0
$\begingroup$

Today it is wide spread notion that the commercial banks cat create a money out of thin air. Simply by typing numbers on computer. Every time a bank gives a load to a borrower, the loan money do not come from other people deposits (at least not entirely but fractionally) but they are simply created out of nothing. This form of banking is called Fractional reserve banking .

The problem I have with this concept is the following: A bank give a Merry loan of 100,000\$. Merry buys a house with this money. For a period of 1 year, Merry has paid back 10,000$ to the bank. Afterward Merry's finance condition worsen and she no longer can pay her debt. So in theory, if all the bank borrowers end up in the same situation as Merry did, the bank is going to bankrupt.

But if the bank never had the load money in the first place, every penny received from borrowers is a pure profit. Even if Merry returned only 10% of her loan, the Bank still profits 10,000$ because the given 100,000\$ to Merry were not bank's money in the first place.

This leads me to the question: Why do banks put interest on top of this fraud? And what prevents banks from putting huge amount of money to some people's account (for example to the Bank's CEO )? This black magic is not quite clear to me.

$\endgroup$
  • $\begingroup$ Hairi suggest you post this on Money and Personal Finance. This economics stack only has a few members and is ridden with ideology. The Money and Personal Finance is actually frequented by people from the finance sector who can talk to you about banking back office operations. $\endgroup$ – Frank Mar 31 at 8:39
  • $\begingroup$ Hi! Ideologue and otherwise foolish person here: seems to me interest is an unnecessary obfuscation here. If I (the bank) get 20 dollars from someone (depositors), lend you the 20 dollars, you hand it back to me, and I go tell my creditors that I am bankrupt and will not be repaying them then yes, indeed, I made some money. This is not magic, or surprising in my opinion. We probably should have written a better contact at the start that does not let me so this, or perhaps even without an explicit clause this is illegal. $\endgroup$ – Giskard Mar 31 at 9:34
  • $\begingroup$ Be advised that the US reserve requirement is 0% for all institution categories. Prior to this month banks had to have reserves of either 0, 3 or 10 % depending. However even then independent banks managed their own reserve requirement by product category (eg 0% for mortgages or commercial loans) federalreserve.gov/monetarypolicy/reservereq.htm @Giskard - your scenario cannot apply because no deposit is ever transferred. $\endgroup$ – Frank Mar 31 at 12:20
  • $\begingroup$ Why was this question closed? Just because it is duplicated, why close it? $\endgroup$ – Frank Mar 31 at 20:30
3
$\begingroup$

Very good question.

Let's break it down:

A bank give a Merry loan of 100,000$

Concretely, the bank records an asset of 100,000 (the loan) and a liability of 100,000$ (the amount recorded in Merry's deposit account).

Note that at this point, the liability is what appears on your internet banking statements as 'money' and those liabilities to you from banks are today what is traded in exchange for goods and services. In this sense the liability is 'money', and it is why people consider this money to have been synthesized commercially ex nihilo. This is essentially correct. Banks are licensed to create this money from nothing.

Merry buys a house with this money.

Analyse it in detail: Merry finds a supplier, who implicitly trusts the bank, who probably has an account at another bank (though not necessarily), and agrees to accept payment in the form of a bank liability. Merry initiates a bank transfer from MerryBank to SupplierBank. MerryBank decreases its liability to Merry by 100,000, keeping only the asset, but adds a new liability to SupplierBank. SupplierBank records an asset of 100,000 (MerryBank's liability to SupplierBank) and a liability to Supplier of $100,000.

For a period of 1 year, Merry has paid back 10,000 to the bank.

Yes, in 99% of cases in the form of bank transfers from other newly created debt from other banks. These become assets in the books of MerryBank (liabilities from SomeOtherBank) and the loan asset is reduced. So while MerryBank gains a 10k asset from SomeOtherBank it actually cancels 10k of loan asset, so its position has not changed - only its risk position.

Afterward Merry's finance condition worsen and she no longer can pay her debt. So in theory, if all the bank borrowers end up in the same situation as Merry did, the bank is going to bankrupt.

No. The bank still has an asset of 90,000$ and will use debt collectors to take Merry's property. The bank will then cancel the 90,000 loan asset and record a property asset at market value.

But if the bank never had the loan money in the first place,

Yes. Fractional reserve requirements for loans was/is often 0%. Also, the asset (for example) at SupplierBank is then used as reserves to issue further debt. Two banks in a fractional reserve system act as feedback-loop amplifiers, so if the reserve requirement was 10%, that does not mean that the money multiplier would be 10 times, but depending on flow rates and dynamic systems calculations you can end up with hundreds of thousands times the base reserve. Incidentally, this was the keystone to the financial crisis.

every penny received from borrowers is a pure profit. Even if Merry returned only 10% of her loan, the Bank still profits 10,000 because the given 100,000$ to Merry were not bank's money in the first place.

No. See above. The asset position is unchanged.

This leads me to the question: Why do banks put interest on top of this fraud? And what prevents banks from putting huge amount of money to some people's account (for example to the Bank's CEO )? This black magic is not quite clear to me.

Interest rate is primarily determined by interbank lending rates to cover reserve and capital requirements.

I don't know if it applies to the rest of the world, but the main source of income for banks where I live is actually transaction fees.

As for CEO payments, auditors. But in general CEOs reward themselves by issuing debt (bonds) to cover stock buybacks, to boost stock price, to which their bonuses are tied. Calling this kind of activity fraud is to some extent true, as outside the US a lot of this kind of thing is regulated.

Banks could be pure digital banks that have a employees in the hundreds. Typically they are dinosaur institutions that employ in the 10s or 100s of thousands of people. The banks use fees and interest to cover the cost of employees mainly. Incidentally, this is one reason why governments chose to assist banks in 2008. Directly and indirectly they employ a big chunk of the economy, a consequence of Western deindustrialization and financialization.

| improve this answer | |
$\endgroup$
  • $\begingroup$ Very comprehensive explanation, kudos. I wonder which institution follow and regulate banks balancesheets. Is this information (bank's equity) stored on some centralized system (Central bank) for example? $\endgroup$ – Hairi Mar 31 at 16:57
  • $\begingroup$ @Hairi good question, I think the short answer is nobody really. Otherwise they would not need auditor firms to do occassional risk assessment audits. Also bank core systems tend to be very old. COBOL on fragile systems in very secure places, for example $\endgroup$ – Frank Mar 31 at 20:24
0
$\begingroup$

Fantastic question! Fractional Reserve Banking is a fascinating topic :)

So, the bank never created the money out of thin air. To be clear, the loan money DOES come ENTIRELY from the depositor. This below example should be clear:

If I put $100k into a bank...what do I get back? I get back a checking account...I effectively get an "IOU" back from the bank. So, now the bank has $100k in cash, but still owes me $100k (i.e. its Account Payable). It keeps 10% in cash, because it assumes I'll never withdraw more than $10k in a short period of time. But now it can use the other 90% for longer-term assets, which have a higher yield. They're borrowing short & lending long.

Thus, the bank can only lend out $90k to Merry...not the full $100k. It needs to keep a fraction of its payables as reserves (i.e. cash) -- hence the term "Fractional Reserve Banking."

Now Merry has $90k in cash. She could go put that into another bank - they keep 10%, and lend out the remaining $81k. Ad infinitum.

This is fine as long as I am fine having an IOU from the bank for my full $100k. If everybody in the system demanded back their FULL IOU...then the situation I described above would reverse itself & contract. If I was the ONLY member at the bank, and I decided to buy a $100k Porsche...I would be calling in the loan I gave to my bank. My bank would then have to call in its loan it gave to Merry. And Merry to her bank, etc.

| improve this answer | |
$\endgroup$
  • 2
    $\begingroup$ This is fundamentally wrong. This is not how it works at all. $\endgroup$ – Frank Mar 31 at 7:58
  • $\begingroup$ I think you should provide backup for such an ipse dixit, so we can let others decide :) -- They don't "create" money - they just take your deposit, (which is your AR, their API), and you can treat the AR as cash. There's nothing mystical about it. -- Do you agree with that characterization or not? If not, you should think hard until you understand what I just said. $\endgroup$ – Davis Clute Mar 31 at 8:13
  • $\begingroup$ econintersect.com/pages/opinion/opinion.php?post=201901200002 $\endgroup$ – Frank Mar 31 at 8:16
  • $\begingroup$ OK, sounds like you agree with my characterization...thank you. Feel free to point out anything I said that was wrong about the mechanics of borrowing short & lending long (i.e. typical Commercial Banking). Otherwise, I'll just let the readers decide which answer is more intuitive. $\endgroup$ – Davis Clute Mar 31 at 8:19
  • $\begingroup$ Wrong. At the time of creating a loan, they simply record an asset for the amount of the loan (your loan liability to them) and a liability to you (the amount that appears in your deposit account). You then trade that bank liability to you. That is all there is to it. No deposit is initially required when fractional reserve requirements are typically 0%. If however they are not 0%, then the very first loan in the first bank requires a deposit. However, when you trade that liability by paying to another bank, that is recorded as a deposit in the other bank. So it goes on ad infinitum. $\endgroup$ – Frank Mar 31 at 8:20

Not the answer you're looking for? Browse other questions tagged or ask your own question.