you receive from the bank is newly created money? That makes me wonder where the new money that is created goes. Our money supply is constantly increasing, I thought that was done via new bank loans.
The idea that money is created through fractional reserve banking is not quite accurate, it's more of a metaphor.
Let's take a simple case. I start a bank with a 10% fractional reserve. Alice deposits $1000 with my bank. I can then lend $900 to Bob, who wants to start a small business and pays the $900 to Charlie for equipment. Charlie deposits this money in my bank. I can now lend $810 to Debbie ...
Let's stop it there and see who has what. Alice "has" $1000 (which she doesn't), which is "in" my bank (though most of it isn't). Charlie has $900, which is also "in" my bank. And Debbie is holding $810 of actual money. (You might ask: what about the $190 reserve in my bank? But we've already counted that once, it belongs to Alice and Charlie.) So it looks almost as though I've turned Alice's original $1000 into $2710 just by moving it about and signing things. In that sense, whoopee, I've "created" money.
But note that there's still the same amount of actual cash. Debbie has $810 of it and I have $190 of it.
Furthermore, let's look at my balance sheet. I am holding $190. Bob owes me $900. Debbie owes me $810. I have assets of $1900.
But on the other hand, I owe Alice $1000 and I owe Charlie $900. I have liabilities of $1900.
Unless I charge interest, which I will, I'm not up on the deal.
Let's do one more sum. Alice has assets of $1000. Charlie has assets of $900. Debbie has assets of $810. I have assets of $1900. Total assets in the system: $4610. Whereas on the other side of the balance sheet, I have liabilities of $1900, Bob has liabilities of $900, and Debbie has liabilities of $810. Total liabilities in the system: $3610. Total assets minus total liabilities = $1000, which is what Alice started off with. So I'm only "creating" money by creating debt at the same time. Debt being, as it were, negative money.
Now, if this all still sounds suspicious to you, do the same math where Alice has $1000, she lends $900 directly to Bob who pays Charlie, Charlie lends $810 directly to Debbie, and everyone keeps their money under their mattresses.
The "creation" of money works out the same. Alice has $100 under her mattress and an IOU worth $900. Charlie has $90 under his mattress and an IOU worth $810. And Debbie has $810 in cash. Which makes $2710 --- again. It's the existence of lending and borrowing that "creates" the money: my bank has no special power to do so. What my bank did was to arrange the loans and act as a rather more secure substitute for the mattress. There's nothing particularly unreasonable (or profitable) about a bank doing this rather than people doing it for themselves.
I hope that this helps to clarify things for you.
Thanks, that's a great explanation of the process. I appreciate your spending the time to help me understand it.
Also, the interst you charge on you assets has to be greater than the interest you have you pay on your liabilities which build up as you work your way down the pyramid
That's assuming they don't loan it out more than once. Let me guess: We're supposed to trust these thugs. Right? Sounds like a crises waiting to happen.
Well, they could loan it out again if someone deposited it with them, but that's not what you mean, is it?
I don't think you have to trust them as such, people do check up on them. Most problems with the system are not caused by banks doing something that's illegal, but something that's perfectly legal but stupid.
Then why do the derivatives markets exceed the bank's balances?
There is a 600 Trillion or more derivatives market, obviously there is not enough money in the whole world to pay them out if they all go bad at the same time.
Is that because there is no capital requirement? If so, why is it allowed?
It is allowed because the clearer heads that realized derivatives were basically offering insurance without the capital to back it up was BS and they failed to convince the policy makers in the late 1990s to regulate them to insure that they were properly backed up by actual collateral (if they had to pay too many at the same time).
So derivatives are just a scheme. I've actually heard some practical examples of how derivatives are used, but I've also heard about how they're used to bet on Greece's default, the Housing Market failure. It's just gambling on things in such a way as to degrade their meaning. It's sick! Like betting on when Granny's going to die.
Derivatives have turned into casino wagers whether an asset will default or not, and can be placed entirely by third parties with no interest at all in the asset in the first place. In a way they are like someone besides yourself also taking out fire insurance on your house. If your house burns down, you get paid, and someone somewhere else gets paid, even though it was not their house. Strange stuff.
Not strange...try amoral, criminal, sick. It is just as bad as companies taking out life insurance policies on their employees. We should do away with derivatives. If you want to place a bet, go to a casino. Thanks for your insights and understanding. Sorry about the lapse, but I work long hours.
I'm not sure that I understand what it is that you don't understand. If you can spell out the problem more carefully I'll see if I can have a crack at answering it.
P.S: Or I might go to bed instead, I make no promises.
Hahahaha. Looks like I went to bed before you.
I guess you did. OK, I think I see what's puzzling you. Let's continue my story about Alice and Bob and the rest of the gang.
Suppose Alice, Charlie, and Debbie all decide to use their money to buy derivatives from Edward. Alice and Bob both write him checks, and Debbie pays cash.
And now between them they own $2710 worth of derivatives, even though the system of transactions is based on only $1000 of actual cash. And at this point I, the banker, still have net assets of $0 and hold only $190 in actual cash.
(Moreover, when Edward pays the checks he got from Alice and Bob and the cash he got from Debbie into his account at my bank, then I'll have $1000 in cash and liabilities (to Edward) of $2710, and can start looking around for someone who wants to borrow $729 ... quite possibly to buy some more derivatives.)
The money still isn't coming out of nowhere, it's coming from the obligation of people who borrow money to pay it back. And again, the bank as such is not "creating" the money, it's the fact that people are lending and borrowing that does that. The bank is just the middleman.
Good question. Maybe the money is considered to be borrowed from the FED, but it is provided somehow. Isn't it?
No. With a fractional reserve, you only have to keep 1/10 of your deposits on hand. You can loan out the other 9/10s. So say I put $10 unto the bank, the bank could loan out 9 of those. On paper, the bank has $19 worth of money in it's system but in reality, it just took $9 of my dollars and lent them out. I can however still acces my funds at the same time they are lent out.
I thought the bank could lend 10 times the amount of their deposits. Then how is new money created? The money supply is growing, where does the new money come from?
hey sorry I ment those 10s to be 1s my bad
Well yes and no. It's called a multiplyer. In economics you take the fractional reserve ammount (say it's 10%) and turn it into a fraction (1/10). You invert the fraction and you get whatis called the money multiplier (10 in this case). That means that for every $1 but in, 10 comes out. $9 of it coumes out as loans however, $1 comes out as the dollar you initially put in.
I put $10 in. They save $1 as par of their reserve and loan you $9. Now that mean that while I can still spend my $10 dollars using my debit card, you can also go out and spend your $9 loan on whatever you took the loan out for.
It's sounds like you really know this stuff. I'm still trying to learn this. So where does the new money supply in the economy come from?
What do you mean? It comes from a lot of places but people often mean different things by money suppy? There is M1 (physical money and moeny in the bank), M2 (small loans like credit cards, checks, savings, and some investments[usually money market]), and M3(long term loans and investments). They all sum up to MS(total money supply). It depends on who you are talking to as to which money supply you are talking about however
I'm just trying to figure out where the new money created overall goes. If you look at the historical charts of the various money supplies, they all grow with time. Who is getting this money, it must be entering the economy somewhere.
M1(physical money) is increased whenever the federal reserve prints more money (which is a natural and needed thing with a fiat currency system). M2 is increaed by banks issuing loans for things like cedit cards and the fluctuations in the US dollar in comparison to other currencies (the exchange rate between the USD and GBP is a ver common one). M3 is increaed by banks making loans for things like houses and new businesses and by the changes in stock price (if i by a stock at 1$ and sell it at $8, that $7 in effect comes from no where[though technically it could be argued that is came from whoever bough it but it doesn't entirely work like that])
Thank you that clears it up quite a bit. Does the newly created bank loan principle disappear when the loans are paid off or does the bank keep the newly created principle after you pay it off?
No it doesn't dissapear, but the money isn't just hoarded by the banks either. You have two things, banks and credit unions. Both loan out money and do all the same things but have diffent policies on what to do with the money they make.
Cedit unions are a 0 sum institution meaning that they make no profit. When they loan is paid back, the money is used to pay for the credit union (staff, utilities, things like that) and the rest is divided equally among each share of the credit union and payed out as interest. In a credit union, every dollar you deposit in a credit union buys you a share of that union[(your deposits/total depoits)=%of the credit union you own and the fraction of the profits you get].
A regual bank, is not a 0 sum institution and this time there are two sperate groups that need to get paid by whats left. One is the depositors, they get a pre-set percentage rather than a fraction of the total profit. The rest of the money is used to pay the stock holders of the bank (these are stocks just like any other, traded on stock exchanges like the NYSE). They get a dividend which can either be a set ammount per share or a set % per share. What ever is left is put into the banks accounts and is used for whatever the bank decides to use it on.
Thanks, now I know how banks can amass such incredible wealth. I'm in the wrong business.
It's a how but not a why. The why deals entirely with interest and inflation. Those two in tandem determin how much wealth a bank can amass or loose