Would it be possible for a business like say A fairly large corporation who is in no way involved with banking (maybe Ambercrombie & Fitch) to obtain a commercial banking license and use fractional reserve banking to pay people they are indebted to?
Or am I missing how fractional banking works?
No. It is unlikely that the people they are indebted to would actually want to just leave their debt repayments on deposit with the corporation. Most likely, their creditors would want to transfer the corporation’s debt payments to their own bank and the corporation would have nothing to transfer to their creditor’s bank.
The popular youtube videos about the evils of the fractional reserve banking system paint a picture of a universe where people borrow money from a bank, a bank creates an account for the borrower, and uses bookkeeping magic to credit that account with money. And in this fictional universe, no one ever tries to transfer money out of the bank or perhaps only tries to transfer money to other people who are content to leave it on deposit at the bank.
Ultimately, when the corporation you describe needs to pay its creditors, the creditors are going to demand money that they can transfer to their own bank. They either will want cash or a check which their bank can redeem for electronic fed funds. The corporation cannot create cash or fed funds by simply making an electronic entry or creating a checking account. In the United States, only the Federal Reserve can do this.
The banking system is run on trust. I write a cheque, the merchant cashes it, his bank expects my bank will honor it. At the end of the day, everyone has to square up their accounts.
the system would work while A&F employees leave much of their money “on Deposit” with First National A&F. Perhaps A&F can attract depositors from outside. But generally, expect for a few special cases, people spend what they have, and save larger sums nowadays in something other than cash savings accounts. So every time someone moves their money out - to pay bills, to buy savings bonds, whatever - A&F must transfer that amount to the other location.
If employees or other depositors also leave enough money in, maybe A&F can loan money to employees who need car loans, for example. Then they have less money on deposit, but a steady stream of income in repayment and interest. Plus, presumably they keep their sales deposits etc. in their own bank, pay their bills.
So they basically act as their own bank - fine, as long as they have the money. If A&F or any bank runs low on cash for the day, they can borrow from the Fed. This allows them to settle up with other banks each night if they are a little short. But if they start to be consistently short, guaranteed the Feds will visit and take stock of the situation… Do they have enough to remain solvent?
This is the key - not everyone can be a bank. To get a license, to have your deposits insured by the FDIC, to take advantage of the Fed loans and other support - the company has to demonstrate a stable financial investment, and meet a number of regulations and requirements. Not just anyone can get a license, and unless you process a lot of financial transactions, it’s probably not worth it.
not sure about the USA, but in Canada IIRC banks are not allowed to operate some other businesses. the biggest problem is conflict of interest and exposure - would the bank arm of the conglomerate make its financial decisions in the best interest of the bank, or blow all their money running some energy company or gold mine?
Thinking about my post, I think the real question I wanted ask is this:
Could A&F use funds from the federal reserve to pay for their debts if they were to get a commercial banking license. Borrowing a huge fortune at 0.25% interest.
Contrary to popular belief, the Fed only lends money to banks for short-term and seasonal needs. And it requires the borrower to put up collateral.
The bank that you describe would need long-term loans and would not qualify for the seasonal lending program. The bank would probably not be fiscally sound and probably would be shut down in short order.
Borrowing from the Fed is collateralized.
The new Abercrombie bank would need to hand over legitimate assets, most normally Treasuries, in order to borrow funds from them. The Fed held its nose and took whatever stinky collateral they were given during the financial crisis, but that’s an exception. It’s not the normal state of affairs.
More than that, the cost of primary borrowing from the Fed’s discount window is not 0.25% interest. It’s 0.75%. Secondary credit is 1.25%. You can’t borrow from the Fed at a quarter point today. The federal funds rate is under a quarter point, but that is interbank borrowing not borrowing from the Fed. If Abercrombie wants to borrow at a quarter point, they would need to convince another bank to cough up the funds. If they’re not a real bank but just lucked their way into an account, then why would other banks ever do that?
ETA: Well I guess two answers is twice as good.
More generally, this is an illustration of the idea that there are no “magic words” (like “fractional reserve” or “commercial bank”) that will gain you automatic access to hidden riches. Finance is just like law in this respect, in that there are no such phrases that when properly uttered will get you out of paying taxes or obeying other laws.
There is a system somewhat like this used by various insurance companies.
When someone dies, and you are the beneficiary of a large life insurance policy, they will offer to pay you the full amount at once, with all of the tax consequences (which they will stress), or leave the money in a retained asset account, where they keep the money, give you a ‘checkbook’ which you can use to make withdrawals, and pay you interest on the funds. Someone I know has left money in such an account for several years, because the interest rate that they guaranteed was better than any CD’s or similar liquid investments available. Presumably the insurance company is also making money by retaining these funds, rather than paying them all out.
Ebay wanted a bank.
It had to buy one.
If ebay can’t get a Charter (license to operate a bank - issued by either the Fed or by a State), you need to figure there is a fairly high bar.
During the Reagan years, S&L Charters were handed out to anyone with the right connections - those S&L’s were Federally Insured, so the owners simply looted them and let the Fed pay off the depositors. Your tax money is probably still paying off that little gift to the 1%.
I’m not quite sure what you mean by “ebay had to buy a bank”. If you’re referring to the takeover of PayPal, then the situation is a bit more complicated than that. PayPal does not have a banking license in the United States; it is licensed as a money transmitter, but that’s a business different from banking because it does not involve the creation of credit by means of fractional reserve banking. As far as the European Union is concerned, PayPal actually does have a banking licence there (granted by the Luxembourg authorities, but under EU law a bank licensed in one Member State may conduct business in all other Member States too). That was, however, after the takeover by ebay, so the move from non-bank to bank took place under ebay’s control; ebay did not buy PayPal as a readymade bank.
As to the OP’s questions: There are two separate questions here, which should be distinguished.
First: Could a company turn itself into a bank and pay off its creditors by means of fractional reserve banking? In a sense, this is what banks themselves do. Suppose an employee of a bank holds his checking account with the bank he works for - banks cannot legally force their employees to do so, but they certainly like to see it, and I know many people who work for a bank and keep their own account there. Now the bank can make salary payments by simply crediting the employee’s own account held by the same bank. But this will create a deposit in the bank account, and deposits are liabilities from the bank’s point of view. In essence, by making the salary payment that way, the bank merely substituted one liability (the salary owed to the employee) with another liability (the account balance). As soon as the employee uses the account balance to make a cash withdrawal, or to transfer moey to an account held with another bank (which requires the bank to make a cashless transfer of central bank funds to the other bank), the bank loses liquidity. The key aspect to keep in mind here is: Banks can create money as a consequence of fractional reserve banking, but they do so simply by creating a new liability, and they may have to make a payment on this liability in the future.
The second question here is: Can a company obtain a banking license in order to borrow cheaply from the central bank? Sure it could. But it wouldn’t be worth the trouble. Firstly, banks need to post collateral to borrow from the central bank, and since the central bank applies a haircut policy (there’s a deduction made on the value of the collateral to determine the amount that can be borrowed against it), it needs to have more collateral than it wants to borrow. Secondly, in addition to the central bank’s borrowing policies, banks are subject to all sorts of prudential regulatory requirements. They need to meet organisational and procedural standards, and they need to maintain solvency and liquidity ratios. This makes banking a complex business totally different from A&F’s normal business model, and if A&F decided to go that way, it would likely transform its entire business model. Which is totally possible - there are companies who started as non-banks and then transformed into banks (American Express and Wells Fargo are two well-known examples). But it wouldn’t be A&F afterwards any more.
Wasn’t there a thread about a Doper that did this? I want to say Carol Stream and it wasn’t pretty. IIRC the insurance company made it very difficult to actually get the money.
Paypal (owned by ebay) now offers a real credit card, called “Bill Me Later” - they bought the bank which runs that card.
I am quite aware that paypal ducked the charge that it was acting as a bank and should be regulated as such. Its trick of refunding a buyer’s money by taking money from the seller’s account is something no bank would be allowed to do.
Interesting; I didn’t know that. Indeed, in many cases if you’re a company and, for whatever reason, you want to have a bank in your group it’s easier to purchase one that’s already in existence - it’s quite a cumbersome process to set up a new bank from scratch, since you need to meet all sorts of regulatory requirements (and cough up a lot of money upfront) before you can even apply for a banking licence. Sometimes, however, big corporations do take the cumbersome route and set up a new bank from scratch. In Germany, for instance, Volkswagen did that many years ago - it’s banking subsidiary, Volkswagen Bank, is now actually one of the top 30 or so banks in the country. They set it up for a number of things to do through them, but as far as I’m aware access to cheap central bank funding wasn’t one of them - they use it mostly to keep the car leasing business inhouse, and I guess it also makes the treasury business of the Volkswagen group easier since they can do transactions which require a banking license and which the parent company can therefore not do itself. It does, however, also offer checking accounts and other financial services to private clients.
Well, when you get a loan from a commercial bank, as opposed to a savings bank or a credit union or your friend at work, new money is created. Of course, people can transfer the money to other banks and write checks to others who can deposit it in their own banks, but the money will stay in the banking system as a whole, except for that which gets stuffed under mattresses.
I seem to remember that most of the YouTube videos explain this.
Strictly speaking, no. It’s when a bank takes deposits that new money gets created. If I deposit $100 cash in my bank account, the bank now has $100 more money (which it can then loan out), but the $100 credit applied to my account is also “money” by all but the most restrictive definition.
Of course, if the bank didn’t then loan it out, the “new” money would be irrelevant to the rest of the world.
And there’s no difference in this between a commercial bank and a credit union. They both do exactly the same thing, the difference is in the ownership.
One of these days, I’m going to write the king of all money creation posts and then I’ll be able to just link back to it for thread after thread…
I don’t see how this claim could be true by the official definition of the M1 stock of money.
Officially the M1 is currency out there in the world – that is currency outside of bank vaults – plus all checkable deposits. When a customer makes an outside deposit of currency, they’re bringing in money that’s placed in a bank vault, and therefore that currency disappears from the M1. Simultaneously a checkable deposit is created of the same amount, which increases the M1. The net change is nothing. Depositing currency does not actually expand the M1. It’s difficult to say whether “new money is created”. If you add up all the monetary base plus all the checkable deposits, the number is larger after a cash deposit, but that’s not how these things are typically measured.
But a loan clearly and indisputably does expand the M1, and it expands the M1 regardless of whether the loan check is deposited in full or whether some cash is taken out. After a bank approves a loan, they do some fiddling around with their accounting ledgers, and it looks something like this:
DEBIT New loan assetCREDIT New checkable deposit liabilityThe M1 consists of currency outside of bank vaults, plus checkable deposits. The new loan increased the amount of checkable deposits. There is no dispute about this, you can see it right there in the accounting entry. The new loan increased the stock of M1. It’s really as simple as that.
If the check is cashed, then the deposit for the loan is eliminated, but that also means that an equivalent amount of currency was withdrawn from a bank vault, so there’s no net change in the M1. That is to say that loans expand the M1 regardless of whether the money stays in the banking system, or whether it’s removed. That’s the simple fact of these definitions, which is very easy to get wrong. (I’ve gotten it wrong plenty of times before.)
The deeper problem is none of these definitions really matter on their own.
The definitions are only the first step. It’s a lot more important to know the reasons why the stock of money might increase, under what circumstances, how profitable these loans might be, how the central bank will react, and how fast money will flow through the economy for the purchase of new goods and services. Mastering a few formal definitions won’t provide any deeper understanding into the world of money. If we want to say anything sensible, we have to know how all the gears fit together.
And that serves me right for try to over-simplify.
I should have said that the “created” money is only added to the money supply when the bank loans it out.
If you’re using the M1 money supply as your formal definition of “money”, then yes, no money is created when a deposit is made, because M1 specifically excludes cash in bank vaults. But that requires you to believe that the cash I handed over at the bank counter stopped being money as soon as the bank took possession and only became money again when the bank loaned it out. I’ll wager that not many people, even in banking, would say that a $100 bill stops being money because someone puts in it a bank vault.
I was trying (badly) to use the everyday definition of money (i.e. stuff you can spend) to show how “Fractional Reserve Banking” does not mean “a license from the Banking Mafia to create money with a stroke of the pen”.
It’s completely correct to say “banks increase the money supply when they make loans”, but if you say “banks create money when they make loans” you have to be clear what you mean by “money”, otherwise you end up perpetuating the belief that the modern financial system is just accounting fraud by the 1%.
The original question, that I was answering, was whether a large corporation could pay off its creditors just by creating a bank and using the magic of fractional reserve banking to create money.
Of course, if the corporation wanted to create a bank, properly capitalize it, convince customers to open accounts and deposit money, then they could certainly take out a loan from this bank just like anyone else and then be obligated to pay it back. But that’s a lot more trouble than just taking out a loan from an existing bank.
But they can’t just get a banking license and start writing checks to their creditors or start creating checking accounts with fictional deposits. Opening a bank is no magic panacea for debtors to pay off their creditors.
You’ll notice that in the youtube videos, they never show the bank’s assets being reduced when someone writes a check. Or they just never show anyone writing a check for deposit outside the bank.