How fractional reserve banking and M0 work

Great Debates
1

Based on this thread which got a little off the rails and was closed. I just want to see if we’re all clear on the concepts involved.

Fractional Reserve Banking is a system that requires a bank to keep a portion of the assets which have been deposited with it on hand so they are available to be withdrawn. In the United States, the percentage varies from three to ten percent (depending on the total amount of the assets). So, as an example, if you ran a bank and people had deposited a hundred million dollars in your bank, you would be required to keep three million dollars on hand. You could loan out the other ninety-seven million and receive interest from those loans.

M0 is the term for the total amount of currency. It’s essentially the amount of bills and coins that are in circulation. It’s the simplest description of how much money exists.

Is this what mustang19 (the OP from the other thread) understands these terms to mean? And if so, can he explain what he means by banks buying M0? Buying money won’t generally make you any wealthier because the amount you’re paying is equal to the amount you’re receiving.

Obviously, I may be the one who’s wrong in my understanding of these terms. If so, I’d welcome somebody explaining them to me.

2

You got it.

I won’t pretend to understand what mustang19 thinks these terms mean, but his JAQing-off seems reminiscent of various conspiratorial lines of thought regarding radical full reserve banking proposals.

Full reserve isn’t necessarily completely insane, but it’s, like, 90% insane.

3

I’m assuming there’s some misunderstanding and he’s actually referring to some other financial terms. I’m hoping to clear up the confusion. I’m not saying I’ll agree with his idea but I’d like to at least understand what his idea is.

4

I think what he’s saying is why don’t banks simply get low interest loans from the fed and then use that to offer more and more consumer loans at a higher rate - repeat infinitely to generate infinite profit - but frankly I’m not very sure that’s even it.

5

The obvious problem with full reserve banking is that banks have no incentive to do it. Why should they take on the responsibility of holding your money when they can’t use it to generate income via interest?

The answer would be that banks would require people to pay them significant fees to hold their money. And most customers would resist using such a service.

6

It’s the “repeat infinitely” part that has me confused. Fractional reserve banking doesn’t give a bank access to infinite assets. It still limits a bank to the amount of money its depositors have put into the bank. To use the example from my OP, the bank I described doesn’t have infinite assets; it has ninety-seven million dollars.

Once again, I’d like to have mustang19 come in and give us the details on what it is he’s proposing.

7

Yeah, the other OP was pretty much word salad, there’s no point trying to deconstruct what it means. I’m just worried about that poor goat.

8

And note that fractional reserve banking can operate independently of the Federal Reserve System. A bank can just take in deposits, for which it pays interest, and then lend out money, for which it charges interest. No Federal Reserve needed.

Many people leave most of the money they’ve deposited untouched for a long time, which is what allows fractional reserve banking to work. It’s only a problem if everyone wants to withdraw all of their money all at once. This was nicely illustrated in the movie It’s A Wonderful Life in the scene in which the panicked residents are trying to withdraw all of their money from the building and loan society. George Bailey says to them, “You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?”

And of course the amount of money that actually exists in paper form (M0) is a lot less than the amount that exists in bank accounts. I know for me personally, my bank deposits are a hundred or a thousand times greater than the amount I have in paper form.

9

I think I kind of understand what mustang19 meant. He had a badly distorted idea of what “fractional reserve banking” means, which understanding seems to be shared by the crankier overlap of sovereign citizens, gold bugs, and full reserve banking enthusiasts.

I think mustang19 thinks that fractional reserve banking works basically in the reverse of how it actually works. If I understand the reasoning correctly, it goes like this. Bank A has $3 million in actual specie on hand. The bank declares by fiat a 3% fractional reserve. It now has $97 million in nominal, m1, money that it can lend out.

Yes, I realize this is not how fractional reserve banking works.

Under this scheme, mustang19 is wondering why the bank doesn’t use its nominal, m1, money to buy actual, m0, specie money, then add that m0 to its reserves, then apply the fractional reserve rules to create m1, then use that to buy m0, and so on, ad infinitum.

An obviously absurd result from applying a basic rule might lead one to suspect that their understanding of that basic rule is flawed. Equally, if an obvious outcome from applying a basic rule seems like it should happen all the time but in reality never actually happens might also lead one to suspect that their understanding of that basic rule is flawed. However, mustang19 seems so convinced of their understanding of fractional reserve banking that they are looking for some added complicating factor that forbids the obviously absurd result that doesn’t actually happen.

10

That sounds like the misunderstanding is equating debt obligations as assets with deposits as assets. In one case, Joe has given you $1M to hold. In the other case, Bob has borrowed $900,000 and the bank holds a marker of his for that amount; technically an asset, whereas Joe’s $1M is actually a liability balancing the asset they used to have of $1M now $100,000 plus the loan asset. AFAIK, IANABanker, this does not mean the bank now “has” a $1.9M kitty to use and count toward the credit in central reserve. It still only has $1M.

(But… if Bob puts his $900,000 loan back in the bank as a deposit, then…)

11

But if they paid $27 for the rooms and the bellboy has $2, where is the extra dollar?

12

$20, same as in town.

13

nm

14

I assume that you are talking about what could happen in a hypothetical unregulated economy?

In reality, of course, the reserve fraction is a statutory requirement for all banks. Since the reserve may only be physical currency in their vault or a deposit at the Fed, no banks can operate independently of the Fed. All banks hold a reserve balance at their regional Fed (some smaller banks may hold their reserves at a larger correspondent bank that passes them through to the Fed).

15

Double-entry book-keeping should be a required curriculum for all high-school students. It really clarifies the movement of money. Here’s a really basic example.

[spoiler]Let’s start a bank with zero assets and zero debts, for a net worth of $0 = $0 - $0.

Alice deposits $1000 with the bank. That increases the banks assets by $1000 (that’s the cash on hand) and increases the debts by $1000 (what it owes Alice). The bank’s net worth is $0 = $1000 - $1000.

Betty takes $800 loan from the bank. That decreases the bank’s cash by $800 (cash given to Betty) but creates an asset worth $800 (what Betty owes the bank). The bank’s net worth is $0 = $200 + $800 - $1000.

The bank pays 1% interest to Alice. That increases the bank’s debts by $10, so the net worth is decreased to -$10 = $200 + $800 - $1010.

The bank is paid 2% interest by Betty. That increases the bank’s cash by $20, so the net worth is increased to $10 = $220 + $800 - $1010.
[/spoiler]And so on. The important points are that every transaction changes two numbers and the equality is preserved.

How does the bank get more cash? By “buying” it: increasing the cash on hand and increasing its debts. And those decrease its net worth when the interest is paid. How does the bank increase its net worth? By “selling” cash (decreasing its cash and creating loan assets) and collecting interest on it (increasing its cash and net worth).

But cash has very little to do with the bank increasing its net worth. It’s only a medium of exchange for transforming its debts into loans. The fractional reserve is simply a limit for how much of a bank’s assets must be in the form of cash. In the above example the bank has cash equal to 22% ( = $220 / [$220 + 800] ) of its assets.

16

That was a weird thread.

It’s difficult to understand why the OP would tell others to “do more reading”, while simultaneously asking a question. If the OP had done reading personally, then wouldn’t they already have the answer to their own question? Wouldn’t they have figured it out?

But it’s actually an interesting question, when approached the right way. I hope the following might be a slightly more clear presentation of how it works.

Banks absolutely can buy currency in circulation (“M0”) by increasing their own deposit obligations.

This is normal. Happens all the time. This is called a “deposit” at the bank. When you show up at the teller and plunk down a Franklin to put in your account, this is exactly what the bank is doing. They are buying your physical cash, and issuing you a deposit liability in exchange for that cash. And that fact, almost by itself, explains why banks can’t get “infinite money” out of this process.

In order for the bank to get that physical cash, it needs to convince someone to sell them a physical dollar in exchange for a deposit liability dollar. Why do people give banks physical dollars in exchange for having a credit to their account at the bank? One dollar handed over = one dollar change in the ledgers. Why? Well, it’s useful to have a bit of money in checking to write checks or use a check card. It’s also useful to have a bit of money in savings, earning a small rate of return, rather than earning 0% in the sock drawer. This is to say that deposit liabilities are actually liabilities for banks. They’re not free. Banks have to provide a service in order to entice people to exchange their dollars for bank account numbers. This service costs the bank money. And what does the bank get out of that money? Physical cash?

So what?

The value of holding physical currency is not, generally speaking, going to match the cost of holding large deposit liabilities. (There’s a potential wrinkle on this given IOR, but we can ignore that wrinkle at present.) So while it’s technically possible that a bank could use its own vault cash as required reserves in order to issue more deposit liabilities, in order to increase its vault cash required reserves, in order to issue more deposit liabilities… there is no incentive for any bank to do this. The cash in the vault is (basically…) just sitting there are doing nothing. But the deposit liabilities are a genuine cost to the bank. The bank would be losing money. It would become insolvent. The assets aren’t valuable enough to justify the increase in the liabilities.

And all of its depositors would then want to pull their deposits out of the bank. An insolvent bank can’t provide the services, most especially the interest payments, that depositors want from their banks.

The business of banking is not buying low-return cash in exchange for low-return deposit liabilities. The business of banking is buying high-return loans in exchange for low-return deposit liabilities. High-return loans can justify the costs of those deposit liabilities. And if the loan returns are sufficiently high enough, banks can offer higher interest rates on their accounts, with which they can buy M0 (i.e. attract depositors) who will continue to give them low-interest deposits which can help them continue to finance their high-interest loans.

A final point on all of this is that even if a bank could mysteriously convince everyone to fork over their physical cash in exchange for deposit liabilities, there is still a limit on the process. The private bank itself does not create the M0 (or the MB). There is a limited amount of monetary base in the world, and even if the private bank gobbled up literally all of it, they can’t create more by themselves.

Base money is created by the government bank. So even if one private bank somehow monopolized all available reserves, that still wouldn’t dictate “infinite money”, given the ultimate limitation on base money that is not determined by them.

17

Okay, I can see how somebody might think this.

18

The thread we’re talking about seems to lump the idea of fractional reserve banking and the Federal Reserve. I was just trying to make it clear that it’s not necessary to lump them together. Yes, you need some sort of regulatory mechanism so that the banker isn’t just loaning out money whether or not there are sufficient reserves. But that doesn’t have to be the Fed.

19

If banks were rational they would just buy m0 with m1 and infinitely inflate the monetary base.

The only thing preventing banks from having infinite money is their own laziness and indifference.

20

Yes it would. Because the mint replenishes consumer cash demand, so every time cash is withdrawn new money is created. So “consumers”, meaning whoever participates in this scheme, can keep withdrawing and depositing in different banks indefinitely and the MB will continually increase. The only reason the world hasnt collapsed is that nobody has deliberately tried to withdraw and redeposit massive amounts of cash at separate banks.