This post was prompted by a comment somebody left on a thread elsewhere, saying that if he deposits £1 in the bank, that the bank can then lend out £10. This is basic Obanomics and completely untrue, of course.
Background (skip down to para 6 if you know this stuff, most people don't)
1. Remember:
a) A bank is a balance sheet exercise - assets are positive and liabilities are negative, and the two always net off to precisely zero. If asset values fall (because of reckless loans on land and buildings which fall in value) then the value of the liabilities fall as well (i.e. if you own shares or bonds in a bank which is making big losses, the value of your shares or bonds fall).
b) A financial asset is unlike a real asset (a building, a car, a television, a painting) because there can only be a financial asset (notes and coins in your pocket, cash in the bank, corporate or government bonds) if there is an equal and opposite financial liability. The two always net off to nil. So, for example, if you have a mortgage on your house, you have a liability but the bank records it as an asset.
2. The traditional books explain how banks started off using 'fractional reserve banking', i.e. they take 100 gold coins as deposits and lend out 90 of them, keeping 10 in the safe in case depositors come round to make a withdrawal.
3. So in the old fashioned view of banking regulation (or self-regulation), we look at the assets side: as long as the bank has a tenth* of its assets in liquid form (i.e. gold coins in the safe), it will probably do OK.
4. The modern view of banking regulation (i.e. Basel rules), we look at the liabilities side, and say that share capital (a non-repayable liability or source of finance) should be at least a tenth* of total assets; so if the value of assets falls by a tenth or less, there are still enough assets left to repay depositors and bondholders.
5. Quite how the myth that a bank can lend out ten times as much as it takes in deposits (or bonds) arose, I have no idea, it is quite simply not true. The Basel one-tenth* limit is imposed by regulators, so it might be accurate to say that "The total amount that a bank can lend out is no more than ten times its share capital", but that is merely the upper limit, and depends on people wanting to borrow that much.
So much to the background
6. Modern banking, i.e. 'how banks behave once the government takes its eye off the ball' and which has been around for centuries, has very little to do with the old fashioned idea that the banks take deposits or otherwise raise money and then lend it out.
7. What actually happens is that bankers (i.e. employees of banks, who ultimately work on commission) just make loans willy nilly to all and sundry, usually 'secured' on land and buildings whether the bank has the cash in the metaphorical safe or not.
8. They do this because they know what happens after they hand over a cheque to the borrower to buy his house: the borrower in turn gives the cheque to the vendor, and the vendor then gives the cheque back to the bank.
9. So before the transaction the bank had net assets of nil (or so little as makes no difference - see para 1 a) above).
a) It makes a loan to the borrower of £100,000 to buy a house (this is a liability to the borrower so it is an asset from the bank's point of view - see para 1 b) above) and
b) accepts a cheque from the vendor (taking all banks to be part of a closed loop, which they are). The vendor clearly has a financial asset (a bank account with £100,000 in it) so again, referring to para 1 b) above, that deposit is a liability from the bank's point of view, so
c) the new asset and liability of £100,000 each net off exactly to nil. The bank's net assets do not increase or decrease as a result, but their gross assets do.
10. Having achieved this new state of affairs by 'splitting the zero' (TM Onus Probandy, I think) into a debit and a credit (in the same way as empty space sometimes splits into matter and anti-matter) the bank can then start making money by charging the borrower five per cent interest and paying the depositor three per cent interest, pocketing two per cent for itself.
11. Some refer to the process outlined in para 7 to 9 above as 'printing money', which it is - but the problem is that people don't realise what money is, namely the physical or electronic record of who owes whom how much; 'money' is a liability as much as it is an asset; you can only have cash in the bank if somebody somewhere owes the bank money.
12. As a final thought: the Basel capital requirement rules (see para 4 and 5 above) are of very limited use in preventing credit bubbles. All the banks would have to do is tell the vendors who arrive in their branches brandishing cheques for £100,000 that their deposit accounts are only paying 3% interest and that they would do better to subcribe for new shares in the bank, which pay 5% or 10% (in the good years). Shares in a bank are just a slightly different kind of 'money', but can be created out of thin air the same as the mortgage loan or the deposit.
I hope that clears things up a bit!
* I'm using "a tenth" for illustration purposes only, it's a bit more complicated than that.
Big Green Bills
2 hours ago
19 comments:
I'm not sure of the import of the photo of the attractive woman, but I suspect you of lewdness.
Can't read all of this. The photo disappears when I scroll down.
D, that's Lorraine Pascale who did a BBC series called Banking made easy, I'm just summarising for posterity.
AKH, is there a clever html way to make the photo scroll down as well?
Bingo. Glad someone explain the modern banking system property (As opposed to those £1 lend £10 myth - where even professors believe in)
Anon, glad to be of service.
I must admit that I had also believed that 'banks take deposits and then make loans', which is the first thing to unlearn. It's a bit more worrying when professors peddle the £1/£10 myth - as ever the question is, are they stupid or corrupt?
The 1/10 reserve does appear to be a myth that has crept into the general psyche. If you look at any economics text book they will have the one tenth model "for illustration purposes only". However the more times this gets printed and then read, I think the more people believe it represents reality! Now the more I read up on economics the more I see it as a field detached from reality, dominated by "big names" with vested interests and politics. I think there are a few good players, though sadly they appear to get ignored by policy makers. At the moment I am reading quite a bit of Steve Keen and his take on "endogenous money supply".
DNAse, one-tenth is a good place to start if you are looking at sensible old fashioned FRB, or for relativly sensible Basel purposes, the real myth is that banks take £1 deposit and turn it into £10 loans.
They don't - they make £10 loans and turn it into £10 deposits.
Steve Keen makes it seem more complicated than it is, but he is top man nonetheless.
"that's Lorraine Pascale": there you are, it's a lewd allusion to Pascale's Triangle. I knew you were being smutty.
I must admit that I had also believed that 'banks take deposits and then make loans', which is the first thing to unlearn.
It doesn't help that YouTube - the source of most peoples' education these days, it seems - is stuffed full of little animations, and with garbage produced by various production companies for sale to Channel 4 and the like. All promoting this ancient FRB legend about banks and money, and always with Zionists or Multinational Business or some other bogie-man lurking unseen and unheard in the background, ready to snatch your first-born.......
It's not difficult to exercise the imagination and see it as a propaganda job, though I do generally try to avoid conspiracy theories.
It's even easier to exercise the imagination about the lovely and extremely personable Ms Pascale :-) .
Gor blimey here we go again!It might help if you depicted the fons et origen of the banking system fully.They did n't loan out gold coins: they loaned paper promissory notes and kept the gold coins in a box under the bed,The 1-10 rule of thumb originates from the bankers' rough estimate of the amount of gold they needed to keep in reserve to pay off any awkward customers who wanted "real money" instead of home made 10U's .
This is why Brit bank notes carry the empty boast "I promise to pay the bearer X pounds" meaning at one time you would be given one pound's weight of silver .Now they would just hand the note back saying "There you go squire" while pressing the "Help Nutter" button under the desk.
No, since you ask I have n't tried it.
D, that's a pure coincidence.
FT, what videos on YouTube - the ones that say banking is a completely innocent activity where they take deposits and then wait for a worthy borrower to come along; or ones which say it's all a conspiracy, maan?
DBC, yes, that would be step 2a.
Remember - originally the "bits of paper" were always issued to DEPOSITORS as a receipt for their coins. The depositors were allowed to lend these to other people, assuming an honest banker, these things were as good as gold.
It's only when the bank can issue bits of paper to BORROWERS as well, rather than giving them an actual gold coin.
But this is supposed to be "banking made easy" and not a complete history or anything.
You'r quite correct fractional reserve does not describe modern banking well.
A better description is Leverage. The bank raises money from share capital and leverages it with deposits.
Den, that's exactly not what they do. They first create the deposits by issuing loans (see step 7), which magically turn into deposits.
During the years of the credit bubble, banks were not issuing any new shares - if anything they were buying them back (reducing share capital).
It is only after things went horribly wrong again in 2008 that banks started raising more share capital (or converting bonds to share capital).
OH I uderstood and agree your point about making loans from deposits and you made is succinctly. I just thought you are in danger of starting a new "10Xdeposits"
type myth is you don't make it clear that arrangements have to be made to keep the balance sheet in order for the time period before the cheque comes back.
I liked your post. From a mathematical analysis the Bassel ratio is mathematically arbitary and If all maturities were matched the process could work with no ratio. The profound consequence in instance is that modern money is not a tangeble asset. It is a record of who owes what to who with the banks recording it. I think a suprising amount of people would be comfortable with this nowadays but back in the days of Henry Ford they were not. He is quoted as saying "It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. "
Den: "you don't make it clear that arrangements have to be made to keep the balance sheet in order for the time period before the cheque comes back."
It happens almost instantaneously.
i. The lending bank hands over a bit of paper with a number written on it (the cheque, which the buyer gives to the vendor).
ii. If the vendor loses the cheque or forgets to ever bank it, the lending bank gets off scot free.
iii. The lending bank doesn't incur the liability until the cheque is actually paid in, whether that is minutes or days later doesn't really matter.
iv. Sure, the vendor might pay it in at a different bank, but the lending bank will also accept cheques issued by other banks, so it all cancels out (and the rest is just inter-bank lending, which by definition also nets of to £nil).
And would that be the same Henry Ford who said: "The time will come when not an inch of the soil, not a single crop, not even weeds, will be wasted.
Then every American family can have a piece of land. We ought to tax all idle land the way Henry George said — tax it heavily, so that its owners would have to make it productive"?
The 1-10 rule probably dates from before the end of gold/silver convertibility when banks had to keep an eye on reserves in case people demanded they pay the bearer in some kind of precious commodity.Obviously its all willy nilly nowadays and banks make loans to whoever looks credit worthy.But,of course,these are not loans (because there is no deposit money kept in reserve) but sums of money conjoured up on the spot and created with the signing of the (unsupported ) cheque.MMT points to the government taking over the creation of credit but the easiest way is by nationalising the banks which you never seem very keen on.
DBC, nationalise banks? Are you mad? With politicians at the helm, there'd be the house price bubble from Hell!
Far better to slap 'em with a bank asset tax; politicians like tax money coming in so all-in-all, this would mean a much smaller, leaner, meaner banking sector.
As I've said before,at least I think I've said it before (the indifference is disorienting), there's a similarity between nationalising the money supply and nationalising the land.You can use interest rates as a charge for the use of money which you can add to the revenue from LVT,which in the case of my Sentinel Tax could be pretty skinny-if its working optimally,that is.
It goes without saying it has to be introduced with LVT-to stop low interest rates ,aka the tax on money, pointlessly inflating land values (as per usual).
Which bank assets are you talking about? MMT-ers believe in the Guv creating money (hooray) but how?
DBC, whether or not you can 'nationalise the money supply' depends on how you define money. What about HP debts? Is that money? Does that mean to buy a sofa or washing machine you have to get a govt approved loan from the nationalised bank?
"Which bank assets are you talking about? MMT-ers believe in the Guv creating money (hooray) but how?"
I'm talking about the higher of [total cash lending to UK based borrowers] and [govt. protected deposits]. The MMTers are making a slightly different point.
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