Understanding CC Chapter 7, Fractional Reserve Banking

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Understanding CC Chapter 7, Fractional Reserve Banking

I ‘m having trouble with the rationale behind the explanation of Fractional Reserve Banking in CM’s CC Ch7. What are your thoughts on the subject?

Ch 7 explains the concept on the basis of passing around FED Reserve Notes: Multiple lending and redeposit, restricted by always withholding a reserve fraction in the lending process, results in the determined money multiplication.

I'd like to know if this explanation isn’t unnecessary palliative and disguising partially. I think it serves the illusion that actually liabilities from the reserve bank (what we call money) get passed around through lending and redeposit.

Supposed a commercial bank holds $1000 in liabilities from the reserve bank not yet leveraged (excess reserves). An excellent debtor with sound securities walks in and asks for a 10000$ loan. Wouldn’t the bank be able to lever the $1k reserves and endow the guy with 10k chequebook money right away? Is the explained redeposit scheme helpful for understanding the nature of the FRBanking-procedure?

As long as the legal chequebook money is commonly accepted the bank grants the guy access to public resources until the chequebook money has vanished by its built-in lifecycle. Also, the bank makes sure that the available resources are optimally allocated by doing god’s work in the process. It is also clear that a bank would never issue Ninja loans since unless they’d have access to counterfeit money eventually;-)

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Baywork wrote:

Ch 7 explains the concept on the basis of passing around FED Reserve Notes: Multiple lending and redeposit, restricted by always withholding a reserve fraction in the lending process, results in the determined money multiplication.

I'd like to know if this explanation isn’t unnecessary palliative and disguising partially. I think it serves the illusion that actually liabilities from the reserve bank (what we call money) get passed around through lending and redeposit.

Hello Baywork, you have hit on the most misunderstood concept in banking - fractional lending.  I think you are correct in pointing out that "fractional lending" is palliative as it is more a symptom; an effect rather than cause.  I'll try to explain how bank lending really works but first let me expose the two myths that often accompany fractional lending.

  1. Banks do not lend their or their depositors money.  The money they lend is created on the spot, for virtually free.  They hold a monopoly to monetize promissory notes that are backed with adequate collateral.  If all goes well, and the loan is repaid, they profit from interest payments on money that was never theirs to begin with.  If payments are not made, they may seize the collateral, for free.
  2. Banks hold some cash and coins in their vaults as a convenience to their customers.  All other "reserves" are held at the banks Federal Reserve branch - and they are almost entirely liabilities of the Federal Reserve.  The Fed builds "common" reserves by buying bonds and government securities through the FOMC (open markets committee) at the New York branch.  The Fed creates the money virtually for free as they accept government bonds and securities as a promise to pay and collateral.  It is important to note that customer deposits are not included as reserves.

Now, on to how banks really operate.  There are two key ratios that determine if and how much a bank may create as loans.  It is up to regulators to ensure that banks maintain the required minimum ratios.  

  1. Capital Ratio - is the ratio of a bank’s capital (equity) to a risk-weighted sum of the bank's assets.  I think the weightings are 0 for reserves, 0 for government securities, 0.2 for loans to banks, and 1.0 for ordinary loans.  The BIS (Bank of International Settlements) has established a minimum capital ratio of 8% but I am not sure if it is currently used by the Fed.
  2. Leverage Ratio - is the ratio of a bank's equity to the unweighted sum of its total assets.  I think the required minimum is 3 - 10%, depending on the size of the bank.  The reserve ratio is the ratio of a bank's reserves (deposits at the Fed plus vault cash) to its demand deposits, i.e. checking deposits.

When a bank issues a loan, it's assets (A) and liabilities (L) increase equally.  It's reserve ratio (R) decreases (R/L) but the capital remains the same (C = A - L) which causes a reduction in the capital ratio (C/A).  Banks with an adequate capital ratio may lend without enough reserves.  If a bank has a profitable lending opportunity, it will issue the loan and then borrow reserves later if needed.

If a bank is unable to maintain the minimum ratios, technically they cannot lend regardless of any "fractional lending" multipliers that might be used.  If a bank loses money through loan defaults, bad investments, fraud, etc., their liabilities may exceed their asserts and they become vulnerable to a bank run.  This is a major problem today as regulators have not done their job and subsequently, we have lots of insolvent banks. 

While a bank run would be bad for business, a solvent bank; one that maintains the above ratios, should always have enough money to allow all of their depositors to withdraw their money.  Banks do not keep enough cash and coin in their vaults to allow depositors to "cash out" but people should be able to write checks for the full amount of their deposit.  An insolvent bank will not have enough assets to survive a bank run without at least some depositors losing their money (FDIC insures against  depositor losses).

The Federal Reserve supplies most bank reserves, when they want an increase in lending, they increase the reserves by buying bonds and securities.  If they want the money supply to decrease, the sell off bonds and securities or allow them to mature without repurchasing more.  Unfortunately, these gyrations may cause boom and bust cycles.

Banks are free to create money for their own account in order to provide some extra profit through investments.  Commercial bank investments were almost all very conservative (government securities and bonds).  The elimination of Glass-Steagall Act in 1999 allowed the same institution to operate as both a commercial and investment bank.  Investment banking includes corporate fund-raising, brokering, mergers and acquisitions and derivative trading.  Commercial banks typically made the bulk of their profits from banking services and loans while investment banks created money for their own accounts for investment purposes.  The line between the two has been blurred with increased risk.

According to Money: What It Is, How It Works the 10 biggest banks hold half of all the banking assets in the U.S.  They include Citibank, J P Morgan Chase, B of A, etc.  These conglomerates have combined commercial and investment banking.  The "too big to fail" banks operate more as giant casinos where profits are private and losses are public (FDIC, Fannie % Freddie, bail-outs, etc).  They create money, for free, for their own investments rather than serving the public's banking needs.  And they do not maintain the required ratios under generally accepted accounting practices.

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

DrKrbyLuv, thanks for the comprehensive answer. It’s an excellent wrap-up that banking is not earmarked by public weal.

Why do you think that 'fractional lending’ is a symptom? Me thinks 'fractional lending' is more like an misleading attempt at explanation. If banks weren’t allowed to create chequebook money from thin air, they probably would have to inform their depositors by law that a depositor won’t be able to get interest unless he or she agrees to lock a reserve fraction of the deposit to the bank in order to make the subsequent interest paying credit possible;-)

In addition, assuming the fractional lending-from-deposit-schema would be formally obligatory, I do think that banks could raise the final maximal credit sum by playing the game on the computer among themselves if a real customer providing the collateral for the entire credit is waiting.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Baywork wrote:

Why do you think that 'fractional lending’ is a symptom? Me thinks 'fractional lending' is more like an misleading attempt at explanation.

Interesting point, I think you are right on this...fractional lending is a misleading term; on purpose.

Fractional lending is even more irrelevant when it comes to investment banks.  The truth is that they operate like giant hedge funds on steroids in that they may create the money, for free, for their own investments.  If you remember, during the the big meltdown, some investment banks were leveraged as high as 47:1.

And, creative off-balance-sheet accounting procedures are becoming more common which enables banks to increase their leverage.  For example, here is what WFC is doing to "eliminate" liabilities:

Reading through the Qs for this quarter, a picture starts to emerge of utter chaos when it comes to how banks are implementing -- or not -- the changes by the FASB as to how organizations account for off balance sheet ("OBS") exposures. Let us take two examples: Wells Fargo and PNC Financial.

In the case of WFC, the bank has taken the position that NONE of its conforming residential exposures should be brought on balance sheet despite the FASB rule change. As we discussed in The Institutional Risk Analyst this week, "Why? Because the loans inside these securitization vehicles are insured by FHA, so goes the thinking of WFC and its auditor, thus the bank has no liability to these entities or the securities they have issued to investors. Pretty neat trick, eh?"

Thus WFC is basically saying that none of the bank's $1.1 trillion in conforming OBS exposures need to be represented or reserved against. My problem with this is two-fold: First, the FHA and/or GSEs will return some portion of the securitized loans, so WFC should explicitly disclose this cost and reserve against it. Second, it seems to be pretty arrogant for WFC to take such an aggressive positions with respect to these OBS vehicles, even with a third party guarantee, especially given the intent of the FASB rule change. BTW, WFC has another $0.6 trillion in non-conforming exposures we have yet to hear about. That is next quarter presumably.  - complete article link

From a banking perspective, it may be that commercial banks are becoming obsolete.  From a peoples perspective, investment banks have become an unnecessary scourge and threat to our financial well being.

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Hi Larry, thanks to your hints, I tried to read and understand the regulations about FRBanking. As I see it, the laws require banks to measure and comply to overall leverage ratios only. No offence meant to CM, but the mechanism described in cc ch 7 looks to me very much as if it is a brainwashing superfluous shell game.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
Baywork wrote:

Hi Larry, thanks to your hints, I tried to read and understand the regulations about FRBanking. As I see it, the laws require banks to measure and comply to overall leverage ratios only. No offence meant to CM, but the mechanism described in cc ch 7 looks to me very much as if it is a brainwashing superfluous shell game.

Baywork

To my knowledge, there is nothing wrong with Crash Course Ch 7. I think the problem is, you guys are putting the proverbial cart before the horse here. CC 7 is meant to provide an understandable and digestible explanation of the actual "theory" behind fractional reserve banking, NOT a detailed chronicling of the real world torturing and bending of the rules as now practiced by the banks. Before getting too concerned with all the sophisticated nuances and complex machinations of the banking world, I think it's a good idea to understand the basics of "how" the banks actually create new money through loan origination. That's what CC 7 is about. So in the parlance of epistemology (theory of knowledge), I think it's important to make a distinction between 'knowledge-that' (i.e., it is known 'that' 2+2=4, or something more complex, like, 27x96=2592 is 'known'), and 'knowledge-how' (knowing 'how' to actually add and subtract, or solve math problems). CC  7 is all about 'knowledge-how.'  And in my opinion, it does an excellent job explaining 'how' the money creation process actually works -  in necessarily simplified, and understandable terms. So I would recommend that you be sure you grasp the fundamentals first, BEFORE you move on to all sorts of complex factual information about the banking system. Otherwise, no matter how much you read about it, you may be prone to confusion.

Best

Greg

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Baywork wrote:

Hi Larry, thanks to your hints, I tried to read and understand the regulations about FRBanking. As I see it, the laws require banks to measure and comply to overall leverage ratios only. No offence meant to CM, but the mechanism described in cc ch 7 looks to me very much as if it is a brainwashing superfluous shell game.

Hello Baywork - I'm glad that you researched banking ratios. "Fractional reserve money multipliers" are secondary at best, to the more significant capital ratios. CC-7 shows Fed published material, traditionally held as accurate, on fractional lending.  And, we have to remember that banking has radically changed over the past year or two.  For example, I think it is safe to say that commercial banks are losing ground against combination investment & commercial banks.  The investment bank model is to create money for their own accounts for investment purposes.  Deposits and standard public loans are a smaller part of their business.

As a regular paid subscriber, I get to read a lot of CM's stuff and I can tell you that he has written over and over about insolvent banks and the fact that they are juicing up their balance sheets to extend their leverage.  He has been on target with his analysis.

That said, in a perfect world, where everyone had infinite time, I'd like to see CC-7 updated. 

Thanks for the great discussion,

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

And in my opinion, it does an excellent job explaining 'how' the money creation process actually works -  in necessarily simplified, and understandable terms. So I would recommend that you be sure you grasp the fundamentals first, BEFORE you move on to all sorts of complex factual information about the banking system.

Hello Greg,

do you want me to feel like an idiot? I do think I’m able to understand the presented theory behind FRBanking. The fact that you claim to understand the hypothesis doesn’t proof that the theory is appropriate. I’m just looking for an ascertain prove beyond doubt that what you call ‘fundamentals’ explained in ‘simplified’ terms holds scrutinization. All what’s necessary is to find and present the piece of evidence showing that the presented multiple deposit-loan sequence theory is actually fundamental ingredient in the FRBanking process. You did not provide much in evidence.

So, in the parlance of epistemology, maybe the FED documentation tells us a story about horse-drawn carriages. You tell us that our body of knowledge tells us that the horse needs to be put in front of the cart using proper harness… Excellent. Well, however, my question was that since the cart behaves like an automobile that can go a 100mph easily on its own, it might actually be an automobile? Explained in ‘simplified’ terms the practice might be like: apparently FRBanking banks don’t ride horse-drawn carts, they always enjoyed automobiles and have to take notice of legal speed limits. People would understand this even without simplified terms. However, the FED presented horse might be shown to set people's confused minds at rest while a harness connecting to the cart never existed…

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
Baywork wrote:

Hello Greg,

do you want me to feel like an idiot? I do think I’m able to understand the presented theory behind FRBanking. The fact that you claim to understand the hypothesis doesn’t proof that the theory is appropriate. I’m just looking for an ascertain prove beyond doubt that what you call ‘fundamentals’ explained in ‘simplified’ terms holds scrutinization. All what’s necessary is to find and present the piece of evidence showing that the presented multiple deposit-loan sequence theory is actually fundamental ingredient in the FRBanking process. You did not provide much in evidence.

So, in the parlance of epistemology, maybe the FED documentation tells us a story about horse-drawn carriages. You tell us that our body of knowledge tells us that the horse needs to be put in front of the cart using proper harness… Excellent. Well, however, my question was that since the cart behaves like an automobile that can go a 100mph easily on its own, it might actually be an automobile? Explained in ‘simplified’ terms the practice might be like: apparently FRBanking banks don’t ride horse-drawn carts, they always enjoyed automobiles and have to take notice of legal speed limits. People would understand this even without simplified terms. However, the FED presented horse might be shown to set people's confused minds at rest while a harness connecting to the cart never existed…

That might be the most confusing two paragraphs I have ever read.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Goes211, I do apologize to you for those two lousy confused paragraphs. The fact that I did use Bing for the translation made things even worse.

 

Rereading Greg’s comment, I do think that one cannot understand FRBanking unless an explanation illuminates that its mode of operation explicitly requires putting in the factor time into the underlying math.

By considering the factor time in the underlying math of the checkbook money creating credit contracts, one will eventually spot that the proverbial ‘thin-air’ comes from time as contracted.

E.g. zero repayment periods would fully avert FRBanking, whereas indefinite repayment periods would produce pure counterfeit contrariwise. (Just compare a bank handing out counterfeit money to a bank issuing credits with infinite repayment periods.)

The bank deposits as explained in cc ch7 refer to liabilities with ‘zero repayment periods’. They are not simply handed down to the next borrower as if they were the banks available equity again. Banks create loans by balance sheet extension. And the respective balance sheet extensions are usually not meant to be undone before maturity. I think the prevailing implicit commingling of ageless deposit vs. maturing credit money in simplified explanations isn’t sheer coincidence.

Sorry for any confusion this has caused.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Baywork

Very sorry for insulting you. It was certainly not my intention. It could well be me who is the "idiot" for misunderstanding you, so please forgive me if I'm wrong. But in all sincerity, your comments strongly seem to suggest that in fact, you do not understand the process of money creation. It's my impression that this is common - that in fact, many of the people challenging CC 7 and other chapters on money have this problem. That may seem ridiculous to you, but I think it's because as simple as the process of money creation may be, it's also profoundly counterintuitive. As Galbraith said, it's so simple it repels the mind. Ironically, for a lot of people, I think the more they read about it, the MORE confused they get. As I see it, all the reading in the world about advanced math does NOT help you better understand how to solve a simple equation - and until you understand how to solve the equation, the advanced reading is probably going to be a lot less useful, anyway.

Chris Martenson wrote:

... For now, I want you to understand that money is loaned into existence. Conversely, when loans are paid back, money ‘disappears.’...

This is the essential concept of chapter 7. None of the technicalities of real world banking change this one iota. In the real world, only a small portion of  bank deposits are technically even subject to any reserve requirements at all, http://www.financialsense.com/fsu/editorials/gnazzo/2005/1129.html and the banks have devised creative ways to get around even that. As I understand it, many banks simply have vault cash on hand, and that's it.  http://www.elliottwave.com/freeupdates/archives/2009/07/01/Some-Thoughts-on--Fractional-Reserve--Banking-System.aspx But whether banks are required to hold 10%, or 0%, the process of loaning money into existence is the same. It is true, with the stroke of a pen (or a keyboard) when a bank writes a loan, new money that did not previously exist is simply conjured into existence on the basis of the borrowers promise to pay it back. BUT ... even when there are no reserve requirements at all, and no matter how many times money gets multiplied this way, there still remains one other fundamental and inviolable requirement. Every liability  has to have a corresponding asset upon which it is based. That's the only way it can be created.  A loan works very much like a clone - there has to be something to base it on.

So, while with a 10% reserve requirement, a $1,000 deposit can indeed be turned into $10,000, as described in CC 7, and with a 0% requirement it can theoretically be turned into ANY amount of money, there is one very important caveat.  Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit - because each liability must have a corresponding asset (that's how it's created). So the only way to get to the $10,000 (or more) is to make a new loan on the basis of the loan made from the deposit, and then another loan on the basis of that new loan, and so on, creating a tandem chain of alternating assets and liabilities - the repeated iterations of the original loan process, known as the 'multiplier effect.' To better understand this process, it may be helpful to think of the banking system as one big bank, within which, effectively, all the individual banks operate the same way, making clones of each other's clones (loans from each other's loans). With minimal reserve requirements, this process can go on practically forever. But theoretically, if nothing goes wrong, and everyone pays each other back in good faith, all of the money goes away again, and we are right back  where we started! In a certain way it's actually an elegant, if inherently vulnerable system. The real fly in the ointment is the interest - the devise by which the banks get very rich, and most of the rest of us get poorer. But that's another story.

I hope this helps

Best

Greg

 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

GregSchleich wrote:

Ironically, for a lot of people, I think the more they read about it, the MORE confused they get.

Hi Greg, I’m glad you took the time to post an answer. Yes! I do agree.

GregSchleich wrote:

Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit - because each liability must have a corresponding asset (that's how it's created). So the only way to get to the $10,000 (or more) is to make a new loan on the basis of the loan made from the deposit, and then another loan on the basis of that new loan, and so on,

 

  • Greg, do you imply that the bank’s initial original equity money actually leaves the bank (e.g. 900 out of 1000) thought the first loan?

Pondering on Ch7…

... For now, I want you to understand that a bank’s checkbook-money (not legal tender) is loaned into existence.

Upon loan agreement, the newly created bank’s liability to pay on demand gives the borrower new effective buying power, but not currency. The ch 7 part of FRB works for the reason that hardly any trading partner demands deals with actual money from the vault/ bank equity/ respectively deap breath treasury-$.

The bank’s promise to convert checkbook-money to legal tender on demand doesn’t convert the bank’s loaned into existence balance sheet numbers into money. The fact that we treat the checkbook-money as if it is money still doesn’t transform it into money. Maybe it is a misunderstanding, I do deem that yet the very first borrower doesn’t get money at all, nor does he get money from the vault. He gets a bank’s liability grant to pay on demand. (Yes, the borrower keeps the loan collateral for his own utilization also.)

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Baywork wrote:

The fact that we treat the checkbook-money as if it is money still doesn’t transform it into money...He gets a bank’s liability grant to pay on demand. (Yes, the borrower keeps the loan collateral for his own utilization also.)

Agreed, our money is a promise to pay - but payment in another promise to pay - another FRN (Federal Reserve Note).  There are no reserves backing the system; just more promises to pay.  The promise is free; the banks pledge no collateral and they offer no guarantees or warranty.  The borrower provides a promise to pay secured by collateral.  

GregSchleich wrote:

So, while with a 10% reserve requirement, a $1,000 deposit can indeed be turned into $10,000, as described in CC 7, and with a 0% requirement it can theoretically be turned into ANY amount of money, there is one very important caveat.  Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit - because each liability must have a corresponding asset (that's how it's created).

So the only way to get to the $10,000 (or more) is to make a new loan on the basis of the loan made from the deposit, and then another loan on the basis of that new loan, and so on, creating a tandem chain of alternating assets and liabilities - the repeated iterations of the original loan process, known as the 'multiplier effect.

Hello Greg,

We've discussed some of this stuff before and I always enjoy your well worded posts even though we don't always agree. 

Your explanation of bank reserves and lending requirements is contrary to my understanding.  You suggest that "with a 10% reserve requirement, a $1,000 deposit can indeed be turned into $10,000...with a 0% requirement it can theoretically be turned into ANY amount of money, there is one very important caveat. Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit...

In your equation, deposits determine how much money a bank may lend via a money multiplier.  Mish (H/T JAGS) refutes this claim in an article entitled "Fictional Reserve Lending And The Myth Of Excess Reserves"

  

Money Multiplier Theory Debunked

The chart shows an unprecedented amount of excess reserves, almost $1.2 trillion.

According to Money Multiplier Theory (MMT) and Fractional Reserve Lending, this amount may be lent out as much as 10 times over and when it does, massive inflation will result.

Money Multiplier Theory Is Wrong

The above hypotheses regarding "Excess Reserves" are wrong for five reasons.

  1. Lending comes first and what little reserves there are (if any) come later.
  2. There really are no excess reserves.
  3. Not only are there no excess reserves, there are essentially no reserves to speak of at all. Indeed, bank reserves are completely "fictional".
  4. Banks are capital constrained not reserve constrained.
  5. Banks aren't lending because there are few credit worthy borrowers worth the risk.

If money multipliers (fractional reserve lending based on deposits) were a defining variable, then how could "investment banks" act as money centers?  They are not in the banking business, at least by the traditional definition of attracting depositors and borrowers; they are in the speculative investment business.

The Glass–Steagall Act (1932) was overturned during the Clinton administration which blurred the difference between commercial and investment banks.  Goldman Sachs has creatively worked one against the other in creating a new beast; explained by Ellen Brown - 

"Goldman's superpower status comes from something more than just access to the money spigots of the banking system. It actually has the ability to manipulate markets. Formerly just an investment bank, in 2008 Goldman magically transformed into a bank holding company.

That gave it access to the Federal Reserve's lending window; but at the same time it remained an investment bank, aggressively speculating in the markets. The upshot was that it can now borrow massive amounts of money at virtually 0% interest, and it can use this money not only to speculate for its own account but to bend markets to its will."  - complete article link 

There are two ratios that really matter, as I mentioned earlier, that determine if and how much a bank may create as loans or for their own account.  It is up to regulators to ensure that banks maintain the required minimum ratios.

  1. Capital Ratio - is the ratio of a bank’s capital (equity) to a risk-weighted sum of the bank's assets.  I think the weightings are 0 for reserves, 0 for government securities, 0.2 for loans to banks, and 1.0 for ordinary loans.  The BIS (Bank of International Settlements) has established a minimum capital ratio of 8% but I am not sure if it is currently used by the Fed.
  2. Leverage Ratio - is the ratio of a bank's equity to the unweighted sum of its total assets.  I think the required minimum is 3 - 10%, depending on the size of the bank.  The reserve ratio is the ratio of a bank's reserves (deposits at the Fed plus vault cash) to its demand deposits, i.e. checking deposits.

(A) = Assets, (C) = Capital, (L) = Liabilities, (R) = Reserve ratio

When a bank issues a loan, it's assets (A) and liabilities (L) increase equally.  It's reserve ratio (R) decreases (R/L) but the capital remains the same (C = A - L) which causes a reduction in the capital ratio (C/A).  Banks with an adequate capital ratio may lend without enough reserves.  If a bank has a profitable lending opportunity, it will issue the loan and then borrow reserves later if needed.

When interest is paid out of a deposit within the bank, L decreases while A and R remain unchanged - an increase in both the reserve ratio and the capital ratio. If the borrower pays interest from an outside source, A and R increase while L remains unchanged - again, both the reserve ratio and the capital ratio increase.

Banks may issue (create) money for their own accounts for expenses and investment purposes.  According to Ellen Brown, "thirty percent of the new money created by banks, with accounting entries, is invested for their accounts" (Federal Reserve Statistical Release - H.8).

The big investment banks create money for virtually free to use for investments, market manipulation, bribes, campaign contributions, sweet-heart deals, hookers, monopolies, CIA, etc.

The problem is not that banks may create money in some theoretical multiplier, the big problem is that the big banks may create all the money they want for free. 

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

The problem is not that banks may create money in some theoretical multiplier, the big problem is that the big banks may create all the money they want for free.

And then they only loan it to us, and demand back more than what was created...........Then when we cannot pay, they come and take the things of real value (the property).......  It's complete theft.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Hello Larry, self-evident, I do agree with your post 100%, without reserves;-)

DrKrbyLuv wrote:

… There are no reserves backing the system; just more promises to pay. …

…The problem is not that banks may create money in some theoretical multiplier, the big problem is that the big banks may create all the money they want for free. 

My intension was to confine the debate to what’s said in cc ch 7. The truth behind the reserves backing the system, the bank’s kludge named FED, aso., ... yet another story.

GregSchleich wrote:

CC 7 is meant to provide an understandable and digestible explanation of the actual "theory" behind fractional reserve banking, NOT a detailed chronicling of the real world torturing and bending of the rules as now practiced by the banks.

Greg basically already said that the actual "theory" is immune against reasoning based on taking real world capital ratios, leverage ratios, banks issuing credit for their own accounts, aso., as evidence.

Only a few people insist in their claim that the MMTheory is wrong. Obviously the majority thinks the theory is correct, including Mr Martenson. There are many smart people here at the cm forums; a final close of argument beyond opinions should be feasible.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Addendum:

cc 7: “Now, there’s a rule on the books, a federal rule, that allows banks to loan out a proportion, a fraction, of the money they have on deposit to others.” -> 1.

“We now have a bank with $1000 on deposit, and banks do not make money by holding on to it – rather, they make their living by borrowing at one rate and loaning at a higher rate.” -> 5.

…” With this new deposit, the bank has a fresh $900 to work with, and so it gets busy finding somebody who wants to borrow 90% of that amount, or $810.” -> 4.

..later.. “Is this all real money? You bet it is, especially if it’s in your bank account. … ->2.

-
  1. The reserves must be central bank high powered money. Laws establish high powered money as legal tender. In short, we’ve to accept high powered money as being our ‘real’ money.
  2. Banks do not “loan out a proportion, a fraction,” of high powered money. Borrowers get bank checkbook money. “Is this all real money?” See 1. above: no, it is not our ‘real’ money at all.
  3. Sure enough banks augment checkbook money with 0% high powered money, for the reason that merely a promise to pay high powered money on demand is satisfactory. The required reserves and the loaned checkbook money are different species.
  4. Re-deposited checkbook money originating from former bank loans still contains 0% high powered money.
  5. Thus, the high powered money, the reserves, is continuously held in reserve by the bank. Upon demand they are touched to convert checkbook money into legal tender, nevertheless that’s fundamental difference from getting them touched by loaning them.
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DrKrbyLuv
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Re: Understanding CC Chapter 7, Fractional Reserve Banking

Hello all,

I wanted to add more evidence to support the premise that fractional reserve banking (money multiplier) is a myth, at least in today's banking system.  And to be fair, I think we have to say that the banking model has changed dramatically, especially within the last two-three years.

Myth  >>>   "Banks create money based on fractional lending (money multiplier)"

Many from the Austrian economics camp suggest that fractional reserve lending should be abolished - Mises argued for a 1:1 ratio.  The argument is that 1:1 lending would stop inflation and reign in debt (stop the presses!).  This is based on the belief that the market would correct the problem, given the chance. 

The facts on the Ground -

According to the Federal Reserve Chart below; the money multiplier hasn't been higher than 1:1.75 for almost 10 years.  And, it's been at or below 1:1 for around year now. They got what they wanted... 

- Link

Conversely, in the same time period, bank "reserves" have been growing in magnitudes to new historic highs.

M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks

Several things are happening here:

  1. An obvious disconnect exists between reserves and lending (money multiplier).
  2. Effective October 1, 2008, the Fed started paying interest on both required and excess reserves.  Are you surprised that money created for free is being parked in guaranteed return government accounts?
  3. Note: Bank reserves cannot be created by banks or their depositors.  Reserves exist in a common pool created created through the FOMC in "buying" securities from the government (Treasury bonds, etc.) via the omnipotent New York Federal Reserve branch as "high powered" money.  Translation - "high powered money" = debt backing debt to create the illusion that there are reserves.

Excess reserves are defined as the amount beyond the required quantity.  Here is a chart from the Federal Reserve that illustrates the increase in "excess reserves."

 

Look forward to any comments...

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

I'm pretty smart and you guys lose me in the details.  I'll stick with Chris's simple expanation.Smile

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

docmins,

Go back to my Post 1 for an easy to understand explanation. 

Larry

 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
Baywork wrote:

GregSchleich wrote:

Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit - because each liability must have a corresponding asset (that's how it's created). So the only way to get to the $10,000 (or more) is to make a new loan on the basis of the loan made from the deposit, and then another loan on the basis of that new loan, and so on,

 

  • Greg, do you imply that the bank’s initial original equity money actually leaves the bank (e.g. 900 out of 1000) thought the first loan?

Baywork

In the real world of fiat debt-money, most of the time, fractional reserve banking is an abstract process. Except for a few cash transactions, most deposits and loans are simply accounting entries, involving no physical process that can be described. So in the real world, the answer would be no. But for the purposes of understanding the theory of FRB, in a simple example like CC 7 it's easier to make sense of the process if in fact, we say yes, the money actually leaves the bank - because that clarifies the important point that once the money has been borrowed, it cannot be borrowed again from that same source, until it has been returned. Here's an analogy that might help: You borrow (or rent) a post-hole-digger from a friend, with the assumption he probably won't be needing it back right away. So after you get done using it, you loan (or rent) it to your neighbor, who in turn uses it, and then loans (or rents) it to another neighbor, and so on...  Now, if at any point in this process, someone else wanted to borrow the post-hole-digger from you, obviously it would not be available, having already been loaned out, and if at any point, unexpectedly, your friend came back needing his post-hole-digger, you would have some explaining to do. But if all goes well, and after using it, each person returns the post-hole-digger to the person they borrowed (or rented) it from, eventually a lot of people in the neighborhood have new fences, some may even have made a little money (from renting out the post-hole-digger), and your friend comes back to get his post-hole-digger, none the wiser. That's how fractional reserve banking works. (obviously though, in this example the reserve requirements are 0%. The post-hole-digger doesn't get progressively smaller!)

Quote:

... For now, I want you to understand that a bank’s checkbook-money (not legal tender) is loaned into existence.

Upon loan agreement, the newly created bank’s liability to pay on demand gives the borrower new effective buying power, but not currency. The ch 7 part of FRB works for the reason that hardly any trading partner demands deals with actual money from the vault/ bank equity/ respectively deap breath treasury-$.

The bank’s promise to convert checkbook-money to legal tender on demand doesn’t convert the bank’s loaned into existence balance sheet numbers into money. The fact that we treat the checkbook-money as if it is money still doesn’t transform it into money. Maybe it is a misunderstanding, I do deem that yet the very first borrower doesn’t get money at all, nor does he get money from the vault. He gets a bank’s liability grant to pay on demand. (Yes, the borrower keeps the loan collateral for his own utilization also.)

From the standpoint of this discussion, there is no reason to distinguish checkbook-money from currency. They are both money. They behave in exactly the same manor and are fully fungible. Remember, only about 2 or 3% of the money supply is in currency. The rest comes from accounting entries - 97% of the money supply. Believe me, it's money!

I hope this helps.

Best

Greg

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
DrKrbyLuv wrote:

Your explanation of bank reserves and lending requirements is contrary to my understanding.  You suggest that "with a 10% reserve requirement, a $1,000 deposit can indeed be turned into $10,000...with a 0% requirement it can theoretically be turned into ANY amount of money, there is one very important caveat. Unless and until it's paid back, only one loan at a time, of $1,000 (or $900, in the case of a 10% reserve requirement) can be made DIRECTLY against the original deposit...

In your equation, deposits determine how much money a bank may lend via a money multiplier.  Mish (H/T JAGS) refutes this claim in an article entitled "Fictional Reserve Lending And The Myth Of Excess Reserves"

  

Money Multiplier Theory Debunked

The chart shows an unprecedented amount of excess reserves, almost $1.2 trillion.

According to Money Multiplier Theory (MMT) and Fractional Reserve Lending, this amount may be lent out as much as 10 times over and when it does, massive inflation will result.

Money Multiplier Theory Is Wrong

The above hypotheses regarding "Excess Reserves" are wrong for five reasons.

  1. Lending comes first and what little reserves there are (if any) come later.
  2. There really are no excess reserves.
  3. Not only are there no excess reserves, there are essentially no reserves to speak of at all. Indeed, bank reserves are completely "fictional".
  4. Banks are capital constrained not reserve constrained.
  5. Banks aren't lending because there are few credit worthy borrowers worth the risk.

 

Come on Larry, who you gonna believe, me or Mish? Smile 

But all kidding aside, I think you're misinterpreting Mish's meaning here. Yes, banks have gotten more aggressive, and more adept at fudging and bending the rules, I'm sure, but the basic principles of accounting remain unchanged.  As long as money = debt, a banks liabilities must be equal to it's assets. There is no way around that fundamental principle. Only the Federal Reserve, in concert with the treasury, can create money out of thin air, by fiat, with no countervailing asset. Mish is NOT saying that the multiplier effect is theoretically incorrect. What he's saying is that the "theory" that it's going to cause inflation any time soon is wrong, because there are no excess reserves. He is not saying the theory that 2+2= 4 is false, because addition is an invalid concept. He's saying it's false because we don't actually have 2 and 2 - a big difference.

Quote:

 

If money multipliers (fractional reserve lending based on deposits) were a defining variable, then how could "investment banks" act as money centers?  They are not in the banking business, at least by the traditional definition of attracting depositors and borrowers; they are in the speculative investment business.

The Glass–Steagall Act (1932) was overturned during the Clinton administration which blurred the difference between commercial and investment banks.  Goldman Sachs has creatively worked one against the other in creating a new beast; explained by Ellen Brown - 

"Goldman's superpower status comes from something more than just access to the money spigots of the banking system. It actually has the ability to manipulate markets. Formerly just an investment bank, in 2008 Goldman magically transformed into a bank holding company.

That gave it access to the Federal Reserve's lending window; but at the same time it remained an investment bank, aggressively speculating in the markets. The upshot was that it can now borrow massive amounts of money at virtually 0% interest, and it can use this money not only to speculate for its own account but to bend markets to its will."  - complete article link 

 

Banks may issue (create) money for their own accounts for expenses and investment purposes.  According to Ellen Brown, "thirty percent of the new money created by banks, with accounting entries, is invested for their accounts" (Federal Reserve Statistical Release - H.8).

I think it's a really bad idea to jump ahead to the extremely complex machinations of the investment banks and their proprietary trading, etc., without a solid understanding of the basic principle of money as debt. But ultimately the investment banks function on exactly the same principles as the commercial banks, just in a far more sophisticated way. They are NOT a repudiation of these principles, any more than aviation is a repudiation of the law of gravity - but it certainly might seem that way to someone new to the subject.

Quote:

The big investment banks create money for virtually free to use for investments, market manipulation, bribes, campaign contributions, sweet-heart deals, hookers, monopolies, CIA, etc.

The problem is not that banks may create money in some theoretical multiplier, the big problem is that the big banks may create all the money they want for free.

I'm no more a fan of the system than you are, but fractional reserve banking is not just "some theoretical multiplier." By all accounts, it accounts for about 95% of the money supply, or more. You will not find a credible source that disputes that.

Best 

Greg

 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

GregSchleich wrote:

In the real world of fiat debt-money, most of the time, fractional reserve banking is an abstract process. Except for a few cash transactions, most deposits and loans are simply accounting entries, involving no physical process that can be described.

Bank lending is not an abstract process, there are rules and regulations that determine the mechanics.  Regulators have been looking the other way as banks have been creative in disguising liabilities or simply eliminating them from their balance sheet but there is a process as I described earlier (minimum capital and leverage ratios must be met).

You are confusing the issue by clinging on to the concept of "fractional reserve lending" which is irrelevant.  Banks create as much money as they want as long as they meet the required capital and leverage ratios.

  • M0 (the monetary base) = Physical currency in circulation + reserves held at the Federal Reserve
  • M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks
  • The M1 Money Multiplier is the ratio of M1 to M0, that is, M1 / M0

So, as you can see above, the fractional lending money multiplier is less than 1.  Did someone determine that < 1 was the current multiplier to be used?  No, the multiplier is calculated as an effect, it has nothing to do with determining how much money banks may create.

If you are an Austrian believer, you should be very happy that fractional lending has stopped, or gone negative.  Mises would be quite happy except for the fact that it is obvious that  the Austrian "fractional lending" bugaboo doesn't really exist.  Ooops.

Larry

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
DrKrbyLuv wrote:

Hello all,

I wanted to add more evidence to support the premise that fractional reserve banking (money multiplier) is a myth, at least in today's banking system.  And to be fair, I think we have to say that the banking model has changed dramatically, especially within the last two-three years.

Myth  >>>   "Banks create money based on fractional lending (money multiplier)"

Many from the Austrian economics camp suggest that fractional reserve lending should be abolished - Mises argued for a 1:1 ratio.  The argument is that 1:1 lending would stop inflation and reign in debt (stop the presses!).  This is based on the belief that the market would correct the problem, given the chance. 

The facts on the Ground -

According to the Federal Reserve Chart below; the money multiplier hasn't been higher than 1:1.75 for almost 10 years.  And, it's been at or below 1:1 for around year now. They got what they wanted... 

- Link

Conversely, in the same time period, bank "reserves" have been growing in magnitudes to new historic highs.

M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks

Several things are happening here:

  1. An obvious disconnect exists between reserves and lending (money multiplier).
  2. Effective October 1, 2008, the Fed started paying interest on both required and excess reserves.  Are you surprised that money created for free is being parked in guaranteed return government accounts?
  3. Note: Bank reserves cannot be created by banks or their depositors.  Reserves exist in a common pool created created through the FOMC in "buying" securities from the government (Treasury bonds, etc.) via the omnipotent New York Federal Reserve branch as "high powered" money.  Translation - "high powered money" = debt backing debt to create the illusion that there are reserves.

Excess reserves are defined as the amount beyond the required quantity.  Here is a chart from the Federal Reserve that illustrates the increase in "excess reserves."

 

Look forward to any comments...

Larry

Larry

Banks absolutely do create money based on fractional lending. It is NOT a myth! That's the ONLY way they create money. If you dispute that then you clearly do not understand the concept of money as debt. One party's liability cannot exist without another party's asset. Period. Only the Fed, by fiat, is granted the power to create money (debt) without a countervailing asset.

These graphs do not repudiate fractional lending or the multiplier effect. All they do is show that we are clearly in recession - meaning bank write-downs and money being extinguished is still overwhelming the multiplier effect. Lot's of money is being lost or paid back, and not enough people are taking out new loans. That's all.

And by the way, if we had followed Mises' advice, we wouldn't be in this mess. At the time of the collapse, the investment banks were leveraged at ratios of 30 or 40 to 1. In the case of credit default swaps, it's my understanding that it was about 100 to 1! Is it any wonder we're having a hard time growing the money supply?!

Best

Greg 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
GregSchleich wrote:

But for the purposes of understanding the theory of FRB, in a simple example like CC 7 it's easier to make sense of the process if in fact, we say yes, the money actually leaves the bank - because that clarifies the important point that once the money has been borrowed, it cannot be borrowed again from that same source, until it has been returned. Here's an analogy that might help: You borrow (or rent) a post-hole-digger from a friend, with the assumption he probably won't be needing it back right away. So after you get done using it, you loan (or rent) it to your neighbor, who in turn uses it, and then loans (or rents) it to another neighbor, and so on...  Now, if at any point in this process, someone else wanted to borrow the post-hole-digger from you, obviously it would not be available, having already been loaned out, and if at any point, unexpectedly, your friend came back needing his post-hole-digger, you would have some explaining to do. But if all goes well, and after using it, each person returns the post-hole-digger to the person they borrowed (or rented) it from, eventually a lot of people in the neighborhood have new fences, some may even have made a little money (from renting out the post-hole-digger), and your friend comes back to get his post-hole-digger, none the wiser. That's how fractional reserve banking works. (obviously though, in this example the reserve requirements are 0%. The post-hole-digger doesn't get progressively smaller!)

Greg, I guess you realized that in your explanation the post-hole-digger doesn’t multiply. Through the stacked ‘naked short borrowing’ post-hole-digger process only one borrower has access to a fully fungible post-hole-digger at a time.

An antagonism on

GregSchleich wrote:

From the standpoint of this discussion, there is no reason to distinguish checkbook-money from currency. They are both money. They behave in exactly the same manor and are fully fungible. Remember, only about 2 or 3% of the money supply is in currency. The rest comes from accounting entries - 97% of the money supply. Believe me, it's money!

Using the post-hole-digger example, the FRB-process creates new fully fungible dwindling post-hole-diggers (which are preset to lapse on repayment) upon a loan.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
DrKrbyLuv wrote:

GregSchleich wrote:

In the real world of fiat debt-money, most of the time, fractional reserve banking is an abstract process. Except for a few cash transactions, most deposits and loans are simply accounting entries, involving no physical process that can be described.

Bank lending is not an abstract process, there are rules and regulations that determine the mechanics.  Regulators have been looking the other way as banks have been creative in disguising liabilities or simply eliminating them from their balance sheet but there is a process as I described earlier (minimum capital and leverage ratios must be met).

Larry

I completely agree, there are definite rules and regulations,. That is NOT what I was referring to. Baywork wanted to know if the original deposit money actually left the bank. But in the modern world, where most transactions are just accounting entries, there is no tangible, physical process to describe. That's what I was referring to as abstract.

Quote:

You are confusing the issue by clinging on to the concept of "fractional reserve lending" which is irrelevant.  

 

Fractional reserve lending is irrelevant? LOL!  It accounts for 95% of the money supply!

Quote:

Banks create as much money as they want as long as they meet the required capital and leverage ratios.

Yes, and the capital requirements require them to have an asset to base their loans (new money creation) on - which is what fractional lending is.

Best

Greg

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

 

 To use a physics analogy..  I think of credit/debt as a sort of ionisation or pair production process..

 banks create money and antimoney (aka debt) simultanously.. the main difference between this and ionisation is that charge isn't conserved... due to the battle between interest (favours the creditor) and default (favouring the debtor..)

 We can create money and antimoney in the same manner.. all it requires is trust.

 Barter is the simplest case.. we exchange goods and services directly. We can perform a mental calculation of value using something as a standard.. say an apple..

 eg: I think my electrical skills are worth 10 apples an hour.. I value that coat of yours at 15 apples.. I'll do 90 minutes of work for the coat.

 Notice.. although here the unit is an apple.. no actual apples are needed.

 There's no trust required here, just a negotiation about price...that's both a strength and a weakness.

 

  If you're a neighbour and I trust you.. then we could operate on a credit  system (credere = trust)... we negotiate a price for me fixing your wiring (15 notional apples), and you give me an IOU 15 apples note. 

 If we're friends, we can probably skip the haggling and note writing.. it's a sort of higher version of credit...

 No "money" is involved.. only a concept of value measured in a common unit (apples in this case.)  The "money" here exists as a sort of "virtual particle".. creating an exchange which will later be balanced by an opposite exchange.

 Banking is acting as an IOU middleman,  keeping a tally of amounts who owes what and who is owed.. while skimming a portion of the flow..

 In a SHTF scenario gold and silver and tangibles are only needed where you simply cannot or dare not, trust. If you live in a settled community then you can easily create a credit system with a pen and a piece of paper.. no bullion required.. only integrity.

 

 Credit inflation and deflation acts differently to gold inflation/deflation.. a tenfold increase in the amount of trust based activity (loans), doesn't have the same effect as a tenfold increase in money supply.. it's the difference between increasing the charge on an object, and increasing the ionisation within an object.

 The reckless creation of bad credit arrangements with high levels of default / penal rates of interest is a sign that banking has become corrupted..  the fact that the credit rating agencies (the official arbiters of what is trustworthy) have become so discredited indicates the corruption is almost total.

 Huge bonuses aren't needed for the best.. only the greediest.. (the bait you use, determines the fish you catch).

 ... and they are the very last people I would trust to act as an honest third party.

 

 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
plato1965 wrote:

 To use a physics analogy..  I think of credit/debt as a sort of ionisation or pair production process..

 banks create money and antimoney (aka debt) simultanously.. the main difference between this and ionisation is that charge isn't conserved... due to the battle between interest (favours the creditor) and default (favouring the debtor..)

Plato, given that money is debt, I don’t think this way of thinking is very helpful.

plato1965 wrote:

 Banking is acting as an IOU middleman,  keeping a tally of amounts who owes what and who is owed.. while skimming a portion of the flow..

Not a middleman but a protagonist. If a worthy potential debtor (and reserves:-) are available, they can enforce flow: when a bank issues a loan, the total amount of money in this world increases immediately. The total amount of assets and resources money can buy in this world does not increase immediately. A bank loan redistributes access to stuff and resources for the benefit of the borrower and the nuisance of other asset/resources and money holders for some time.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

According to wikipedia,    wildcat banks were banks that issued money without proper gold in stock to back up the supply.

At its core,   the  leveraged modern banking system with its "elastic" currency operates much like the wildcat banks of old, whatever its name.

 

 

 

 

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
Carl Veritas wrote:

According to wikipedia,    wildcat banks were banks that issued money without proper gold in stock to back up the supply.

At its core,   the  leveraged modern banking system with its "elastic" currency operates much like the wildcat banks of old, whatever its name.

Back then couldn't you choose not to except bank notes from banks that you did not feel comfortable with?  The problem right now is there is no easy way to avoid the systematic risk because the money is all fungible.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking

The simple truth is the banking system does not have any reserves what so ever.

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Re: Understanding CC Chapter 7, Fractional Reserve Banking
Baywork wrote:
GregSchleich wrote:

But for the purposes of understanding the theory of FRB, in a simple example like CC 7 it's easier to make sense of the process if in fact, we say yes, the money actually leaves the bank - because that clarifies the important point that once the money has been borrowed, it cannot be borrowed again from that same source, until it has been returned. Here's an analogy that might help: You borrow (or rent) a post-hole-digger from a friend, with the assumption he probably won't be needing it back right away. So after you get done using it, you loan (or rent) it to your neighbor, who in turn uses it, and then loans (or rents) it to another neighbor, and so on...  Now, if at any point in this process, someone else wanted to borrow the post-hole-digger from you, obviously it would not be available, having already been loaned out, and if at any point, unexpectedly, your friend came back needing his post-hole-digger, you would have some explaining to do. But if all goes well, and after using it, each person returns the post-hole-digger to the person they borrowed (or rented) it from, eventually a lot of people in the neighborhood have new fences, some may even have made a little money (from renting out the post-hole-digger), and your friend comes back to get his post-hole-digger, none the wiser. That's how fractional reserve banking works. (obviously though, in this example the reserve requirements are 0%. The post-hole-digger doesn't get progressively smaller!)

Greg, I guess you realized that in your explanation the post-hole-digger doesn’t multiply. Through the stacked ‘naked short borrowing’ post-hole-digger process only one borrower has access to a fully fungible post-hole-digger at a time.

Baywork,

To clarify a few things, post-hole-diggers are probably not 'fungible' in this example. The owner would probably expect to get back the same post-hole-digger he lent out. Also, since it would be difficult for the borrowers to get much use out of the post-hole-digger without actually taking possession of it, there would probably be nothing 'naked' about the process either. Wink (unless perhaps one of the borrowers happens to belong to a nudist colony!) But mostly - I think you're asking a bit too much of my analogy. It was really only meant to illustrate my answer to your question about whether it's implied that the original money leaves the bank, not to describe EVERYTHING about FRB, comprehensively ... Still, for the more limited purpose of tracing the path of multiple fractional reserve banking transactions, it may actually be a better analogy than you think. Yes, the post-hole-digger doesn't multiply. But, in an important sense, money doesn't REALLY multiply either (at least not permanently). Certainly, if we were dealing with gold money, instead of today's paper, it would be fair to say, fractional reserve banking is not alchemy. It is only through the miracle of modern accounting that this useful fiction is actually legally sanctioned, and allowed to work it's magic. But even so, and despite all the dazzling money creation that takes place, the process is still completely linear and non-concurrent. Just like the post-hole-digger, only one "user" has access to it at a time. 

Let's follow the money. (for the purpose of keeping it simple - relatively! - let's say the reserve requirement is 0%, as it would be in the case of a savings account or a CD, and for each transaction, let's spend, borrow, or loan the entire amount) First, a depositor deposits money they're not "using," at least for the time being, in the bank, where they can make a little interest in return for letting the bank "use" it. Next, the bank "uses" the money to make a loan (the money is now gone - having been loaned out) The borrower now "uses" the money to make a purchase at a store (obviously it's gone, having been spent) Now the store deposits the money in the bank, and the bank "uses" it to make a new loan, and so on ... but always, the process occurs, one step at a time. This is the powerful mechanism by which the vast majority of our money is created. Nine loans of the full amount multiplies the original deposit by ten! Yet, just as, once everyone returns it to the person they borrowed it from, the post-hole-digger eventually ends up back in the hands of it's rightful owner, if and when everyone repays their loans, all the new money is extinguished, leaving only the original money, back in the hands of the original depositor. That's the story I was trying to illustrate. And of course, I was hoping it would make FRB just a tiny bit less confusing.

Cheers

Greg

   

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