Simple Fractional Reserve/loan Default Question

[the_austrian]

thanks.

Does this mean that loan defaults are less deflationary in and of themselves than some doomsters on the blogosphere are saying? I often see it written for example, that a default on a loan of $10 will stop the bank lending $90-100(whatever) - from your explanation this simply is not the case. Not only this of course but the original loan money is still in circulation somewhere.

If the loan doesn't get paid back it's bad news for the banks. They make less profit and they may feel less inclined to lend in the future but it doesn't affect bank lending from a reserve ratio standpoint.

It is deflationary when loans are paid back to the bank (or at least more paid back than new loans taken out). The amount of commercial bank money (bank credit) is reduced. If enough borrowers default the bank itself will go bust and then the money is added permanently to the circulation (because the central bank will bail out the deposits).

[tegan]

As many have said, the banking system is a closed loop, essentially a franchise. Think of it like a candy floss machine - a small amount of sugar is put into the machine and is repeated spun round until it becomes this massive piece of candyfloss, 100s of times larger than what was originally put in. And of course candlyfloss is 99.9% nothing. If people realised this was also true of the banking system it would collapse.

[aliveandkicking]

My opinion piece here is that somebody has created a myth and many people keep repeating it.

Ordinary banks and hedge funds do *not* create money.

1. If I can find a broker (like the hedge fund uses) who allows me to place 1000 at risk and I buy via the broker 20000 shares i have now borrowed perhaps 'permanently' for myself 19000 i never had and since the risk is mainly mine the broker is not impacted if their risk management systems are working and they can arrange to pass on my requirement for 19000 in another trade. Therefore if i always have this leverage i can earn via my profits more and more money i never had. But actually no money is being created via the leverage.

2. A bank starts with 10 and can lend 100 *but* to lend 100 it has to get 90 from someplace else. In fractional reserve banking that someplace else has to come significantly from savers money who trust the bank with their real money.

No tricks or mirrors just hard work (of sorts)

If it can get deposits (liabilities owed to some other person) at 5% cost and it lends out at 7% it gains 2% for the work of attracting and accounting for this money. Or it can go to the money markets and do a similar deal where possible.

A bank can of course be run in an illegal manner at any time anywhere and then it comes to effective/fair/honest regulation as to how often that is happening

And there is a lending food chain that starts at the central bank which can create money to ensure there is never a shortage of money.

The USA has the highest inflation in 17? years. Which is why it is *now* problematic if F and F go bust because the bailout involves the creation of yet more money at a time when investors are worrying about holding devaluing dollars.

[aliveandkicking]

The crucial point you are missing is that the money leant out has to go somewhere...typically back as a deposit into a bank somewhere - where it is treated as money to be leant out again. It is this feature that makes it look as though they are creating money through the credit creation process - because in effect they are.

The point you are missing is that no money can be leant out if no money is sourced from another place. Zero can be leant out if no money is sourced from somewhere else.

You need to begin from the reality no money is created and then think from there, rather than beginning from the unreality they create money and think from there.

You said:

It is this feature that makes it look as though they are creating money through the credit creation process - because in effect they are.

you begin with right thinking.

If i deposit a massive amount of money in the bank then a massive amount of lending is possible via the massive amount of bank borrowing that the bank has *from* me. If i ask for my money back then the bank cannot just invent my money instead it has to borrow again a massive amount of money or it has to ask for the money *i gave to the bank* back from whoever the bank gave it to.

There is no money creation. None. My money goes to the other borrowers and the bank tells me my money is safe and i agree to that in return for being paid for the risk. Or alternately i let them have it for nothing to do whatever they want with it because it is convenient for me to allow them to have it for nothing or i just dont realise what i am doing:-)

[mattyboy1973]

The point you are missing is that no money can be leant out if no money is sourced from another place. Zero can be leant out if no money is sourced from somewhere else.

You need to begin from the reality no money is created and then think from there, rather than beginning from the unreality they create money and think from there.

So who creates the money? Seriously

[benj]

If i deposit a massive amount of money in the bank then a massive amount of lending is possible via the massive amount of bank borrowing that the bank has *from* me. If i ask for my money back then the bank cannot just invent my money instead it has to borrow again a massive amount of money or it has to ask for the money *i gave to the bank* back from whoever the bank gave it to.

You are right, except that the bank knows very well that not everyone will ask for their money back at the same time.

You deposit £100,000 at the bank on Monday. You have £100,000 "in the bank", or you think you do. The bank itself has £100,000 of cash. I have no money. Total money held by customers of the bank: £100,000.

The bank lends £10 of that cash to me on Tuesday. So now I have £10 in my hand. The bank has £99,990 of cash. If you came back asking for your money, they'd have to find £10 from somewhere. At this point, how much money do you have? You look at your balance, it says "£100,000". But I have £10 in my hand that I did not have before. So the total amount of money held by customers of the bank is now £100,010. Money has been created.

On Thursday I bring back the £10 I borrowed, with £1 interest, and give it back to the bank. My debt is paid - I have no money again. The bank now has £100,001 of cash. You still have £100,000 in your account. The total amount of money held by customers of the bank is back to £100,000. The money created by the loan is gone again.

On Friday, you come back to the bank to withdraw your money. The bank hands you £100,000.

This is how money creation works. It works because "money" is not just banknotes, but also includes the debt of banks. When you transfer money from your bank account to your gas company's account to pay your gas bill, all that happens is that instead of owing you £100, the bank now owes the gas compmany £100. We use the debt of private banking corporations as a medium of exchange.

[aliveandkicking]

You are right, except that the bank knows very well that not everyone will ask for their money back at the same time.

You deposit £100,000 at the bank on Monday. You have £100,000 "in the bank", or you think you do. The bank itself has £100,000 of cash. I have no money. Total money held by customers of the bank: £100,000.

The bank lends £10 of that cash to me on Tuesday. So now I have £10 in my hand. The bank has £99,990 of cash. If you came back asking for your money, they'd have to find £10 from somewhere. At this point, how much money do you have? You look at your balance, it says "£100,000". But I have £10 in my hand that I did not have before. So the total amount of money held by customers of the bank is now £100,010. Money has been created.

Listen friend! wot you aint getting is that it is my money!! you aint got no bleeding money. I have the money and you are the one in debt.

I have everything and you have nothing at all. You only *think* you have the money but it all belongs to me.

1 + 0 = 1

And if we kiss and make up and go down the pub together and i loan you 10 of my 20 we aint got no stinking 30 quid:-)

[benj]

Listen friend! wot you aint getting is that it is my money!!

When I walk out of the bank with a £10 note in my pocket, I am in no doubt that I have money. True, I also have a debt to the bank, but there's nothing wrong with that per se. I can spend it down the pub, therefore it is money.

You, sitting all smug and looking at your bank statement on Wednesday which reads "£100,000 credit", are similarly in no doubt that you have money. You could spend it down the pub too, using your debit card. In fact, from Tuesday to Thursday the bank was unable to pay you all of your money back, but you don't know that. They have no obligation to tell you what they've done with the banknotes after you handed them over the counter. The only obligation they have is to give you your money back on demand. Which, in this scenario, they do.

Of course in a more realistic example there would not just be one depositor with £100,000, but a thousand depositors with £100 each. Then, by loaning out £10 of their deposits, the bank are running a negligible risk. If 99.9% of their depositors came and asked for their money back, they would have no difficulty in paying. Only if the all did so would the bank find itself short of cash.

When you deposited your money, you exchanged £100,000 of cash for essentially a piece of paper saying "the bank owes me £100,000". When you withdraw your money, you do the same thing in reverse. While your cash is in the bank, all you are really in possession of is a promise to pay. But these promises are treated as money. That's why banks are able to create them.

[JustYield]

You need to begin from the reality no money is created and then think from there, rather than beginning from the unreality they create money and think from there.

Anyone who takes on a loan and promises to repay it with interest is creating money.

e.g. Simple repayment mortgage: 100K 5% 20 year term.

Total repaid: 158,389.37

Of which

Original loan: 100,000

Interest: 58,389.37

The interest cash stream is new money isn't it? 100K goes out the bank's door on day 1, and a total of 158K comes back in by the end of the loan. What's more some of this cash stream is profit, so the bank can lend a bit more against its enlarged capital base.

You get your loan and the bank gets its profit which comes from you finding some new money from somewhere.

[AteMoose]

for the 30% of forum members who work in IT here is a concept:

'Money is recursive'

Its just clicked why 75% of people don't get it ;p

Edited August 28, 2008 by moosetea

[aliveandkicking]

Anyone who takes on a loan and promises to repay it with interest is creating money.

e.g. Simple repayment mortgage: 100K 5% 20 year term.

Total repaid: 158,389.37

Of which

Original loan: 100,000

Interest: 58,389.37

The interest cash stream is new money isn't it? 100K goes out the bank's door on day 1, and a total of 158K comes back in by the end of the loan. What's more some of this cash stream is profit, so the bank can lend a bit more against its enlarged capital base.

You get your loan and the bank gets its profit which comes from you finding some new money from somewhere.

Your example can be shortened to:

Anyone who takes on a loan and promises to repay it with interest is creating money.

which comes from you finding some new money from somewhere.

So in your own example the bank gets new money that came from somewhere but that bank did not create any money.

So at this point in time people seem to want to answer me with words that end with "no money was created by the bank"

[Ologhai Jones]

'Money is recursive'

You can say that again...

... I'll get me coat.

[JustYield]

Your example can be shortened to:

Except you cut out the crucial part. Never mind, you know it all.

Good day to you.

[benj]

'Money is recursive'

You can say that again...

... I'll get me coat.

Money (n.) from acronym: Money Offers Never-Ending Yield.

[aliveandkicking]

Except you cut out the crucial part. Never mind, you know it all.

Good day to you.

The insults dont change reality.

Reality is that your example of a bank creating money is no different to me lending you a car and you returning the car plus giving me a hire fee. I dont create money and neither does the bank.

Instead of insults how about just sticking to explaining why you think you are right?

Edit to make example clearer.

Edited August 28, 2008 by aliveandkicking

[Injin]

The insults dont change reality.

Reality is that your example of a bank creating money is no different to me lending you a car and you returning the car plus giving me a hire fee. I dont create money and neither does the bank.

Instead of insults how about just sticking to explaining why you think you are right?

Edit to make example clearer.

No, no.

Yopu lend your friend a car, in exchange for a car + a new tyre later on. He swaps it for a new 4x4 with someone else.

That person gives you your own car back.

Then you drive to the first guys house and demand a car + tyre.

If he's an idiot he'll pay you, if he's smart he'll tell you to sling your hook.

http://injinsalternativeuniverse.blogspot....ing-part-1.html

[athe]

...and I'll have to hunt them down with an elephant gun or something.

Careful, or you'll be off to chokey with UmbrellaBoy

[Injin]

Careful, or you'll be off to chokey with UmbrellaBoy

[crash2006]

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.

yes you forget if that £90 comes back into the bank it then can lend out $81 etc... thats if the liquidity ratio is 10%, and thats were money growth comes from.

[Injin]

yes you forget if that £90 comes back into the bank it then can lend out $81 etc... thats if the liquidity ratio is 10%, and thats were money growth comes from.

Just to add - we have a zero resrve system right now.

[aliveandkicking]

No, no.

Yopu lend your friend a car, in exchange for a car + a new tyre later on. He swaps it for a new 4x4 with someone else.

That person gives you your own car back.

Then you drive to the first guys house and demand a car + tyre.

If he's an idiot he'll pay you, if he's smart he'll tell you to sling your hook.

http://injinsalternativeuniverse.blogspot....ing-part-1.html

Injin

Like many other people i have tried to talk to you before.

Once again your example adds confusion rather than clarifies.

As i understand the example you have given i am still entitled to my new tyre in accordance with the agreement made earlier.

But i will not continue a discussion further with you.

And i and others have pointed out you are wanting to create an alternate reality.

Please dont bully me about this. I dont want to continue. Thanks.

[benj]

yes you forget if that £90 comes back into the bank it then can lend out $81 etc... thats if the liquidity ratio is 10%, and thats were money growth comes from.

I didn't forget - you just didn't bother to read the rest of the thread.

Not that I can blame you!

[Injin]

Injin

Like many other people i have tried to talk to you before.

Once again your example adds confusion rather than clarifies.

As i understand the example you have given i am still entitled to my new tyre in accordance with the agreement made earlier.

But i will not continue a discussion further with you.

And i and others have pointed out you are wanting to create an alternate reality.

Please dont bully me about this. I dont want to continue. Thanks.

No worries.

I have no desire to bully anyone, you can be as factually incorrect as you like. Go for it.

[aliveandkicking]

No worries.

I have no desire to bully anyone, you can be as factually incorrect as you like. Go for it.

Injin

it is more of the same kind of abuse when you dont like a persons answer.

[Injin]

Injin

it is more of the same kind of abuse when you dont like a persons answer.

It's not abusive to point out that something presented incorrectly is incorrect.

It's just a fact. if facts offend you, that's not the fault of those who present them.

For the record - I have no wish to offend you, nor do I care if I do. I just like facts and don't like fiction. When I see fiction pretending to be fact, I point it out.

Your analysis is incorrect. I suggest changing it to a more accurate one.