Banks Borrow Money Into Existence, But Not At 0% Interest

[Injin]

which question? whether i want a million of your student prank pounds or what?

They sent me a bill saying I had received several thousand pounds in my account.

I asked them what that meant had happened in the real world.

Apparently it meant nothing had happened but some numbers and accountancy had been done.

The going rate for 15 minutes of accountancy isn't several thousand pounds. Writing down £6,000 on a piece of paper and doing some data entry isn't the same as handing someone £6,000 in legal tender..far from it in fact, a claim that it's the same is fraud.

After very many silly question asking for proof, evidence, facts and that kind of thing they stopped bothering me.

Go figure.

[kokyu]

Yes, and I have a great idea for a new trading strategy for my employer (a bank):

We'll create a new regulated banking entity called, say, Money Machine Ltd. That'll cost around 100K for legal work, initial ante to the BoE etc. We'll then go and borrow 3M at LIBOR by issuing some commercial paper (we do lots of this already so 1M more won't be hard to get) which we'll deposit with Money Machine Ltd who'll pay us, say, 3% interest. We'll then create 100 new legal entities - standard UK limited companies at 100 GBP a shot give or take will do fine - each of which will borrow 1M off Money Machine at 4%. They'll then use that money to buy 1 year gilts - which yield around 4.4% right now - which will allow them to pay the interest they owe to MM. So, the net result for MM will be:

startup costs - ~110K

interest receivable - 4% x 100M (i.e. all the interest due from the 100 companies) - 4M per year.

interest payable by MM - 3% x 1M (i.e. all the interest due to my bank) - 30K per year.

interest payable by us - ~5.3% (1 year libor) - ~53K per year.

The remaining ~3.9M will be paid out as a dividend to the shareholders (i.e. my employer). That's not a bad zero risk return. And, of course, it could scale up a long way from there - I doubt we'd had much trouble borrowing 5-10B from the money markets if we wanted to although we might just exhaust the UK government's appetite for bond issuance at some point before that. But then there's plenty more sovereign debt out there, so no worries!

What do you suppose our new products committee would say if I proposed that to them?

Good example but unfortunately it doesn't help prove your point as the % of deposits withdrawn here are very high (i.e 100% being taken out to buy gilts) and the reserve ratio very low. This is not realistic at these %'s, however banks can and do create money via debt at much lower levels of risk.

Banks know from experience the % of 'real' money that is required to meet normal levels of deposit withdrawls and manage their assets to meet this level of risk. The amount of money they can loan is only limited by their knowledge of what likely % of the deposits will be withdrawn from their systems combined with the managements attitude to risk and the regulations that they are subject to (or can bypass).

I would imagine the bank that you work for might struggle to find the funding if 100% of its customer deposits were to be withdrawn tommorow morning to buy gilts. Hence, I would say, proving that they are already in fact doing something like you propose but probably at a much lower risk level.

[Mr Nice]

yawn.

if you have no reserve requirement then if £100 is deposited the bank can lend a maximum of £100. obviously.

if the requirement is 5% they cant lend £2000, they can lend £95. where on earth has this £1900 just come from?

next.

it comes from the same place the money came from in the fractional reserve examples that were previously given, accounting entries.

so far we have all agreed (except injin ) I think, that if you deposit a 100 pounds in the bank, and they have a %10 reserve requirement, they can, and usually will end up with much more in loans than there was in original cash.

you are saying they do it through re-lending and taking off the %10 for reserve each time until they hit a maximum, I am saying that they don't have to do that they can just do it all at once.

THE END RESULT IS EXACTLY THE SAME

so if they can make up the money through accounting entries through re-lending, they can do it through accounting entries by loaning it all out at once.

there is no reason to make them go through all of those steps.

for example, your way, if a bank had 1000 pounds and I wanted to borrow 10,000 pounds, they would have to lend 900, keep 100 etc to me over and over until we got up to 10,000. that's a pretty big waste of time.

what they do, is at the end of the day, they look at how much they have created, and see if they have the capital reserve to back it.

If not they borrow that reserve from the money markets.

NOT the whole amounts of the loans created, just the bit needed for the reserve.

the creation of the money is totally separate from the reserves

Edited February 28, 2008 by Mr Nice

[the_austrian]

Yes, and I have a great idea for a new trading strategy for my employer (a bank):

We'll create a new regulated banking entity called, say, Money Machine Ltd. That'll cost around 100K for legal work, initial ante to the BoE etc. We'll then go and borrow 3M at LIBOR by issuing some commercial paper (we do lots of this already so 1M more won't be hard to get) which we'll deposit with Money Machine Ltd who'll pay us, say, 3% interest. We'll then create 100 new legal entities - standard UK limited companies at 100 GBP a shot give or take will do fine - each of which will borrow 1M off Money Machine at 4%. They'll then use that money to buy 1 year gilts - which yield around 4.4% right now - which will allow them to pay the interest they owe to MM. So, the net result for MM will be:

startup costs - ~110K

interest receivable - 4% x 100M (i.e. all the interest due from the 100 companies) - 4M per year.

interest payable by MM - 3% x 1M (i.e. all the interest due to my bank) - 30K per year.

interest payable by us - ~5.3% (1 year libor) - ~53K per year.

The remaining ~3.9M will be paid out as a dividend to the shareholders (i.e. my employer). That's not a bad zero risk return. And, of course, it could scale up a long way from there - I doubt we'd had much trouble borrowing 5-10B from the money markets if we wanted to although we might just exhaust the UK government's appetite for bond issuance at some point before that. But then there's plenty more sovereign debt out there, so no worries!

What do you suppose our new products committee would say if I proposed that to them?

Banks are not allowed to issue bank credit in excess of their deposits (available on demand). Money Machine has issued 100M in bank credit without having any deposits

[davidhpc]

Banks are not allowed to issue bank credit in excess of their deposits (available on demand). Money Machine has issued 100M in bank credit without having any deposits

so they CAN'T just create money. is that what you are saying?

Edited February 28, 2008 by davidhpc

[davidhpc]

2 things.

I'm not sure why everyone keeps using that %10 number for their examples i.e bank takes in 100, reserves 10 re-loans out 90 etc.

Like "legal tender," I don't think it means what a lot of people are using it to mean.

That "fractionable reserve" only applies to certain kinds of deposits, like demand deposit accounts.

Since we have been talking about the "saver's money being re-lent" SAVING'S ACCOUNTS DO NOT HAVE FRACTIONAL RESERVE REQUIREMENTS.

they could lent infinite money with 1 pound from a savings account.

the thing that stops them is the LAW saying that they can only lend so much more than deposited through CAPITAL ADEQUACY REQUIREMENTS.

there is absolutely no reason for banks to do that peanut shuffle of keep 10 loan 90, keep, 9 loan 81, keep 8 etc.

if you deposit 100 pounds and the capital adequacy requirement for that type of account is %5 they can loan out IMMEDIATELY 2000.

you also say that if banks could do this, then they could just make unlimited amounts of money, eventually loosing a tide of pounds upon us.

isn't that exactly what is happening to us now?

the 10% is an easy example, the maths is easy and thats why it is used, you can also up it to 20% and see that it has the effect of reducing the total money that can be lent or down it to 5% and see that more can be lent.

if you deposit 100 and then lend out 2000 you have a situation where the bank has deposits of -1900 and has lent 2000. THAT nowhere near meets any sort of capital adequacy or reserve requirement. it can obviously lend 90 and must wait for more deposits before it can lend more.

[Mr Nice]

the 10% is an easy example, the maths is easy and thats why it is used, you can also up it to 20% and see that it has the effect of reducing the total money that can be lent or down it to 5% and see that more can be lent.

if you deposit 100 and then lend out 2000 you have a situation where the bank has deposits of -1900 and has lent 2000. THAT nowhere near meets any sort of capital adequacy or reserve requirement. it can obviously lend 90 and must wait for more deposits before it can lend more.

the mortgage itself is the asset, why is that not making sense?

if you do it your way of lend 90 keep 10 etc etc etc you end up in the same place.

1900 in mortgages, 100 in cash.

everything else is accounting entries that we treat as cash.

[davidhpc]

the mortgage itself is the asset, why is that not making sense?

if you do it your way of lend 90 keep 10 etc etc etc you end up in the same place.

1900 in mortgages, 100 in cash.

everything else is accounting entries that we treat as cash.

but you have deposits to match it, the money is coming back in every time.

[Mr Nice]

but you have deposits to match it, the money is coming back in every time.

but no new "hard" money is created in either case.

you still end up with just 100 "real" cash.

the rest is all accounting.

and since there is no mathematical different between 15 transactions that add up to 1900 in mortgages and 100 cash and 1 transaction that ends up in 1900 in mortgages and 100 in cash, then both are possible.

they tally at the end of the day

[davidhpc]

but no new "hard" money is created in either case.

you still end up with just 100 "real" cash.

the rest is all accounting.

and since there is no mathematical different between 15 transactions that add up to 1900 in mortgages and 100 cash and 1 transaction that ends up in 1900 in mortgages and 100 in cash, then both are possible.

they tally at the end of the day

no they don't. the second one doesn't. the bank lends 100 and then has nothing else to lend out. as you say, it has no more real cash.

[Mr Nice]

no they don't. the second one doesn't. the bank lends 100 and then has nothing else to lend out. as you say, it has no more real cash.

sure it does

your way you end up with several mortgages that total 1900 and 100 cash reserve.

my way you end up with 1900 in 1 mortgage and 100 in cash reserve.

in your way you hand out and take back fractions of the 100.

my way, they never hand out the hundred at all.

they both end up in exactly the same place.

I think the main trouble is that you are using the fractional reserve banking thats in that youtube video.

Fractional Reserves AREN'T used for most monies in banks.

Capital adequacy is a totally different thing.

[the_austrian]

so they CAN'T just create money. is that what you are saying?

Let's imagine that you are working at your bank but it is a full-reserve bank. One day you hear an "oink oink" coming from your filing cabinet. You open up the drawer and inside you see a little magic pig. The pig has the ability to magic "money out of thin air" but only if you promise to pay it back (at no interest). This sounds great so you immediately ask "how much can I borrow at any one time?" to which the pig replies "only as much as your bank has in deposits".

[Japhy Rider]

All

Sorry to have missed all the good discussion since post #73 but work has interfered with this important business.

I note that Post #73 has come up in conversation a bit so I'd like to add something if I may. When DavidHPC referred to that post, I think the bit he was interested in is this bit.

The money "creation" that banks engage in is purely a recognition of the mismatch between the terms of deposits received and loans made. If a bank accepts a deposit with a fixed duration of ten years and then makes a loan on the exact same terms then no money is created.

If a bank accepts a deposit with little or no time limitations (called a demand deposit) but then makes a loan fixed at 10 years, then money has been created because there are two people who have the right to demand that cash (the person who has it and the holder of the demand deposit receipt). No money has been created in an absolute sense because assets remain balanced by liabilities, but in terms of monetary measures like M4 there is money creation.

I think perhaps there are 3 kinds of people on this site:

1. People who agree with that statement
   
2. People who disagree with that statement
   
3. People who don't understand that statement
   

It's difficult to discuss these things without some degree of simplification so I concede that the above may be over simplistic, but I really believe that it goes to the heart of the discussion. I'd be glad to hear views from any of the 3 groups of people above.

Sorry all, I don't want to talk about definitions of money. Not because it isn't relevant or interesting. Ijust think it is a bit too philosophical for what is a nuts and bolts topic.

Great discussion btw and sterling work (pun!?) by DavidHPC amongst others on both sides.

JR

[davidhpc]

sure it does

your way you end up with several mortgages that total 1900 and 100 cash reserve.

my way you end up with 1900 in 1 mortgage and 100 in cash reserve.

in your way you hand out and take back fractions of the 100.

my way, they never hand out the hundred at all.

they both end up in exactly the same place.

I think the main trouble is that you are using the fractional reserve banking thats in that youtube video.

Fractional Reserves AREN'T used for most monies in banks.

Capital adequacy is a totally different thing.

well its all well and good creating mortgages and calling them your assets. but dont you think, just possibly, that the people selling the houses might want some money from you?

they ain't going to accept the fact that you have created some mortgages out of thin air and that they should accept that as payment. they want their money, and you haven't got any, you're bust.

[Mr Nice]

well its all well and good creating mortgages and calling them your assets. but dont you think, just possibly, that the people selling the houses might want some money from you?

they ain't going to accept the fact that you have created some mortgages out of thin air and that they should accept that as payment. they want their money, and you haven't got any, you're bust.

no.

you don't walk out of the bank with 200k in pounds.

you get a credit (accounting entry) to your account for 200k which you draw on to pay for the house.

which is then redeposited into the banking system.

if for some reason the house builder stuck the 200k you gave him under the mattress, THEN you might have to borrow from the money markets.

[davidhpc]

no.

you don't walk out of the bank with 200k in pounds.

you get a credit (accounting entry) to your account for 200k which you draw on to pay for the house.

which is then redeposited into the banking system.

if for some reason the house builder stuck the 200k you gave him under the mattress, THEN you might have to borrow from the money markets.

draw on what? your bank doesn't have any money. it has a 100quid, if it lends any more it doesn't have it.

the fractional reserve way, watch

Mr A deposits 100

MR B borrows 90 and buys something from Mr C

MR C deposits it

Mr D borrows 81 and buys something from mr E

Mr E deposits it

everybody is receiving and depositing cash, we have deposits of 271 and 100 in cash and 171 in loans to balance up.

your way

Mr A deposits 100

Mr B borrows 1900.

the bank doesn't have it. you can't do it. the banks books have a deposit of 100 and a loan of 1900. it doesn't have the money.

[Mr Nice]

draw on what? your bank doesn't have any money. it has a 100quid, if it lends any more it doesn't have it.

the fractional reserve way, watch

Mr A deposits 100

MR B borrows 90 and buys something from Mr C

MR C deposits it

Mr D borrows 81 and buys something from mr E

Mr E deposits it

everybody is receiving and depositing cash, we have deposits of 271 and 100 in cash and 171 in loans to balance up.

your way

Mr A deposits 100

Mr B borrows 1900.

the bank doesn't have it. you can't do it. the banks books have a deposit of 100 and a loan of 1900. it doesn't have the money.

you are leaving out that the home builder re-deposits the 1900 into the bank.

that would be like leaving out the "Mr E deposits it" step in your example

[davidhpc]

you are leaving out that the home builder re-deposits the 1900 into the bank.

that would be like leaving out the "Mr E deposits it" step in your example

no it wouldn't then we would have 190 in deposits, 19 in cash and 171 in loans to balance up.

[davidhpc]

you are leaving out that the home builder re-deposits the 1900 into the bank.

that would be like leaving out the "Mr E deposits it" step in your example

and your builder doesn't have 1900, you only had 100 to give him

[Mr Nice]

and your builder doesn't have 1900, you only had 100 to give him

he has a CREDIT for 1900 just like all of your people have CREDITS for 1900.

in either case if everyone tried to remove their money the bank would collapse.

they are the exact same thing

Edited February 28, 2008 by Mr Nice

[davidhpc]

he has a CREDIT for 1900 just like all of your people have CREDITS for 1900.

in either case if everyone tried to remove their money the bank would collapse.

they are the exact same thing

well, if you want to do it backwards way round, then it is exactly the same and still no new money is created.

your bank, though has increased its deposits by 1900 it has 2000 in deposits now.

[Mr Nice]

well, if you want to do it backwards way round, then it is exactly the same and still no new money is created.

your bank, though has increased its deposits by 1900 it has 2000 in deposits now.

so does yours, you just have a lot more transactions involved.

In BOTH cases what you are doing is leveraging (gearing) the deposit of 100.

in your case you are applying fractional reserve techniques to end up with what I end up with in one transaction.

since franctional reserve banking ISNT USED on most money held by the banks it is inappropriate to use fractional reserve techniques.

Capital adequacy requirements are used, and those say that at the end of the day, you tally your books, and if you haven't taken in enough deposits to off-set the mortgages (the requirement is a tiny percentage of the total mortgages) then you have to borrow from the markets.

there is no "save 5-10% reserve" or anything like that, that is fractional reserve.

both ways allow you to greatly leverage your money.

[davidhpc]

Capital adequacy requirements are used, and those say that at the end of the day, you tally your books, and if you haven't taken in enough deposits to off-set the mortgages (the requirement is a tiny percentage of the total mortgages) then you have to borrow from the markets.

woah. you would need to borrow more than you have lent out, not a tiny %.

[algobet]

my morning dose on this thread:

i want to make the point again between banks creating money and actual wealth/assets.

banks create money. yes.

but no there are no new assets/wealth/value backing the money.

imagine if you could only spend your new loan on physical assets eg a newly built house. you cannot buy existing houses or cars. you could only buy newly produced assets. what would happen?

only roughly 3% of new money would be used (ignoring replacement need for simplicity) = GDP increase.

the rest of any new money created would sit in bank accounts as it has no use.

it is only because the money supply grows faster than output that you get asset price inflation. it doesnt create wealth which is why when you look back over history when money supply contracts asset prices correct

question for those who believe banks do not create new money: why do you think inflation exists if no new money is created in excess of increases in output

[davidhpc]

woah. you would need to borrow more than you have lent out, not a tiny %.

and that's where some of the confusion is, isn't it? i think.

a bank can take in 100 in deposits lend 90 and have 10 left. ie 10% * 10 giving 100%

it can't take in 100 and lend 1000. that would be 100% * 10 giving 1000%

if it did the second, it would in effect be 900quid out of balance and would need more money from somewhere.