Simple Fractional Reserve/loan Default Question

[Guest Steve Cook]

Does not the fractional reserve lending occur at the level of the CB? This newly lent-into-existence-money then cascades down the system to joe publuic eventually.

In a sense, it doesn't really matter, in principle, where the money has been lent into existence. However, this has to occur at some level. The only advantage for this to be only done by the CBs is that it is easier to police.

Of course, this all relies on CBs not being a bunch of irresposible, criminal *rseholes themselves...

Edited August 26, 2008 by Steve Cook

[PotNoodle]

Anyone confused at this point should simply Google "Fractional Reserve"

where they will be reliably informed that :-

A fractional reserve of 15% means that Banks will hold £15 for every £100

they lend out.

Simple.

Now for the funny stuff :-

Banks create "credit" when they lend.

They are then paid back real money !!

Figure that one out.

[Injin]

Its more like Tim buys 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/earnt is there's to spend. 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 stops and alot of work is done to make people think everything is ok and they start spending the money they don't have.

Quite right - bullshitters have convinced people they are rich/owe and so they work.

If they wake up and realise either that they have ****** all/don't owe anything, then the work ceases.

Good work bankers, you mess up your little fraud and we all might starve.

Dipshits.

[Nicholas Cage]

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.

I think the terms used may be getting a bit too loose. The example can either be what happens in banks over the last 20 years, the initial deicisions on lending and requirements by law or by investors or regulators , or what happens to the money once it has been lent out. Combining them is going to cause all kinds of confusion crossing timelines.

[Injin]

Does not the fractional reserve lending occur at the level of the CB? This newly lent-into-existence-money then cascades down the system to joe publuic eventually.

In a sense, it doesn't really matter, in principle, where the money has been lent into existence. However, this has to occur at some level. The only advantage for this to be only done by the CBs is that it is easier to police.

Of course, this all relies on CBs not being a bunch of irresposible, criminal *rseholes themselves...

There is only one bank.

it has many faces and branches but it's like a McDonalds that has different signs over the door - a franchise.

[Mr Nice]

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.

the trouble with that is that is not what the banks are doing.

if a bank has 10 in reserves, it never lends out ANY of those reserves. They stay either in the vault or in accounts with the central bank.

the 10 is used as a basis for computing how much in loans (assets) the bank can create.

so at 10 to 1 the bank could create 100 in loans based on the 10 in reserves.

the money created for that loan is a book-keeping entry by the bank, balanced by the loan created by the bank.

[AteMoose]

the trouble with that is that is not what the banks are doing.

if a bank has 10 in reserves, it never lends out ANY of those reserves. They stay either in the vault or in accounts with the central bank.

the 10 is used as a basis for computing how much in loans (assets) the bank can create.

so at 10 to 1 the bank could create 100 in loans based on the 10 in reserves.

the money created for that loan is a book-keeping entry by the bank, balanced by the loan created by the bank.

Not to my knowledge....

BUT it can use the 10 quid in its vault to borrow 100 quid from other banks which it can lend out (which is the same thing just worded differently ;p)

Edited August 26, 2008 by moosetea

[RufflesTheGuineaPig]

Does not the fractional reserve lending occur at the level of the CB? This newly lent-into-existence-money then cascades down the system to joe publuic eventually.

In a sense, it doesn't really matter, in principle, where the money has been lent into existence. However, this has to occur at some level. The only advantage for this to be only done by the CBs is that it is easier to police.

Of course, this all relies on CBs not being a bunch of irresposible, criminal *rseholes themselves...

The central banks can also hold "reserves" but fractional lending rules don't apply.

Also, commercial banks can deposit money with the central bank, e.g. the Bank Of England, and earn interest on it.

The BoE can, of course, issue more "currency" either as paper or almost almost electonic numbers, but whenever they issue new "currency" it dilluted the value of the currency already in circulation.

So if the government gets the bank of Englend to issed £50bn in new currency to support northern Rock, the result is the value of the pound falls against other currencies, and everything you import (which is pretty much everying we buy now) becomes more expensive.

Thus inflation in the amount of pounds in circulation means inflation in the price of food and fuel.

So to sum up, your weekly shop has risen by £30 in the last year because Gordon brown decided to bail out northern rock.

[RufflesTheGuineaPig]

Not to my knowledge....

BUT it can use the 10 quid in its vault to borrow 100 quid from other banks which it can lend out (which is the same thing just worded differently ;p)

Correct, but still no "money" has been created... the other banks it borrows from would have to have the £100 in the first place... well £110 as they'de also need to keep a 10% (or whatever it is... probably less than 1%) fractional reserve as well.

[Injin]

Correct, but still no "money" has been created... the other banks it borrows from would have to have the £100 in the first place... well £110 as they'de also need to keep a 10% (or whatever it is... probably less than 1%) fractional reserve as well.

It gets ccreated when everyone goes to the bank on the same day for it - at that point either the banks go insolvent or the presses run.

Which is why we are going to have hyperinflation.

I promise £1 to 76 trillion people and when they all arrive for it then I add 76 trillion pounds to the economy. (Daft example but for emphasis.) Boom - hyperinflation.

[Mr Nice]

Not to my knowledge....

BUT it can use the 10 quid in its vault to borrow 100 quid from other banks which it can lend out (which is the same thing just worded differently ;p)

not exactly.

the banks borrow capital from each other, not "money"

for a bank to increase it's lending, and it is already at it's maximum loan ratio, it has to borrow capital from other banks (or the government now).

so a bank would borrow 10 from another bank, and reloan out 100 to the general public through mortgages etc.

the 10 that it borrowed from the other banks would stay in the vaults as capital reserve.

[AteMoose]

It gets ccreated when everyone goes to the bank on the same day for it - at that point either the banks go insolvent or the presses run.

Which is why we are going to have hyperinflation.

I promise £1 to 76 trillion people and when they all arrive for it then I add 76 trillion pounds to the economy. (Daft example but for emphasis.) Boom - hyperinflation.

I agree, not printing and letting the banks crash will destroy 99% of money in a very nasty chain reaction, the ONLY option is to inflate/hyperinflate out of it. It is the only option available for a government/system thats pushed up against a wall... Things are too bad to deflate...

Edited August 26, 2008 by moosetea

[benj]

Correct, but still no "money" has been created...

Money most certainly is created in this process, for a sufficiently broad definition of "money".

You have £100. You pay £100 into the bank. Your bank balance is now £100. In your mind, you still have £100, because the bank tells you that you do. At any time, you can go to the bank and ask them for £100, and they are obliged to give it to you. You can tell your bank "please pay my gas bill", and they will (so long as it's not more than £100). You can put your money in the bank, take it out, put it in, take it out, it will remain £100. Money in the bank is as good as money in your hand. This we know from experience.

If you put your £100 in the bank and the bank then lends out £90 of it to someone else, that other person has £90. That's the point of loans - if they asked for £90 and got a packet of pencils instead, it wouldn't be much of a loan. When the other person looks at their new loan balance, they discover that they have £90 to spend. They also have an obligation to pay that money back to the bank at some point in the future, but that's less important. For now, they can go to the bank and ask them for £90, and the bank is obliged to give it to them.

So you "have" £100 in the bank, and they "have" £90 in the bank. The total amount of money is £190. Physically there is no more cash than before, but the spending power of all the people in the economy has been increased, and that's what money is. You gave the bank ten crisp tenners. They have promised ten of them to you, and nine of them to the other guy. They have calculated that the chance of both of you wanting the money at the same time is sufficiently small that they won't be caught short. And when the other guy pays back the £90 he borrowed plus £10 interest, they can be sure to meet their £100 liability to you - and they'll have made a £10 profit to boot.

[Guest Skint Academic]

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.

The reason money is created is because the money that is borrowed gets put back into other bank accounts and those other banks can use it as reserves for loans to other people.

So I have £100 and put it into RBS. RBS loan out £90 to someone else. They give it to someone else in exchange for some goods or services and that person puts it into their own bank account at LLoyds. Lloyds can then loan out £81 to another person.

Personally I want to know exactly what happens if the first borrower defaults on their £90. RBS have to make up their reserves so that they continue to hold 10% of what they owe to their savers but where do they get this from?

EDIT: Presumably they can't lend out as much next time when they get another saver depositing money with them

Edited August 26, 2008 by Skint Academic

[Mr Nice]

The reason money is created is because the money that is borrowed gets put back into other bank accounts and those other banks can use it as reserves for loans to other people.

So I have £100 and put it into RBS. RBS loan out £90 to someone else. They give it to someone else in exchange for some goods or services and that person puts it into their own bank account at LLoyds. Lloyds can then loan out £81 to another person.

Personally I want to know exactly what happens if the first borrower defaults on their £90. RBS have to make up their reserves so that they continue to hold 10% of what they owe to their savers but where do they get this from?

in normal times it would come out of the profits (interest) that they have on the other loans.

a certain amount of the interest you pay is calculated to cover losses.

or it could come from other profits like fees etc.

[AteMoose]

The reason money is created is because the money that is borrowed gets put back into other bank accounts and those other banks can use it as reserves for loans to other people.

So I have £100 and put it into RBS. RBS loan out £90 to someone else. They give it to someone else in exchange for some goods or services and that person puts it into their own bank account at LLoyds. Lloyds can then loan out £81 to another person.

Personally I want to know exactly what happens if the first borrower defaults on their £90. RBS have to make up their reserves so that they continue to hold 10% of what they owe to their savers but where do they get this from?

what happens is called 'Northern Rock', some of the original borrowers started defaulting on the crazy 125% loans, and NR business model required them to borrow more and more money from the markets t to keep things going. The markets stop loaning money to them because they thought they were about to go bust, savers rushed to the bank to get savings and they ran out of money very very quickly.

Another thing that happens as part of this money go round is TAX, every time the money goes round a slice of tax is taken. It really is amazing how crazy money is, its like a big joke invented by a couple of guys hundreds of years ago when they were down the pub.

@mattyboy1973 : does all this answer your initial question?

Edited August 26, 2008 by moosetea

[Injin]

I agree, not printing and letting the banks crash will destroy 99% of money in a very nasty chain reaction, the ONLY option is to inflate/hyperinflate out of it. It is the only option available for a government/system thats pushed up against a wall... Things are too bad to deflate...

The only thing it destroys is peoples mistaken belief.

of course that means they stop working and trusting each other, which has ver nasty consequences.

ideally, all deposits should be cancelled as well as all debts (because both are fictional anyway) and the bankers tried for crimes against humanity, but this is a pipedream.

What will happen is that the bankers will hyperinflate, everything will go to hell in a hadbasket and I'll have to hunt them down with an elephant gun or something.

[Guest Skint Academic]

OK thanks. I was wondering about the specifics of this so I could try and figure out in more detail how deflation could happen. Presumably if the defaults start getting too numerous and there are not enough savers then the banks go off to the central banks and borrow more money to replenish their reseves or the government starts swapping bonds for the toxic debt (i.e. bailing them out with tax payers money as loans).

[AteMoose]

The only thing it destroys is peoples mistaken belief.

of course that means they stop working and trusting each other, which has ver nasty consequences.

ideally, all deposits should be cancelled as well as all debts (because both are fictional anyway) and the bankers tried for crimes against humanity, but this is a pipedream.

What will happen is that the bankers will hyperinflate, everything will go to hell in a hadbasket and I'll have to hunt them down with an elephant gun or something.

property is theft egh ;p

http://en.wikipedia.org/wiki/Property_is_theft

These dead people were a clever lot...

Edited August 26, 2008 by moosetea

[Tiger Woods?]

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.

If one doesn't look at this iteratively, then of course...but that isn't how it works. Money keeps moving.

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.

Erm...you need to read the second paragraph in the text book then.

You are missing the fact that this money is deposited again. That $90 leads to loans of a further $81 and so on. By the second turn of the cycle we already have $171 of money at risk of default in the system from an initial deposit of $100. A simple geometric sum shows that the total amount that can be lent is $1000 on an initial $100 deposit. If that isn't creating money, nothing is.

In the context of the OP, the OP asked the question that was the equivalent of "what would happen if the $1000 was lost" not, what would happen "if the initial $100 was lost".

If the first two borrowers default, then the bank has managed to lose more than the initial $100. It is quite possible for losses to exceed the "real" money (whatever that is) that started the lending cycle. It makes more sense if one thinks about the initial deposit in terms of gold or some other tangible thing, and think of the loans as promissory notes. If the initial deposit was "all the gold in the world", and the bank's first two borrowers defaulted, then the bank could end up in the red to the tune of more than all "the gold in the world".

Edited August 26, 2008 by D'oh

[Ologhai Jones]

You have £100. You pay £100 into the bank. Your bank balance is now £100. In your mind, you still have £100, because the bank tells you that you do. At any time, you can go to the bank and ask them for £100, and they are obliged to give it to you. You can tell your bank "please pay my gas bill", and they will (so long as it's not more than £100). You can put your money in the bank, take it out, put it in, take it out, it will remain £100. Money in the bank is as good as money in your hand. This we know from experience.

We might 'know' this from experience, but my understanding is that if you pay your money into a bank, it's no longer your money but an asset of yours instead. It's actually the bank's money. This is why, if a bank goes bust, you don't necessarily get that money back; in other words, under these circumstances your asset has been devalued, maybe to zero.

This is quite different than, say, a safety deposit box, where you pay the bank to hold something of yours (which may be money). In this case, you have a 'custodial' arrangement with the bank where the contents of the safety deposit box remains yours, and in this case if the bank goes bust, you're entitled to the contents of your safety deposit box, i.e. it doesn't become part of the value of the bank to be apportioned to the bank's various creditors by the receivers.

It doesn't really make any different to the central point of this thread, but I thought it was an interesting little snippet nonetheless...

(If anyone knows different, I'd be interested to be corrected.)

[Injin]

You are missing the fact that this money is deposited again. That $90 leads to loans of a further $81 and so on. By the second turn of the cycle we already have $171 of money at risk of default in the system from an initial deposit of $100. A simple geometric sum shows that the total amount that can be lent is $1000 on an initial $100 deposit. If that isn't creating money, nothing is.

In the context of the OP, the OP asked the question that was the equivalent of "what would happen if the $1000 was lost" not, what would happen "if the initial $100 was lost".

If the first two borrowers default, then the bank has managed to lose more than the initial $100. It is quite possible for losses to exceed the "real" money (whatever that is) that started the lending cycle. It makes more sense if one thinks about the initial deposit in terms of gold or some other tangible thing, and think of the loans as promissory notes.

Much easier to realise that the original owner should be handed the item they never stopped owning back and all subesquent transactions be removed as fraudulent.

All deposits cancelled, all debts cancelled, fiat money handed to the BoE.

Done.

[Injin]

We might 'know' this from experience, but my understanding is that if you pay your money into a bank, it's no longer your money but an asset of yours instead. It's actually the bank's money. This is why, if a bank goes bust, you don't necessarily get that money back; in other words, under these circumstances your asset has been devalued, maybe to zero.

This is quite different than, say, a safety deposit box, where you pay the bank to hold something of yours (which may be money). In this case, you have a 'custodial' arrangement with the bank where the contents of the safety deposit box remains yours, and in this case if the bank goes bust, you're entitled to the contents of your safety deposit box, i.e. it doesn't become part of the value of the bank to be apportioned to the bank's various creditors by the receivers.

It doesn't really make any different to the central point of this thread, but I thought it was an interesting little snippet nonetheless...

(If anyone knows different, I'd be interested to be corrected.)

Fiat money remains property of the central bank at all times.

[Ologhai Jones]

Much easier to realise that the original owner should be handed the item they never stopped owning back and all subesquent transactions be removed as fraudulent.

But if my previous post is correct, then they did stop owning their deposit -- the moment they handed it over to the bank.

[Ologhai Jones]

Fiat money remains property of the central bank at all times.

Are you talking about the actual pieces of paper?