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!

Creating Money

In the days of commodity money such as gold, the only ways to create more money were either to mine it, convert it from other uses, trade for it (that is to export more than you import) or steal it. The Conquistadors very successfully used the last method to increase the money stock of Spain. In fact they were so successful that the resultant increase in the money supply is thought by some (incorrectly IMHO) to have caused high inflation which wrecked the Spanish economy.

There are 3 main ways that fiat money is created: by Governments literally printing cash, via a process now known as ‘quantitative easing’ and by banks by a process known as fractional reserve banking. It is also possible to add to the money supply by exporting more than you import but it's quite complex and this is meant to be a simple examination of money.

Pretty much all Governments print more cash than they destroy because as the output of an economy rises, more money is required to buy those things. Sometimes Governments get a little carried away and print too much and the outcome of that can be seen in the monetary experiment in Zimbabwe.

From Zimbabwe we can see that more money chasing the same number of goods and services leads to the goods and services becoming more expensive. The Zanu PF Government was apparently hoping that printing money would lead to more output, the logic being that total money divided by prices equals output so if you free the money stock to expand, you free output to expand if you can keep prices the same by making price rises illegal.

I think it’s reasonable to say that experiment has failed.

Another way Governments can increase the amount of money in the economy is by a process known as quantitative easing (QE).

When output is falling, Central Banks often cut interest rates to try to stimulate people and businesses to borrow to consume and invest. At certain times, that doesn’t work either because interest rates are so low they can’t be cut further or because banks simply don’t have the money to lend, perhaps because they have lost money elsewhere on bad loans or other investments.

In this case, the Central Bank might resort to QE. The mechanism is fairly simple. The Central Bank creates money, usually electronically rather than by physically printing notes but it amounts to the same thing. The Central Bank then uses that money to buy up Government or other debt in the market. That has 2 impacts. Firstly by selling debt, the banks have more cash which they are able to lend. Secondly by increasing the demand for debt, its price rises. The price of debt rising is the same as interest rates falling so it makes borrowing cheaper.

The last way fiat money is created is via the banking system and a process known as fractional banking. I will cover this in the next article mostly because it's a bit mathematical and people sometimes find that intimidating. Also it stands alone as a topic quite nicely.

What is money?

Well I promised I’d do a series on the money supply so here it is at long last. I hope you enjoy it. I’ve split it into 4 sections to make reading easier. As I’m still working on the others, albeit they’re almost done, I’ll post them one-by-one. I’ll start by discussing what money is, what it was and what it needs to do for us.

Money serves 3 functions:

1. A ‘medium of exchange’, ie you can swap it for other things
2. A ‘store of wealth’, ie you can save it up to buy stuff with in the future.
3. A unit of account, that is a standard yardstick to measure transactions, debts and values

So why is it good to have a medium of exchange? I work as a banker and I’m starting to get a little hungry; pretty soon I’ll want to get some lunch. If I was going to barter my services I’d have to go round the local noodle joints until I found someone who needed a little banking doing and then swap that for some lunch. That would take time and effort on my part, time I could be using to do productive work….or surfing the net at my employers’ expense of course.

Instead of that, I can use money as a standardized way across the economy to exchange people’s labour and property for other things. Using money I can compare prices quickly and simply and I can buy from who I want rather than being forced to use the person who happens to want what I have to sell. I sell my labour to my boss in return for money which I can then spend.

What about the store of wealth bit then? I want to take the wife and kids away to the Gold Coast in October. Under a barter system, I’d have to work my way up there as an itinerant banker, offering banking services to people on the way. I might be able to get food by telling humorous banking anecdotes in restaurants (perhaps not on reflection). With a system of money, I can put a little away from each paycheck and store up wealth which I can then exchange for my holiday essentials: petrol, meals, hotel rooms, budgie smugglers and cold beer.

‘A unit of account’ means that it is a standardized way to measure transactions. All money in a system must be easily exchanged for other money in the system and divisible without loss of value, for example a pound coin can be swapped for 2 50pence coins and those 2 50 pence coins back to another quid. As an addition to that, money is helpful as a standardized way to settle a debt. If agree to sell you a car on credit, with a barter system I may agree to receive a tonne of wheat. What if the wheat is of poor quality? It complicates things. However, as all money is the same or ‘fungible’, it doesn’t matter which particular bank note or coin you use to repay me.

Many things have been used as money in the past: cigarettes and phone cards are commonly used in prisons as money (or so I am led to believe); the shekel, now the name of the Israeli currency, was a unit of weight (typically for barley); and precious metals were used through much of the world at times.

In time, the direct use of precious metals gave way in the UK to paper money. A bank would hold some gold for someone in its vaults and issue a receipt for that gold. If the receipt was brought to the bank it could be exchanged for the gold so it became possible to use the receipt as a medium of exchange rather than the gold itself.

In time, banks realized that most of the time they wouldn’t be asked for more than a fraction of the money in their vaults to be returned. This meant that for each unit of gold lodged with them, several units of money could be issued. The biggest problem is that under the fractional reserve banking system, banks can have liabilities to their savers that exceed the cash assets held in the vaults. If everyone wants their money back at once, a so-called run on the bank, the bank can’t do it and will go bust. Fractional reserve banking is also a way to produce money from ‘thin air’, a topic to which I will return.

Mostly these days, people use a system of ‘fiat money’. Fiat (the Latin word for let it be done) means ‘by decree’ or ‘by order of the authorities’ so fiat money is money that exists by Government diktat. Rather than the money being exchangeable for something physical like gold or silver, it is backed by nothing more than a promise that the money has value because other people will take it in exchange for real goods and services.

Some people believe that all fiat money systems will fail in the end as all failed fiat monetary systems failed in the end! I have my doubts as this seems like a circular argument to me. Then again, the UK has only had the current system of fiat money since the 1930s so it could be seen to be the earlier parts of an experiment.

What is LIBOR?

What is LIBOR?

LIBOR stands for the London Inter Bank Offer Rate and is a measure of the average rate of interest at which banks can borrow money unsecured from each other in various currencies for various periods.

LIBOR is used to price a lot of financial contracts, for example a company might borrow money from a bank at LIBOR + 0.75% and according to the British Bankers Association, USD10,000,000,000,000 of loans are linked to LIBOR! Changes in LIBOR can signal changes in the money markets, for example a rise in LIBOR might be triggered by the expectation that interest rates will rise or the fear that it has gotten riskier to lend money to banks in general. LIBOR is quoted at an annualized rate, for example overnight LIBOR at 3% = 3%/365 = 0.00822%.

To calculate LIBOR, between 8 and 16 banks are asked to input the answer to the following question into a Reuters terminal (a secure information and messaging service):

At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?

It is up to the banks concerned to interpret the question (for example ‘reasonable market size’ is undefined). This question is asked and answered for 10 different currencies* over 15 different lengths of loan** to create 150 different LIBORs.

The answers are collated, the highest and lowest 25% of interest rates reported are discarded and the middle 50% taken and an arithmetic mean calculated.



*Pound Sterling, US Dollar, Japanese Yen, Swiss Franc, Canadian Dollar, Aussie Dollar, Euro, Danish Kroner, Swedish Krona and New Zealand Dollar

**1 day (aka overnight or spot/next), 1 week, 2 weeks, 1 month, 2 months, 3 months…..12 months.

Bank Funding - An overview

I thought I'd put this together to give any that may be interested a basic understanding of how banks fund themselves. It's a little simplistic to be honest but should give an idea of how things work. I'll try to post something on how LIBOR is calculated when I get round to it eventually.

There are 4 ways banks can fund themselves in normal times:

1. Borrowing money unsecured from their customers
2. Selling assets
3. Borrowing money unsecured from other banks on the money markets (measured by LIBOR, EONIA etc)
4. Borrowing money secured from other banks including the Central Bank

1. Borrowing money unsecured from their customers

This is the biggest source of funds for most banks, for example for the Lloyds Banking Group, customer deposits were as of 31^st December 2009 £406,741,000,000 compared to total loans of £626,969,000,000.

2. Selling Assets

This is probably the second biggest source of funds for most banks as they sell shares and bonds to raise funds. This is also one of the reasons why the UK and other Central Banks have been engaged in ‘Quantative Easing’ (QE – the polite way of saying printing money) as it allows banks to sell assets at higher prices than the market would otherwise support. Our friends in the Lloyds Banking Group have £233,502,000,000 in debt securities in issue (at present value) and another £43,278,000,000 in shareholders’ equity (which is rather less than they paid for it in most cases but that’s another story).

3. Borrowing money unsecured from other banks on the money markets (measured by LIBOR, EONIA etc)
   

Banks regularly lend and borrow money between themselves as a matter of course. The simplest way to explain the reason for this is to use an example. Imagine you are one of the big clearing banks. Today you have a net £2,000,000,000 in cheques, debit card payments and the like going out and tomorrow you have a net £2,000,000,000 coming in. Do you really want to sell £2,000,000,000 worth of assets today just to buy them back tomorrow, especially given the costs involved? As the amount of cash changing hands through the banking system as a whole must net to £0 it is far simpler and cheaper to borrow the money overnight from another bank that has a net inflow of funds.

LIBOR (the London InterBank Offer Rate) is a way of expressing an average of these rates banks are paying for funds.

4. Borrowing money secured from other banks including the Central Bank

The main way that banks borrow money secured is using an instrument called a ‘repo’ or repurchase agreement. Under this agreement an asset, usually a highly rated Government bond is sent by Bank A to Bank B. In return, Bank B lends bank A up to 95% of the value of that bond. This is usually cheaper than borrowing money unsecured in the money markets. The Bank of England’s base rate is the rate of interest at which the Bank of England will lend money in a repo with a commercial bank.

If any one of these sources of funding becomes more expensive, banks will be pushed towards using the other sources, in turn pushing up the cost of those things. For example, if the Bank of England increases its base rate, a bank will be inclined to offer a higher rate of interest on its savings accounts to attract more funds in. In fact, that is the transmission mechanism that the Bank of England relies on when it changes base rates.

UK Unemployment - lessons from recent history

I thought it might be interesting to compare how unemployment is faring at the start of this recession with the last two UK recessions: 1980-81 and 1990-91.

Unemployment is what is known as a lagging indicator - that is rises in unemployment usually come alongside and later than falls in GDP rather than before. An example of a leading indicator would be changes in company stock levels as companies run down stock if they feel that bad times are coming.

For the purposes of this article, I take a recession to be 2 consecutive quarters of negative GDP growth. I use the unemployment rate (no of unemployed divided by total workforce) rather than absolute numbers of unemployed. All figures come from the ONS (link) unless stated otherwise.

1980-1981

In 1979, there were 2 non-consecutive quarters of negative growth but overall the economy grew at 2% which is slightly below 'trend'* and during this time unemployment was pretty much flat. Then between the first quarter of 1980 and the end of the first quarter 1981, GDP fell by a total of 4.6%.

The reason for the fall was that the Conservative Government pushed interest rates higher in an attempt to bring down inflation rates. They also reduced subsidies to loss making companies and industries. Unemployment rose from 5.5% in Q1 1980 to 8.9% in Q1 1981. Unemployment then continued to rise, quarter after quarter until by the first quarter of 1983, when GDP got back to pre-recession levels, it stood at 11.3%.

The final peak in unemployment was in the second quarter of 1984 and it didn't drop back to levels seen at the end of the recession until mid-1988, more than seven years later!

1990-1991

GDP fell by 2.6% between the third quarter of 1990 and the third quarter of 1991. This was again as a result of increased interest rates to squeeze inflation out of the system, inflation caused by a pre-election give-away by Chancellor of the Exchequer (Finance Minister) Nigel Lawson and a disastrous attempt to shadow the Deutschmark which had led to interest rates being set too low. Unemployment rose from 7.1% to 9.2% during the recession and then continued to climb until it peaked at 10.6% in 1993. It didn't reach the levels of the end of the recession until the last quarter of 1994, more than 3 years after the end of the recession.


Lessons for Today

The biggest problem with unemployment for Government is that it comes with a double fiscal whammy - tax receipts fall as unemployed people don't spend much money and welfare payments to those unemployed rise.

The problem for the UK Government right now is that the UK fiscal position is looking very messy already and set to get worse as the Government is looking to borrow well in excess of £100,000,000,000 - when looking at this figure it is also worth bearing in mind that it seems that almost every official estimate of how bad things are or will be has been too optimistic, probably because the economic models they use just can't respond to a Black Swan event such as the near-collapse of the banking industry.

Clearly the UK can't run such huge deficits indefinitely as ultimately they have to be financed as there is a limited appetite for UK sovereign debt - at some point investors just won't want any more at a rate of interest that can be financed by the UK taxpayer.

If it was down to me, I'd be trying to push people into the jobs that are available, even if they don't want to do them. It's unreasonable to expect the next generation to pay taxes so that you could wait for the right job to come along and the best way to do that is through the welfare system - if you don't genuinely try to work then you don't get benefits.

I'd also be looking to train people for the jobs that can't be filled, not the ones that the Government hopes will be empty when the economy recovers. There's little point in training solar power engineers for the future when the UK needs IT people now!

From looking at previous recessions we can assume that unemployment will rise for a lot longer and stay high for some time. The best that we can hope is that Government policy doesn't worsen the impact now and in the future.




*The trend growth rate is the normal level of growth a country can expect to see and is governed by many factors including investment rates, how well educated and trained the population is, how corrupt or otherwise the country is, the state of its infrastructure and lots of things like that. You get the picture I hope.

Warren Buffett on CNBC

http://www.cnbc.com/id/29595047/

Some highlights of his economic comments - I'll try to post his investment stuff similarly soon:

...ever since we talked in September, we talked about [the economy] being an economic Pearl Harbour and how--what was happening in the financial world would move over to the real world very quickly. It's fallen off a cliff, and not only has the economy slowed down a lot, people have really changed their behaviour like nothing I've ever seen....

...you had 11 trillion of residential mortgage debt built on this theory that who was borrowing it, what their income was really wasn't that important because the house itself had to go up in price. And when that tumbled and houses which might've been worth 22 trillion at the peak are worth maybe four or five trillion less...it's a huge amount out of people's net worth. It's the biggest asset most people have....

When people get scared, they change their buying habits. When they quit buying as much, people lay off. We are in a very, very vicious negative feedback cycle....

...we are doing things now that are potentially very inflationary...if you look at this bill ...on the back it says, "In God we trust,"....And on the front it says, `In the Federal Reserve, we trust,' basically....it is paper money, and if you keep issuing more of it...that is inflationary. The more of these you have out compared to the economic activity, the less it's worth....

Everything will be all right. We do have the greatest economic machine that man has ever created, I believe. We started with four million people back in 1790 and look where we've come and it wasn't because we were smarter than other people, it wasn't because our land was more fertile or we had more minerals or our climate was more favourable. We had a system that worked. It unleashed the human potential. Didn't work every year, we had six panics in the 19th century, in the 20th century we had the Great Depression and World Wars, all kinds of things. But we have a system, largely free market, rule of law, equality of opportunity, all of those things that cause the potential of humans to get unleashed, and we're far from done....

...there was a week where 200 billion...poured out of the money market funds, which had about 3 trillion in them, the money was just gushing out when Reserve broke the buck. That meant that the commercial paper market was disappearing. You know, the blood was being drained from the American economic body and we had some very prompt, wise, action. Chairman Bernanke, the Fed, I mean, they stepped in and said the commercial paper market is going to work...They said the same thing about money market funds we should now say about the whole banking system. ....The president of the United States has to say it very clearly that you just don't have to worry about that.

we need banks to get back to banking. But we need to get through this situation...Banking has never been better in one sense. I mean, the banks are getting their money very cheaply, deposits are coming in, spreads have never been wider, all the new business they're doing is terrific. They will earn their way out of it, in most cases...

the domestic auto industry has a lot of legacy costs. They did some dumb things in the past because they had a business model in mind that doesn't exist anymore. The union bargained for those things, you know, they feel entitled to them, they made a deal, you know, and they've got hundreds of thousands of retirees dependent on it and all sorts of things. So you need a new business model somewhat. You also need a recovery. It isn't just the business model. And I would say net I would come down on--if they modify the business model to adapt to the reality of a 13 million car a year and we'll do better than that in the future in some years. If they adapt, have a business model that works with that I would get them through this period.