Fractional reserve banking

  By Mystic | July 14, 2012 - 02:05 |

Here in the OTP pub, Windy and ~Z~ got to a discussion about `fractional reserve banking`.

It is always tricky to paraphrase what other people were saying, but I think Z’s main gripe is that banks should not be able to lend money they do not have (extend credit they have not earned).

I am not sure why Windy was insisting that the US does not run a fractional reserve banking system; but it was clear he must have something in mind, or he would not deny that that is generally known by everyone.

The following is a clip from Steve Keen’s latest post, which is a reply to Mish -

Not a Fractional Reserve System

My second observation is that we don’t live under a Fractional Reserve System at all; we live under a private banking system in which there is a Central Bank that once sort-of attempted, unsuccessfully, to regulate private lending by imposing a ratio requirement between private bank money creation and government-created reserves.

I say “once sort-of attempted” because the Fed long ago amended its reserve requirements (see Table 12 in O’Brien, Y.-Y. J. C., 2007. Reserve Requirement Systems in OECD Countries.) so that they apply only to household deposits, and because there is a lag between deposits and reserves of 30 days: reserve requirements are based on loans and deposits existing 30 days earlier. This means that, as the European Central Bank recently politely put it in relation to its system:

“In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers.” (ECB 2012, p. 21, emphasis added)

I say “unsuccessfully” because, as a sensible New York Fed Vice-President admitted decades ago, the actual practice of banking, combined with the lagged nature of the reserve requirement, means that loans determine deposits and reserves follow relatively passively afterwards—the reverse of the argument that people who believe we live in a fractional reserve banking system actually put (ranging from Milton Friedman in the 1960s to critics like Mish today):

“The idea of a regular injection of reserves … also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier.” (Holmes 1969, p. 73)

 

Mish (~Z~ and Windy) all know and understand the above, so why does Keen think it  important enough to split hairs over this~?
In my opinion, it is because the fractional reserve explanation, although maybe correct, is a very clumsy way of thinking about the how the banking system works.

The next section in the Keen post talks of how to do the accounting if a bank were to make a loan from reserves………….

Money creation by private banking

There’s a fairly simple way to show from double-entry accounting that banks can’t lend from reserves, and that a system of pure private banking can result in banks creating money

….. and Keen goes on to boggle my mind with all sorts of technical explanations, but the bottom line is, `that banks can’t lend reserves` (from an accounting view-point).

The next step would be to ask if loans can be made out of customer deposits …… and I am not at all sure that the answer will be `yes, of course`~!
Same for borrowing from the central bank, or any individual bank, or private person via CD’s etc.
The only money that I can see, that could be said to be lent from, would be IPO type capital.

When looked at analytically, like Keen is doing, I can only see that all loans are made from `fresh-air-money`, because any other way would throw the accounts out of whack.
Even in countries with large (20%) reserve requirements, it is not practical to call their systems `fractional reserve`, because that is just not how banking works.
The premier criteria is that `the books must balance` ….. anything after that is just pushing and shoving numbers around by the bean counters.

Written by: Mystic on July 14, 2012.
Bookmark the permalink.
  • TheModernMystic

    I would be interested to know how MMT relates to peak oil, fractional reserve banking and climate change. COMMENTS PLEASE!!!

  • windslice

    Well, yep. That’s the  way I see it.

    But onward and upward to the latest scheme to get the people spending again.

    http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9397945/Banks-1bn-windfall-to-boost-economy.html 

    “Easier access to cheap borrowing should boost spending in the economy.”

    WTF!

    Been there, done that, got in a friggin mess, not got out yet.

    So what’s the grand scheme?

    More, more, more just give them more debt, and even cheaper too!

    That will fix it.

    For sure.

    Well, it will won’t it?

    They are the leaders.

    They know about these things?

    We elected them to fix the problems and give us our wealth and living standards back, didn’t we?

    “Oh shut up will you. Just borrow and spend FFS so we can get this GDP heading upward”

    Will they do it?

    That is indeed the question.

  • SeanTheLight

    Most of the folk I talked to, when they mention fractional reserve banking, the aspect they are usually referring to is the creation of money from nothing. Whether it be based on a reserve held first, or created and then tied to a reserve later, the creation of money by untrustable and unaccountable sources is the worrying issue. The discussion of whether it is fractional reserve or not would be an argument of semantics if I presented it to people nearer my level of understanding. Both sides would still agree that money was created based solely on the words of another.

    Another term often used a bit carelessly in such circles is fiat currency.

    When one admits that all loans are fresh air creations not tied to original stores of value, I would hope that the people creating those fresh air currency, are doing so with “an eye towards the future of humanity” since they have been given the power to destroy small (sometimes large) aspects of our lives via credit.

    It seems like the self-serving leaders of our world are running out of ways to convince the masses that their actions are “for the greater good”. It would not have been hard to sort out a renewable energy policy if it had been built-in from the start (woe to us for the loss of tesla’s works). Instead we are being herded into a life of poverty, misery, and most likely ultimately slavery, to maintain what? Lavish lifestyles? Manifest destiny? What does anyone gain from running such an inefficient and harmful system, compared to one run with sense and responsibility?

  • windslice
  • Anne Panne

    Like they are betting the money lent out, will come around and become reserves in thirty days time?

    • http://overthepeak.com/wordpress/ Mystic

       Basically yes.
      It is not quite, but think of it as a closed system.  (?~milk pasteurising plant~?).
      Make a loan, customer spends it ….. it will be deposited back in the system and get back to the central bank.  It might not be into your bank, but the odds are, that other loans will come to you……and it will all level out (small differences are done by inter-bank-lending).

      This is why banks are either `all loaning`, or `all stopped loaning`……as no one wants to be the only one loaning, their loans dropping into other banks and nothing coming back in from other banks.

      • Anne Panne

        But would the other banks want that – to get all the money and not lending anything? Isn’t lending how they make their profit? Do they use the deposits for speculation? Isn’t deposits a liability to the banks?
        If you just pasteurize the milk and leave it in the system – it will only go bad. You don’t process the milk unless you planning to use it in some way – hence it’s not a closed system.

        Is closing the system what they call sterilizing?

  • ZarathustraSpeaksAgain

    One of the things that I have come to realize is that the function of reserves is misunderstood.

    Here in the pub, we have come to understand that there is no real connection between lending and reserves. We know that credit is not transferred into the borrowers account, it is established there. We know that nobody ever checks to see if the statutory ratios are being adhered to and even if they do they just juggle to numbers to make things look good.

    But reserves do play a role in fractional reserve banking that is very important. There have to be enough reserves on account with the Federal Reserve Bank to make settlements happen at the end of the day. That’s it!

    I believe that windslice and others want to argue that we are not a fractional reserve system because either they misunderstand the function of reserves and think it has something to do with how much you can lend or just to make a point that we already get, that there is no connection between lending and reserves.

    The other irony is that the value of the full-reserve banking system has nothing do to with making settlement, which normally works out at the end of the day even with fractional reserves. The real value is that it forces banks to have the credit the lend, mostly in the form of savings accounts, but also in the form of bank capital. Or, banks could borrow from other banks or from the Treasury.

    If banks had to lend this way, they would have to share the profits from lending with the savers or the Treasury. Savers would not have to risk their savings in the Wall Street Casino to get a return.

    If the banks had no place to lend the savings, the Treasury could buy the savings and provide a small return to savers, but not for the purpose of running the government, rather for the purpose of securing savings and keeping the money busy doing things.

    More later,

    Z…

    • CSArichardo

      So reserves provide the liquidy to the money creating system and capital the solvency ?

      • ZarathustraSpeaksAgain

        Yes … I think. Reserves allow the credit deposited in or created by one commercial bank to move to another bank. As long as the credit balance in the reserve account is positive at the time of settlement, the bank is solvent.

  • lgrinaker

    Here’s another person’s work I would not have found without you having brought up his work (a few different times) – Steve Keen.  (That makes Richard Koo and what he brought to my attention with his work on “the balance sheet recession,” some of the key MMT folks, and Steve Keen – who is now working to incorporate into his modelling some of the key work of MMT, in particular, their contributions to the “operational realities” of the Federal Govt/Central Bank.)

    I’m now trying to slowly, but surely find my way with a bit of Keen’s work – and I’m hooked.  I’m really looking forward to the time in which he has completed “The Minsky Project,” creating a system for economic modeling along the lines of what has occurred for weather modelling (just one key example of such modelling) via emergent systems.  I think that’s going to be a huge contribution to economics once that’s complete and up and running (all levels of it that he intends to build into it).

    I’m also now learning that he takes both climate change and peak oil seriously, ;-), seeing at least 3 major global crises we face: those two, along with a financial crises, the area of expertise which he’s working to contribute a better understanding to (so as to work out better solutions to).

    I’m currently (with lots of stops, in order to better take in the information he has on his slides, ;-)) attending to the attached lecture, which he gave in January of this year (after doing so with his “just banking” slide presentation, along with his talk at the very recent gathering with MMT folks, which I could attend to a little better after the “just banking” presentation, in which I could clearly see the slides at least for that):

    http://www.youtube.com/watch?v=XZKjQtrgdVY

    (By the way, Z, you’ve got me turning my attention to more of the details behind MMT’s work on the “operational realities” – and how, exactly, what you’ve been bringing up relates.  I appreciate the general framework that they describe, which makes a lot of sense to me, but I usually stop short of looking into the nitty gritty of what the various factors within the general framework they describe actually are and how they work.)

    Linda

    • http://overthepeak.com/wordpress/ Mystic

       There is not much to `get` with Keen (or too much).
      He knows economic history, or history of economic schools.  He has identified which ones are okay and which ones are full of shit.
      The, very few, which are not full of shit, seem to overlap with the acceptable economists of the MMT school.  (for Keen, Minsky is da man~!)

      The main point is  that, the `full of shit schools` make their models work by leaving out all bank lending.  (which is so obviously silly that I don’t know how they have got away with it~!).

      • lgrinaker

        Odd.  I usually get an email when there’s a response to a comment I’ve made within one of these threads.  But I didn’t this time (of course, I may have simply missed it.)

        Boy, I do think that his modelling project – The Minsky Project - has the chance to make a really significant difference.  He’ll be able to start intro. economic classes with this, illustrating beautifully what he’s been presenting verbally so painstakingly for all of this time.  As he stated, it’ll be able to do for economics what Lorenz’s model has done for meteorology, applying the understanding of real-world chaotic systems, a much more accurate model of how the economy actually works in the world (which Keen credits Minsky as initially articulating)… Essentially, as this video ends with, “turning economics into a science”:

        http://www.youtube.com/watch?v=qepFaJW0-9Y

        Linda

        • Lyle

          “turning economics into a science” – well I hope to hell they do – then maybe I can understand it. :)
          After reading Joebhd’s super consise comment below – I began thinking… that’s a warning ya know… :)

          I can run with the pack on the sun creating all the elements from Hydrogen, the Higgs, worm holes, quantum mechanics, mitachondrial DNA, fiber optics using light interrupted 1.7 billion times per second for communcations, and brain science, but something in me refuses, apparently, to truly grasp what the hell we’re talking about – for years now. I’ve always liked puzzles but… this is really getting to be annoying. :)

          I understand most of the words, a bit of the ‘theories’ – I’ve learned a lot actually.  I’ve watched and listened to who knows how many talks and lectures not counting the ones here. Still… fuzzy images at best. Apparently I’m not completely alone here as other comments would support.

          So I fall from the etheral economic heights with a resounding thump, shake my head, and ask:Why do I even give a rats patoot about FRB, Central Banks, Bank Reserves, Inter-bank lending, etc. etc. ad infinitum? On the other hand if a friend asked me the same question I would probably be able to provide an almost believable response. A shaky snow job perhaps, but an answer. :)I guess that’s some kind of progress.

          Just sayin’

          • Lyle

            Listened to this 41 minute interview this evening. Pretty comprehensive review of much we discuss here.
            Chris Martenson interview with Kunstler.”James Howard Kunstler: It’s Too Late for Solutions”http://www.youtube.com/watch?v=Cwh-t2UPcOw&feature=related

            • Lyle

              The Paul Brodsky interview by Chris addresses my angst above. Half way through it now. I think this is one Nick and you who are far deeper into this stuff than I ever hope to be – will enjoy.
              http://www.youtube.com/watch?v=hSLzEu8erOk&feature=relmfu

              • pw

                Thanks Lyle on first pass Paul Brodsky’s rational seems well grounded, though it will take a few goes to get in to the complexity of the detail.

                I particulary like his seperation of base money from crediit based bank assets and the relationship to the value of currency.

                This is a process I like to call MINC ” money is not credit”. In my view we will get inflation through monetary devaluation as opposed to deflation through fiscal repression.

                Im not very good at articulating this process in pub terms as Nick well knows, so its great to hear Paul’s take which on the surface seems to arrive at the same conckusion.

                Thanks again this link has helped greatly.

            • axionication1

              I enjoyed that, thanks. Hologram ehhh?

              Not sure of advice () to keep fruit trees & chickens. The people without are bound to come for. It’s not the Walton’s… yah know.

          • axionication1

            So many sophisticated money questions in my mind then I think on (kunstler interview) the fact that the banks are broke, the government is broke & the peoples are broke… and I go back to the dummy question ‘ who got the dough?’. Please please please don’t let people tell me the 1% now has it-arghhhh…

            That brings my mind back to double entry bookkeeping! I can’t point you to specific vids/ discussions on it but I can tell you that I am of the belief that this (thought of) simple little mechanism is probably as powerful as the wheel and quite possibly created capitalism ( not the other way round).

      • lgrinaker

        And I do agree, it does seem simple; well, it’s beginning to seem that way to me.

        But we’ve got such a different “model” we have long been working within (or trusting “the powers that be” to work within on our behalf) that it’s quite something when somebody can help to dismantle the old model, as well as provide a new and better model – even when it ultimately is apparent how “full of shit” the old (well, the still current model) is.

        Paradigm shifting is quite something, isn’t it?… when we finally do find our way into a new paradigm, it’s true, it becomes hard to imagine how we could ever have “bought into” the old one; and yet…

        Linda

  • joebhed

    The problems of fractional-reserve-based banking are several.

    There is the moral one raised where a privileged class of businessmen get to create all of a nation’s purchasing power by extending loans of something they don’t have.
    They bring nothing to the table and they leave with the rent.

    Keen’s observations about the complexity of reserves and credits are an attempt to show that the banking system is not “reserve-constrained” ; that is , there is no requirement to have reserves in order to lend. This is correct.

    But what does it prove?
    Merely an unexpected sequence –
    That the loans CAN come first and IF reserves are inadequate, the reserves are obtained, either through other banks or the Fed.

    Importantly, banks cannot and do not lend out their reserves – or no NEW money would be created.
    The reserve-basis for lending is neither causal nor even directly functional to lending.
    Rather it is a requirement THAT all commercial banks MUST have the relationship of required reserves-to-deposits whenever the inspector calls every two weeks.

    The real problem with FRB is that it is the LOANS that create the nation’s MONEY – always as a debt.
    If the bankers created permanent money, their advantage would be singular.
    But since the money and the debt are temporal – REQUIRING constant additional service from and servitude to the bankers – the system is flawed against economic democracy.
    And thus, corrupting.
    The bankers own this town.
    Any town.
    And then there’s the matter of the ever-increasing compound interest.
    But that’s another story.
    Thanks.
     
     

    • http://overthepeak.com/wordpress/ Mystic

       I have just been mowing the lawn ….. and thinking.
      First …. Whatever you want them to do, will be a jump too far.
      The next thing, is that the link is too strong between central banks and sovereigns …. They are too used to scratching each others backs.
      To make anything work, would necessitate breaking the CB / Sovereign link.

      It is all-round impossible.

      My first wish, would be to ban banks and central banks from ever buying sovereign bonds.  From this I see how impossible everything is.

      • axionication1

        I remember you making a you tube vid ‘something? hail mary’. I think the train of thought was that the politicians were going to attack the banks.
        Me thinks we are on the cusp of that.

  • snedmeister1

    Good evening Nick.

    I have been reading this, and the link, but don’t quite follow why banks CAN’T lend from reserves…

    I know it is a balance sheet issue, and I know they don’t lend from reserves to the public, but I don’t follow the actual issue of why they can’t…???

    If you know, or have figured it out, maybe you could straighten it out in my mind..??