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It is my understanding that countries without fractional reserve requirements still have capital requirements, but what I do not understand is how equity can be used to satisfy these requirements without causing large amounts of inflation in the housing market.

If banks are not required to have currency reserves, then what is to prevent them from extending themselves effectively unlimited credit based on their equity? In the short term, they may be limited by debt to equity ratios, but in the long term, wouldn't this lead to a consistent rate of near constant inflation?

Every time a bank issues credit to buy a house, (in aggregate, of course) the price of housing increases, which increases equity, which allows them to issue more credit..

Does anyone else not see a problem with this?

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  • $\begingroup$ I had always had the assumption that Fractional Reserve Requirements applied to Loans, not just Bank Deposits. I have recently learned that this is not so. Has this always been the case in the US? What about outside the US? $\endgroup$
    – KevinBattleson
    Jan 10, 2018 at 1:38
  • $\begingroup$ The price of housing does not increase banks' equity $\endgroup$
    – Henry
    May 29, 2020 at 9:39

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Canada abolished bank reserves in 1992. Canada has had very similar inflation rates as the United States since then.

Increases in house prices do not improve bank equity. Banks make a profit based on being paid a rate of interest above their cost of funds. Increasing house prices just reduce losses in the case of default. Threfore, the relatively steady profits that come from interest rate spreads slowly builds up equity, with the result that bank balance sheets only exhibit moderate growth rates (similar to nominal GDP growth rates).

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  • $\begingroup$ But don't most banks coordinate with realtors and invest heavily in real estate? If someone defaults on their payments the bank has lien on their property through their mortgage. I was under the impression that most banks were held in trust by property groups that act as holding companies. Don't you think this is a conflict of interest? $\endgroup$
    – KevinBattleson
    Jan 19, 2018 at 6:16
  • $\begingroup$ Banks lend against real estate, they are barred by regulations (and common sense) from owning real estate (other than when they are stuck with it after a repossession). Banks make money by borrowing at low rates, and lending them at a higher rate - to entities that pay them back. $\endgroup$
    – Brian Romanchuk
    Jan 19, 2018 at 12:26
  • $\begingroup$ (A bank might have a non-bank subsidiary that is in real estate. That business is supposed to be isolated from the bank parent, even if they have a similar name.) $\endgroup$
    – Brian Romanchuk
    Jan 19, 2018 at 12:29
  • $\begingroup$ So in cases where a bank acquires a property through foreclosure, does the equity of that home count for its debt to equity ratio? If all a bank has to do is make loans in bad faith and sit on its foreclosures to develop equity, it would seem to prove my point. $\endgroup$
    – KevinBattleson
    Jan 23, 2018 at 15:58
  • $\begingroup$ Banks are only entitled to the amount of the loan. They normally try to sell the property in an auction, and anything above the loan value is supposed to be returned to the borrower. If they end up with a large number of properties, that means the recovery value is far below the loan amount, and the banks lost a ton of money. Such a property portfolio is going to be insignificant, or the bank will have failed. $\endgroup$
    – Brian Romanchuk
    Jan 25, 2018 at 1:39

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