While I understand fractional banking I do not understand why it doesn’t lead to humongous profits.
Assuming a bank follows the Basel III accord and for a deposit of $1 only lends that $1 eight times (approx), that implies a very substantial margin for error. If only four out of eight borrowers repaid their loans the bank has to be in a very solid position. Indeed in my experience most borrowers repay their loans.
Yet banks fail. Why is this?
Short answer - fractional reserve banking does not mean “for a deposit of $1 only lends that $1 eight times”.
Assuming your ratio is correct (I can’t see anything in the Basel III accords that requires it), it would mean that the bank must retain liquid asserts equal to 1/8 of its loans - i.e for every dollar deposited it can lend out $8/9.
The “lends out 8 times meme” comes from the fact that if the person who borrows the $8/9 puts in a bank, who lends out 8/9 of it to someone who puts it in a bank, who etc etc, you end up with $8 in circulation for every $1 of the original deposit. That’s very different from saying that any individual bank can lend more than it has in assets.
Yes, merrick is absolutely right.
Let me point out that all of the anti-Federal Reserve or anti-fractional reserve banking screeds and Youtube videos that you will find make the curious assumption that people borrow money from a bank for the sole purpose of leaving it in their checking account at the same bank and that nobody in the chain (neither the person who originally deposited the $1 nor any of the subsequent borrowers) will ever try to withdraw the money from their account. (Or they gloss over it by saying that somehow the bank just does some bookkeeping and does not have to actually turn over any assets when a withdrawal is made.)
The fact of the matter is that if a bank has $1 on deposit and lends out 90 cents, it can’t make any more loans unless the person who borrowed the 90 cents redeposits it in that bank. And if the original depositor comes by and asks to withdraw his $1 before the loan is repaid, the bank is in deep doggy-doo since they won’t have enough on hand to give him his $1 back. (They can scramble to borrow the money they owe him or sell the borrower’s note to raise the money.) Cash management at a bank is a lot more complicated than the Youtube video makes it sound.
I think a lot of the misunderstanding comes from the example that is used in many high school introduction to economics textbooks. They try to illustrate the principles of money creation by imagining a world where there is only one bank and no money enters or exits the world served by this one bank. This does not generalize to the real world.
Off topic and I’m probably confusing things, but the idea of a money multiplier usually comes up in this context and this also tends to get distorted, unintentionally or otherwise. So I’ll just mention in passing that the value in say the US economy will have 2, usually very different values. The theoretical value is 1 divided by the reserve ratio. If that’s 10% then the multiplier is 1/.10 = 10. The other is the observed value.
I agree that merrick is absolutely correct, but think Alley Dweller’s response might mislead slightly. True, the 90 cents borrowed might end up in a different bank, but 90 different cents might end up in the first bank. Thus simplifying to a single bank does not oversimplify first-order effects.
BTW, the way a multiplier of 1.9 turns into a large number is by ordinary geometric sum as the funds recursively run through the system:
1 + 9/10 + 9/10*(9/10) + 9/10*(9/10)*(9/10) + … ~= 10
Of course the multiplier can never make it to 10. (For one thing, much cash is used to buy cocaine: banknotes are taken out of circulation and used as bullion overseas. :eek: )
I think those unfamiliar with the creation of money should ignore the largish multipliers obtained through this recursion, and focus on simpler scenarios. Joe runs up a large bar bill, has forgotten his wallet, so leaves an IOU for $100. Assuming his credit is good, that IOU can circulate in the community as currency: Money from nowhere! The way that banks create money is essentially the same as Joe writing his IOU, a main difference being that the banks typically have a [del]lower[/del] higher reputation than that of the random drunk in the bar.
Wow, look at the sudden drop in the recent crisis … and the on-going financial paralysis. And why the steady drop over the preceding two decades?
There is an interesting Atlantic article about on-going banking problems which I won’t even summarize – it would be way off-topic in this thread. I do hope someone reviews the article and starts a thread about it.
Thankyou very very much guys, the clarity is really appreciated. I shall run this through my troubled mind a few times until it is solid. Cheers.
By coincidence, another thread started after yours that explains in great detail how and why banks can lose money even if they gives loans only to borrowers deemed creditworthy.
Hellestal’s long answer is wonderfully detailed. The important point for this thread is this:
Please check out the whole thread, though.
Cool and thanks. More brain food!