Simple Fractional Reserve/loan Default Question

[mattyboy1973]

I did ask something similar a while back, but I really want to understand the following simple scenario properly.

Today again I have read something, somewhere (on a forum) stating bank lends x, loan defaults, bank cannot lend x * 10 in the future. I just want to know if this is true.

so:

1. Bank has $1 magic reserve money.

2. Bank loans $10 (=$1 + 9 x $1) - ie bank uses $1 of reserves to loan a total of $10

3. Borrower defaults completely on loan repayment.

the upshot:

The bank has lost $1 of its original reserves, and the $9 it created.

Has this reduced the banks future lending capacity by $10 or $100?

thanks.

[benj]

I think we probably don't need any more threads like this.

1. Bank has $1 magic reserve money.

2. Bank loans $10 (=$1 + 9 x $1) - ie bank uses $1 of reserves to loan a total of $10

No, it doesn't. It can't do that any more than you or I can. If the bank has $1, it can lend at most $1. If the bank lends $0.50 and the borrower defaults completely, the bank has $0.50 left and can now lend at most $0.50.

[Tiger Woods?]

I think we probably don't need any more threads like this.

No, it doesn't. It can't do that any more than you or I can. If the bank has $1, it can lend at most $1. If the bank lends $0.50 and the borrower defaults completely, the bank has $0.50 left and can now lend at most $0.50.

Err...apparently we do need more threads like this...the bank can lend more than what it has. This is what is meant by FRACTIONAL reserve banking.

[benj]

Err...apparently we do need more threads like this...the bank can lend more than what it has. This is what is meant by FRACTIONAL reserve banking.

No.

"Fractional" reserve banking means that the bank can lend only a fraction of what it has. The usual example chosen to keep the math simple has a reserve ratio of 10%, meaning that if the bank has $100, the most it can lend is $90.

This is explained in detail in all undergrad economics textbooks.

[Mr Nice]

Has this reduced the banks future lending capacity by $10 or $100?

thanks.

the $1 in "reserves" would be the basis for $10 in total loans they could have on their books.

the $9 in loans on their books doesn't really effect their lending capacity, so the loss of that would go against their profits or losses for the year.

so $10.

[Ologhai Jones]

I'm really looking forward to this discussion!

[domo]

oh this again. FUN!

Fractional reserve is rendered moot by modern lending standards and so isn't really relevant.

Banks obtain funds and lend it out again, if they take a loss the bank still has to cover the funds it borrowed.

[Liquid Goldfish]

what if the $10 is bundled into some sort of CDO - who's left holding the baby?

[benj]

I'm really looking forward to this discussion being moved to the Off Topic forum before Injin finds it!

Fixed.

[Nicholas Cage]

No.

"Fractional" reserve banking means that the bank can lend only a fraction of what it has. The usual example chosen to keep the math simple has a reserve ratio of 10%, meaning that if the bank has $100, the most it can lend is $90.

This is explained in detail in all undergrad economics textbooks.

That would be a 110% capital ratio, HSBC is about 9%.

The usual example chosen to keep the math simple has a reserve ratio of 10%. If the bank has $100, the most it can lend out is $1000.

Edited August 26, 2008 by maxwell

[Mr Nice]

nowadays we use Capital Asset Ratios, not fractional reserves.

Capital Asset Ratios

any discussion that starts off with talk of fractional reserves is doomed before it even gets started.

[Ologhai Jones]

If Paul Grignon's Money as Debt video is to be believed, and I've remembered it correctly:

For every $1.11 of 'good funds' the banking system has lodged with the Central Bank, $10 of debt (at a fractional reserve ratio of (9:1) can be created. Typically, that $10 debt will, by long or short route, be deposited back somewhere in the banking system. Deposits can't be treated as 'good funds', but they can be used as the basis of further debt creation at a 90% level, in this case, a further $9. That $9 can then be used again (once deposited within the banking system) to create a further $8.10 worth of debt, and so on.

If someone borrows $10 (whether based upon 'good funds' or deposits), the $10 is conjured into existence and, even if it's not repaid, that additional $10 is still somewhere in the banking system. However, the lending bank is presumably responsible for making a $10 loan that was never repaid -- they've used some of their apportioned lending power, but blown it.

On average, a bank that mis-uses its lending power (such as by using it in the sub-prime market) has its lending power diminished over time.

But that's about the extent of my limited (and possibly flawed) interpretation of the aforementioned video...

[VeryMeanReversion]

"Fractional" reserve banking means that the bank can lend only a fraction of what it has.

made me laugh. One of us has it wrong and I hope its not me.

More like:

"Fractional" reserve banking means that the bank only has a fraction of what it says it has!!

A fraction of its loans are kept as reserves in case anyone asks to see their money (and to cover any losses/writeoffs). Just like the Goldsmith issuing many gold certificates when he only has a fraction of the total value of those certificates in his value.

My rough understanding is that the Fraction = (1/leverage) .

If you are bank, you can get away with 5-10% as your reserve. If you are one of the US FMAC/FMAEs you only need 1-2%.

VMR.

[benj]

That would be a 90% capital ratio, HSBC is about 9%.

Not quite - that's ignoring the effect of loaned-out funds being redeposited in the banking system. Assuming that there's only one bank, or that all banks operate at roughly the same reserve ratio, the £90 lent out comes back to the bank (or banking system) having been spent in the economy. It can then be used to lend 90%*£90 = £81, which gets spent by the person who borrowed it and redeposited by the person who received it, and so on and so on. The limit of that geometric progression is that the bank(ing system) ends up carrying £900 of loans on the back of the original £100, for a capital ratio of 11%.

I disagree that fractional reserve is irrelevant - the modern banking regulations are, at heart, based on the exact same principles. In order to understand how the banking system creates money, fractional reserve is really the best place to start.

[AteMoose]

fractional reserve means a fraction is held back in the bank safe, money is created through multiple people saving and depositing money:

Person A puts 100 quid in a bank

Bank lends Person B 90 Quid

Person B goes down the pub pays person C money for beer

Person C puts 90 quid in the bank

The bank has still has 100 quid in its safe, however 190 quid exists in the form of money and 90 quid exists in the form of debt owed by person B. Repeating this creates more debt and more money.

Bank lends Person D 90 Quid

Person D goes down the pub pays person C money for beer

Person C puts 90 quid in the bank

bank still has 100 quid in the safe, however £280 exists and 180 quid exists in debt. The system works because of a global economy with multiple banks, everyone is getting more and more in debt with each other so everything balances out. Obviously some countries, banks and individuals do better than others but generally everyone wins because we all have more debt to pay for things...

The result is inflation the price of goods goes up, and people get paid more and more to cover the debt repayments.

Edited August 26, 2008 by moosetea

[Nicholas Cage]

nowadays we use Capital Asset Ratios, not fractional reserves.

Capital Asset Ratios

any discussion that starts off with talk of fractional reserves is doomed before it even gets started.

For an example it doesn't really matter, Tier I and II stay the same under Basel I and II the risk for

example purposes is the same. A residential mortgage owner occupied may be 40% of capital

requirements or 4% instead of the normal 10% but apart from all that it's the same idea.

[benj]

made me laugh. One of us has it wrong and I hope its not me.

More like:

"Fractional" reserve banking means that the bank only has a fraction of what it says it has!!

No, you're right too.

The principle is that the bank takes the initial deposit (in this example it was £100) and lends out some of it (in this example it was £90). But the original depositor still thinks she has £100 too. As you rightly point out, if she comes asking for her money back, the bank will be unable to pay.

[marlint]

Not quite - that's ignoring the effect of loaned-out funds being redeposited in the banking system. Assuming that there's only one bank, or that all banks operate at roughly the same reserve ratio, the £90 lent out comes back to the bank (or banking system) having been spent in the economy. It can then be used to lend 90%*£90 = £81, which gets spent by the person who borrowed it and redeposited by the person who received it, and so on and so on. The limit of that geometric progression is that the bank(ing system) ends up carrying £900 of loans on the back of the original £100, for a capital ratio of 11%.

I disagree that fractional reserve is irrelevant - the modern banking regulations are, at heart, based on the exact same principles. In order to understand how the banking system creates money, fractional reserve is really the best place to start.

But what's wrong with this? If you think of it as people rather than banks- Tim has £10 and lends £9 to Tom. Tom lends this £9 on to Dave who then lends it to Tim. Tim then lends this £9 he has out to someone else. Just because Tim has lent out £19, it doesn't mean we've magically created money somewhere.

[Injin]

It's miles easier if you real;ise that the bankers are just liars.

I lie to my brother I have loaned him £30 and he needs to repay me. He fails to do so.

I lose nothing.

Ta da!

[RufflesTheGuineaPig]

Arrrrrgghghhhh!

The "banks create money" loonies are back again!!!

[Mr Nice]

Not quite - that's ignoring the effect of loaned-out funds being redeposited in the banking system. Assuming that there's only one bank, or that all banks operate at roughly the same reserve ratio, the £90 lent out comes back to the bank (or banking system) having been spent in the economy. It can then be used to lend 90%*£90 = £81, which gets spent by the person who borrowed it and redeposited by the person who received it, and so on and so on. The limit of that geometric progression is that the bank(ing system) ends up carrying £900 of loans on the back of the original £100, for a capital ratio of 11%.

I disagree that fractional reserve is irrelevant - the modern banking regulations are, at heart, based on the exact same principles. In order to understand how the banking system creates money, fractional reserve is really the best place to start.

it (fractional reserve banking) really isn't.

you end up with bad examples like the one you've given.

there is no lend out 90 of 100, take back in 81 and relend a fraction of that etc.

that just isn't how it works at all.

so it's better to not even involve it imo.

[AteMoose]

Arrrrrgghghhhh!

The "banks create money" loonies are back again!!!

everyone creates money, were all loonies

[Injin]

Arrrrrgghghhhh!

The "banks create money" loonies are back again!!!

Quite right, the banks are just bullshitters - they create nothing.

[Liquid Goldfish]

No, you're right too.

The principle is that the bank takes the initial deposit (in this example it was £100) and lends out some of it (in this example it was £90). But the original depositor still thinks she has £100 too. As you rightly point out, if she comes asking for her money back, the bank will be unable to pay.

ooohhhh - I get it now

[AteMoose]

But what's wrong with this? If you think of it as people rather than banks- Tim has £10 and lends £9 to Tom. Tom lends this £9 on to Dave who then lends it to Tim. Tim then lends this £9 he has out to someone else. Just because Tim has lent out £19, it doesn't mean we've magically created money somewhere.

Its more like Tim borrows from tom, who lends to Dave who lends to Tim who lends to tom who lends to Dave who lends to Tim who lends to Tom who lends to Dave who lends to Tim who lends to Tom...

As the money goes round everyone THINKS they are owed lots of money from loans/work they have done and the money they have have borrowed/earn't is there's to spend. Were all fighting against the rest of the world to get our hands on the money and hold onto something that will create more money/rip others off, some of us syphon off a little bit of the money each time it passes us and put it into savings account every time it goes round the merry go round but that only makes things worse as it means it will get sent round again!

Think is the important work, sentiment drives the world economy if people think everything is ok it carries on if people think there is a problem the merry go round slows and people tighten belts which only makes things worse, if things slow too much things eventually stop. Government then need to spend alot of time to make people think everything is ok and they start spending the money they don't have to keep everything running.

Edited August 26, 2008 by moosetea