Article: “And That Is Banking”
Recently this article came in as a trackback to my article on fractional reserve banking. Now the author classifies the article as “thinking out loud”. He gave me a credit as “to get an explanation of how banks account for the loans they make”. And he really should’ve read beyond that, given some of what he says contradicts what I demonstrated.
Not much of his article needs to be corrected or clarified, so I’ll only focus on those sections that do.
Now, say I’m a bank, and I loan someone some money. This decreases my Cash, or the asset pool I make loans from. How do I get more “cash” so I can make another loan? In normal banking I would have to take payments on loans I had already made to other people and put some of them back into my Cash. In mortgage banking I could do something called “selling the loan.” Basically, the loan turns into a security (essentially a document that can be bought and sold) that I can sell to a company that buys those types of securities.
As I demonstrated in my article on fractional reserve banking, lenders, be it a bank or not, get their money from investors. For banks this comes in the form of certificates of deposit, bonds, or other financial instruments. As I also demonstrated, banks loan out the money that is deposited by their customers.
Non-bank lenders, however, still need investors. They can either borrow the money from other lenders and loan out that money at a slightly higher interest rate to turn a profit, or they can sell stocks or bonds against the equity in their business.
And once a lender has written a loan, they can sell that loan to another lender to recuperate some of the loaned value — they’re unlikely likely to recuperate the entire loaned amount. And this is unlikely to occur unless the lender is in need of the cash and needs to sell off assets to get it, knowing they’re likely to also have to write off a loss in doing so. Which is why they’d be more likely to do this on loans that have already generated enough interest revenue to make it worthwhile.
Central Banks have also promoted the practice of fractional reserve banking. This means essentially that the pool of funds available for lending is larger than the bank’s cash on hand. This is possible accounting-wise because the bank can count the loaned money as an asset, as there is a promise to pay it back. They can then loan more money based on a combination of their actual cash and the promises to pay – up to a certain limit set by the Central Bank.
And this is where the author starts to misunderstand what I wrote.
The practice of fractional reserve banking predates central banks by centuries if not millennia. And fractional reserve banking is possible due to the fact customers rarely directly withdraw the funds they deposit with a bank. This is especially true today when liquidity is able to move through the system virtually instantly. Basically in however much time it takes for one bank register a transaction originating from another bank.
But they can’t loan more money “based on a combination of their actual cash and [receivables]”. They can only loan from their reserves, up to a predetermined reserve requirement.
For example, if the reserve requirement is 10% — the general standard in the United States, as far as I’m aware — the bank must maintain reserves equal to 10% of their total demand deposit liabilities. This means they need to have at least $1 on hand for every $9 loaned out. Few banks will loan out to that degree, though, simply because of the risk involved.
They can then juggle their real cash against their loaned amount by selling securities to get more cash or buying some other bank’s debt if that bank needs more cash.
This is a rather crude way of describing the overnight lending market.
You have $100. But you are allowed to loan out $1000.
The author describes this as his “original concept of how this scam works”. And if that’s the original concept, he still hasn’t corrected it. And it only gets worse. Before proceeding, recall from above how I said that banks must have at least $1 on hand for every $9 they loan out. This means that if a bank takes in $100, they can only loan out $90 from that original $100. Not $1000. Not anywhere near that. Since they don’t have the assets to cover it.
If you don’t have to fork over real cash to make these loans, then all you have to do is add $100 to the electronic accounts of the ten people you loaned it to. If they all pay you back, you have $1000. Did you make a $900 gross profit? That’s what it seems like to me.
No bank could do this and stay in business. They’d become insolvent in a heartbeat. Provided the regulators didn’t catch wind of this and shut them down before insolvency took then under.
To make a loan, the bank must first have the reserves to back it. If they don’t have the reserves, they can’t make the loan. Because the principal of the loan has to come from somewhere. If a bank only took in $1 million in deposits and turned around and wrote $10 million in loans, what is the bank to do when the borrowers attempted to withdraw the $10 million? This was the central question I used to support my arguments in the aforementioned article on fractional reserve banking.
The overnight lending market won’t help in that instance either. Since if all banks did that, there wouldn’t be enough liquidity in the system to cover all the outstanding liabilities. The entire banking system would basically collapse as a result.
Do you need to charge interest? No, you don’t! Interest is just the cream on the coffee. You made your profit using fractional reserve banking, not interest-based banking. And if that’s true, it’s something I never fully realized before.
Except it isn’t true since you start off on a very faulty premise.
Interest is how banks make money from their lending practices. That along with any fees they charge on safe deposit boxes and other services they offer. The principal of the loans actually belongs to their customers, since the banks are basically borrowing that money from their customers to make the loans.
Again fractional reserve banking means only that banks need not have $1 for every $1 on deposit with them. But it doesn’t mean they manufacture $10, or any amount, for every $1 on hand. And given some of what I’ve seen written about fractional reserve banking, this misunderstanding of how it works is not uncommon, and fueled likely by a significant ignorance of the accounting underneath the covers.
Fractional reserve banking means that, presuming a reserve requirement of 10%, a bank may loan out $9 of every $10 deposited with them. They can’t use that $10 to then write $100 in loans. Where would that money come from? Yet time and again I see the idea that banks “create money through loans”.
And, by the way, credit unions are no different from banks in how the accounting works. Credit unions still operate on fractional reserve banking principles. Keep that in mind when the author says:
Credit unions don’t have investors so don’t have to make a profit.
Credit unions are not-for-profit financial institutions by definition. They also have investors. Like banks, their primary investors are their customers, but they also sell other financial instruments such as certificates of deposit. Unlike banks, demand deposit account owners are granted an ownership stake in the credit union as a privilege of being a depositor. As such, like banks and other for-profit organizations, credit unions still operate on maximizing shareholder value.
And credit unions have dividend payouts as well, where they return some of their profit to their customers as deposits to their accounts.
In general, though, the not-for-profit focus of credit unions allows them to offer lower rates on loans and higher rates on deposits. Their general exemption from most taxation under the IRS code also allows this. Whereas banks are subject to general taxation on their net revenue, an expense they factor into their interest rates and fee schedules.
But they still operate through fractional reserve banking, and participate in the Federal Reserve System in the United States. This means they also participate in the overnight lending market, but also have a reserve requirement. The only difference between a bank and a credit union is who gets the banking profit.
And I’ve considered moving my finances to a credit union for that reason, as there are several credit union options in my area. Merely because I’d like to earn more than 15 to 20 cents per year on my deposit account. Plus we’re planning to buy a house within the next couple years, and credit unions tend to have more favorable rates on mortgages and other loans, but you generally need to be a member to take advantage. And given my credit score and income, they’d probably love to have me.