Tuesday, August 3, 2010

Fractional Reserve Banking

We have already looked at how Governments can create money. However, the main conduit for money creation in a fiat money system is via the banks and a process known as fractional reserve banking (FRB).

Creation of money via FRB stems from the fact that banks are only required to keep in reserve a fraction of the money held on deposit with them. The idea is that only a few people will want to take their money out of the bank on any given day so rather than having it all hanging around in the vaults (or these days on a computer) gathering dust the banks should do something more useful with the money like lending it to people to buy houses or handbags.

The biggest problem with this idea is that if there is some doubt surrounding whether or not the bank can give everyone back their money then everyone tries to get their money back. This is almost always terminal for the bank concerned as was seen with Northern Rock in the UK.

The simplest way to explain the process of money creation via FRB, also known as credit creation, is to look at an example. We’ll assume for the sake of argument that banks are required to keep 10% of their deposits in reserve and can lend out 90%. It’s a bit more complicated than that but I want to keep this simple as it is really a simple process.

Let’s say that the Bank of England increases the money supply via QE and buys back £1,000,000 in bonds from an investor. The investor is unlikely to want to hold the money in cash so puts it in the bank. The bank isn’t going to make a profit if it just has the money sitting in its reserves so will lend out 90% of the £1,000,000, keeping £100,000 in reserve as it is obliged to do. So the bank lends out £900,000 so the money supply has increased by £1,000,000 with £100,000 of it sitting idle. Let’s say for the sake of argument that the money is lent to Sex in the City fans that go out and buy Hermes and VBH handbags from Selfridges.

Then what happens? Well Selfridges will put the money in the bank so their bank balance increases by £900,000. Their bankers will dutifully put 10% in reserve and lend out £810,000. Now the money supply has increased by £1,900,000. In turn, the £810,000 will be spent, banked and 90% or £729,000 lent. This process goes on and on until in the end the money supply has increased such that £1,000,000 has been added to reserves and £9,000,000 lent out.

In reality it’s not always that simple. Banks can’t always lend all the money they want so adding extra money to the banking system won’t increase the money supply as much as expected. Also the system is a bit leakier than that. If someone borrows some money to pay a tradesman, for example they might decide to pay some of the bill in cash to evade taxes. That money held in cash isn’t part of the Magic Money Multiplier that is FRB. Also, reserves aren’t simply cash held in a bank vault somewhere; there are other assets used in varying amounts. However, the underlying principle remains the same that banks have the ability to create money via credit creation.

It’s worth noting that money can also be destroyed by losses by banks in the FRB system. I will come on to that, the way I’m going it will be in part 6 of the 4 part series!