Mortgages and the true cost to our banks?

[ajlennon]

Hi,

 

(Sidebar: I've posted to these forums before - Caravan purchase troubles - and have been overwhelmed by the helpfulness of the posters here.)

 

As the financial crisis has overtaken us I've been attempting to inform myself as the the true nature of the events we're seeing occur around the world.

 

One piece of the puzzle relates to 'Interest' - or the amount charged over and above the 'credit' made available to the borrower.

 

'Interest' coupled with the 'Fractional Reserve' banking system operated by our banks seems relevant and I am trying to put some sensible baseline figures together.

 

Much of the discussion about 'bank charges' I've read in these forums and elsewhere seems to have been that banks overcharge customers for simple administrative functions, and the banks seem unwilling to disclose true costs for these services.

 

'Interest' seems to me to be (roughly) a kind of bank charge and so as a starting point I would appreciate any feedback on some of the (pretty basic!) working below.

 

An example mortgage -

 

If I take out an interest only mortgage for 120K, say, with a 25K deposit, at a fixed rate of 5% then I'm paying the bank £4750 a year or around £396 a month. (For the purposes of the maths let's forget for a moment the repayment of the principal on this debt and just stick with 'interest only' option).

 

So my question is this:

 

What is the true cost to the bank of the bank lending me this 95K?

 

Ignoring the 25K I have had to deposit with them [updated 12/02/09: This is incorrect as the deposit goes to the vendor, doh], they will have to borrow some money, either from the U.K. Central Bank or through LIBOR I believe to ensure that they have reserves against their lending to me? (I believe there is no legal requirement for these reserves against lending and they simply have to make a call as to how much will be withdrawn by customers?)

 

The bank will be paying a lower rate of interest than I am charged, and from my reading on the 'fractional reserve' system in operation here in the U.K, and the rest of the world, they will borrow a small proportion of 'real' money from the central bank - say 3%.

 

If we assume that they need to hold reserves equivalent to 3% of the credit they make available to me and they pay 3% interest on that then we have a cost of borrowing to them of around £86 a year (3% of £2850).

 

[ Maybe there are charges involved or hedging against rate changes so let's double that figure to £172? ]

 

If this is the case then I'm paying them £4750 / year for credit when their cost of borrowing is

 

If we bring my deposit of 25K into the equation then this more than covers the reserves that I understand banks keep to operate their fractional reserve mechanism (3%).

 

This would mean there was no requirement for them to borrow government money, and therefore no cost.

In addition they could then invest the balance of around £22150 on the money markets, with an expectation

of, say a 7% return or £1550/year. [updated 12/02/09: This is incorrect as the deposit goes to the vendor, doh]

 

 

Leaving my 25K deposit out of the equation for the moment, and so assuming there is a cost to the banks of

borrowing money, then in trying to fit this cost into a 'materials' and 'labour' approach to pricing I might choose

to view the £172 as 'materials'. However I cannot see how the labour involved in signing me up to a mortgage or

rolling me onto a new mortgage product makes the difference between their profits and the cost to me.

 

These profits would be surprising for any 'ordinary' business - butchers, bakers, I.T. consultants and so forth,

but perhaps they aren't for the banking sector?

 

I have an inkling from my reading thus far that this might actually be a fair approximation how credit works in

the U.K, U.S. and elsewhere.

 

I invite more informed readers than I to shoot me down in flames (although I'd appreciate you correcting my

maths and logic without too much laughter and finger pointing!).

 

If these figures are in any way realistic then my next questions go to

 

1) the cost of operations for the average bank, offset against the profits they are making.

 

2) why prices for property would not necessarily become massively overinflated as against a 'true' market value when banks can issue credit with little or no restriction, except a view on reserves they need to prevent a run (clearly not considered for Northern Rock, HBOS etc.).

 

Cheers,

 

Alex J Lennon

Edited February 12, 2009 by ajlennon
Clarification - Rethought issue regarding deposit

[bedlington83]

Ignoring the 25K I have had to deposit with them, they will have to borrow some money, either from the U.K. Central Bank or through LIBOR

You don't give the bank/building society the deposit. It goes to the person who's selling the property you're buying. The reason banks are interested in the amount of deposit is that they want to know what the loan to value ration (LTV) is. In your example they would be lending 95k on a property worth 125k. This means that the house can fall a bit in value and they can still repossess and get their money back if you default.

 

LIBOR isn't a financial institution, its the rate at which banks lend to each other.

 

There is of course a much more traditional (and safer) way of funding their lending - from saver's deposits.

 

The bank will be paying a lower rate of interest than I am charged, and from my reading on the 'fractional reserve' system in operation here in the U.K, and the rest of the world, they will borrow a small proportion of 'real' money from the central bank - say 3%.

I have no idea what the fractional reserve system is but if the banks are only borrowing 3% of the money they lend where does the other 97% come from?

 

These profits would be surprising for any 'ordinary' business - butchers, bakers, I.T. consultants and so forth, but perhaps they aren't for the banking sector?

IT consultants have virtually no fixed costs so their gross profit can be has high as 100% of income, which is far more profitable than any bank

 

1) the cost of operations for the average bank, offset against the profits they are making.

Just get a copy of any bank's accounts

 

2) why prices for property would not necessarily become massively overinflated as against a 'true' market value

Prices for everything, including houses, are determined by their true market value. 18 months ago your hypothetical house might have been "worth" £135,000, today its worth £120,000 and in six months its true market value might be £110,000. The price you pay for something is, by definition, its true market value. I think what you're talking about is the difference between market value and "real worth". The answer is that, even if you could define and calculate "real worth", the comparison would be meaningless. What is a five pound note "worth" really? It has no intrinsic value. It's only because we all agree to pretend its worth something that makes it useful.

[ajlennon]

Hi Bedlington83,

 

Many thanks for your thoughts. In response:

 

You don't give the bank/building society the deposit. It goes to the person who's selling the property you're buying.

 

Ah yes of course - I knew there was something faulty in my thinking there. That is why the bank does have to borrow some money from 'somewhere'

 

The reason banks are interested in the amount of deposit is that they .... get their money back if you default.

 

Yes I understand that - and one of the reasons that the likes of Northern Rock were playing so fast and loose as their 100%+ LTV mortgages did not have this buffer initially, and wouldn't until the price had risen.

 

LIBOR isn't a financial institution, its the rate at which banks lend to each other.

 

Yes I understand.

 

Q. Am I correct in thinking that the two avenues for the bank to borrow from are the Central Bank and through LIBOR, or are there others?

 

There is of course a much more traditional (and safer) way of funding their lending - from saver's deposits.

 

Q. Which bank or building society in the UK, or the US, does this today?

 

I have no idea what the fractional reserve system is but if the banks are only borrowing 3% of the money they lend where does the other 97% come from?

 

Indeed! This is the crux of it. They create 'credit' by entering the remaining number into their balance sheet. I know it sounds ridiculous but it is apparently how things work and has been since the first banks came into existence.

 

IT consultants have virtually no fixed costs so their gross profit can be has high as 100% of income, which is far more profitable than any bank

 

I was including the cost of labour in my idea of 'operating costs' (perhaps bad terminology) and so this would not be the case.

 

Just get a copy of any bank's accounts

 

It seems not to be that easy and I doubt I have the training in accountancy to be able to understand the figures correctly.

 

Prices for everything, including houses, are determined by their true market value. 18 months ago your hypothetical house might have been "worth" £135,000, today its worth £120,000 and in six months its true market value might be £110,000. The price you pay for something is, by definition, its true market value.

 

Again, perhaps I do not have the right terminology here. If there is a lot of money in the economy then the prices of things go up - inflation, as we will see as a result of the US/UK government decisions to 'print money'.

 

If/As the banks create 'credit' from nowhere then they make money very easily available into the market at very little cost. If it is easy to borrow money from banks in this way (which it has been with self certs and so forth) then there is more competition for houses and the price goes up.

 

This factor surely must drive the prices up substantially which is where I was talking about 'fair market value'. Perhaps I should have written 'introduces substantial distortions into the market'.

 

I would like to understand if this is indeed the case, as I think it is.

Edited February 12, 2009 by ajlennon
Quotes

[patdavies]

Q. Am I correct in thinking that the two avenues for the bank to borrow from are the Central Bank and through LIBOR, or are there others?

 

 

They can borrow from anywhere that will lend to them. This was part of Northern Rock's problem; it was borrowing from the US commercial market and when it could borrow no more at rates it could afford/make a profit on, its business model collapsed. Furthermore, it is likely that the risk of the debt will be reflected in the loan carrying an interest rate of X% above LIBOR - not all inter-bank lending is at LIBOR; this has been a part of the recent problem, that banks weren't willing to lend to each other at LIBOR or even close.

[bedlington83]

Yes I understand that - and one of the reasons that the likes of Northern Rock were playing so fast and loose as their 100%+ LTV mortgages did not have this buffer initially, and wouldn't until the price had risen.

120% in some cases. I think NR's problem was more tied up with its exposure to the American sub-prime market that it had invested in via complicated financial packages. There's nothing inherently wrong with lending 100 or even 120% of the value of a property provided the loan is being serviced. Its when it isn't being serviced and you need to repossess that the problem manifests itself. This (at the time at least) was far more prevelant in the States thanks to the rediculous lending to people that could never have afforded to repay. We'll see more of the problem over here over the next 18 months to 2 years, depending on how long and how deep this recession is.

 

Am I correct in thinking that the two avenues for the bank to borrow from are the Central Bank and through LIBOR, or are there others?

Anywhere and anyone who has the money; Foreign governments, particularly the middle and far East, multinational companies, and, in the case of NR, its own offshore vehicle for trading its securitised mortgages called Granite (geddit?). Though where Granite gets its money from is anyone's guess

 

Which bank or building society in the UK, or the US, does this today?

Every building society for certain. Nationwide for example is proud of the fact that all its lending for 2007 was funded completely via investor's deposits. That's one of the main reasons that (IMHO) its one of the strongest financial institutions in the UK at the moment

 

They create 'credit' by entering the remaining number into their balance sheet. I know it sounds ridiculous but it is apparently how things work and has been since the first banks came into existence.

This surely can't be right!? How do they account for it without leaving a great big hole in their accounts. If all they needed to do was conjure it up out of thin air, why go to the trouble and expense of borrowing anything at all? It wouldn't matter if none of it got repaid either 'cos they could just write another number down to cover it.

 

Only the government can do this legally

 

Again, perhaps I do not have the right terminology here. If there is a lot of money in the economy then the prices of things go up - inflation, as we will see as a result of the US/UK government decisions to 'print money'.

It isn't that straight forward. Money supply of itself doesn't cause inflation, a demand greater than supply does. Increasing the money supply increases demand because people like to spend money. A good example is the one you quote of house prices. More money - more people can afford to buy - more houses are sold - owners/builders realise they can get away with charging more so they do.

 

Perhaps I should have written 'introduces substantial distortions into the market'.

I don't necessarily think that there was a distortion in the market. I think the housing boom (and subsequent bust) was a classic example of the market behaving as it should. I certainly disagree that it was caused by the banks lending money they didn't have to all and sundry. Yes they lent to all and sundry and have ended up with "toxic debt" as a result but the problem for the banks is that they were lending money that they themselves had borrowed. Once they stop earning money on it they couldn't afford to repay the money they borrowed and everything went pear-shaped. The only part of the whole process that wasn't pure free market economics was the bale-out of the banks. In a real free market they would've gone under

[ajlennon]

Bedlington83 - thanks again for your comments.

This surely can't be right!? How do they account for it without leaving a great big hole in their accounts. If all they needed to do was conjure it up out of thin air, why go to the trouble and expense of borrowing anything at all? It wouldn't matter if none of it got repaid either 'cos they could just write another number down to cover it.

 

Only the government can do this legally

Are you saying you know that this does not happen, and therefore I am mistaken, or are you saying you find it impossible to believe this can happen? I agree these statements seem dubious but I have been reading a fair few sources prior to posting and they all seem to concur that this is exactly what does happen (excepting that the banks have to have some money to cover day to day transactions, a part of 'M1' I think)

 

The privately owned high street banks do not lend out their saver's deposits as loans to those customers who wish to borrow. They never have. Instead these deposits act as a reserve on any calls that banks have on their money over and above the normal in-flow of funds. It is called their fractional reserve.

Instead of lending actual cash money to borrowers, the banks have only ever lent 'credit'. However, this credit is used by individuals to buy homes and to spend through their credit cards, overdraft facilities and arranged loans. It is also used to run businesses, to pay employees and suppliers, who further use it to run their own finances. Governments borrow it for public spending when income from taxation is insufficient.

This bank-created credit now forms some 97% of the British money supply (with similar ratios affecting all the world's major economies), and it has effectively become money.

 

ref: Personal Debt - Debt - The Economy - Money - Money Reform Party

In the US the government cannot 'create money' (coins yes, notes no). Only the, privately owned, Federal Reserve can do that, which it does and then lends the money to the US goverment charging interest in the process (which is a story in itself).

 

In the UK the government can create notes, since it nationalised the central bank in 1945, I read, but the banks can still make credit available as _multiples_ of deposits they hold, which I understand is how 'private money', i.e. non-Government money, is created and enters the economy when a borrower takes out a loan.

 

From its beginnings in 1694, privately created money grew slowly over the next 250 years as a proportion of the total money until in 1946, the year after of the nationalisation of the Bank of England, it amounted to some 54%. In the last 60 years, it has grown far more rapidly until it now exceeds 97%.

 

ref: History of Money - About Money - Money - Money Reform Party

Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply on an exponential basis. According to the quantity theory of money, this increase in the money supply leads to more money "chasing" the same amount of goods, which leads to inflation.[29] Most monetarists and Austrian economists, and indeed economists in general, believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as the main cause of inflation.

 

ref: Fractional-reserve banking - Wikipedia, the free encyclopedia

If this is rubbish (and perhaps it is!) can you point me to an explanation of why this is wrong, and perhaps how it does actually work?

 

Thanks,

 

Alex/

Edited February 12, 2009 by ajlennon
Clarification

[bedlington83]

Are you saying you know that this does not happen, and therefore I am mistaken, or are you saying you find it impossible to believe this can happen

I'm saying that I find it very difficult to believe that it happens. Certainly in the way that you say: The banks do not create money (IMO).

 

In a simple example Mr A has £5000 savings that he wants put by for a rainy day while making a decent, low-risk return so he puts it into a high interest savings account at Building Society PLC. Mr B wants to buy a second hand car for £5000 and Building Society PLC agree to lend it to him. They lend him MR A's deposit. Mr B then puts it in his bank while he looks for a suitable car. Hey presto! There is now £10k in the banking system whereas before there was only £5k.

 

But what happens if Mr A has his rainy day and goes to Building Society PLC to withdraw his savings? They're still there, so surely Building Society PLC has created the money to lend to Mr B? Wrong. The building society keeps a level of cash in reserve that it never lends out to cover precisely this sort of situation. If a large number of depositors decide to withdraw their money all at once (known as a run) then the society will be in serious trouble because there won't be enough to pay everyone. This is exactly what happened to Northern Rock.

[ajlennon]

I'm saying that I find it very difficult to believe that it happens. Certainly in the way that you say: The banks do not create money (IMO).

I can see your point of view, but the links I reference state categorically that in fact the banks do create money (or 'credit' which has come to mean the same thing).

 

If you Google there is much much more out there that confirms this:

 

"I believe that banking institutions are more dangerous to our liberties than standing armies. Already they have raised up a monied aristocracy that has set the government at defiance. The issuing power (of money) should be taken away from the banks and restored to the people to whom it properly belongs."

- Thomas Jefferson

ref: Nationwide Strike To Abolish The Federal Reserve Corporation!! - 1Club.FM Free Internet Radio

"When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money."

- Putting It Simply, Boston Federal Reserve Bank

ref: Crash Course Chapter 8: The Fed - Money Creation - credit | Crash Course Videos at Chris Martenson - credit, Debt, Federal Reserve, interest, loans, money creation, perpetual expansion, the Fed, Treasury bonds

"I am afraid the ordinary citizen will not like to be told that the banks can and do create money. And they who control the credit of the nation direct the policy of Governments and hold in the hollow of their hand the destiny of the people." Reginald McKenna, as Chairman of the Midland Bank, addressing stockholders in 1924.

ref: Money Myths Episode 2 - Cure for the Credit Crunch

"The banks do create money. They have been doing it for a long time, but they didn't realise it, and they did not admit it. Very few did. You will find it in all sorts of documents, financial textbooks, etc. But in the intervening years, and we must be perfectly frank about these things, there has been a development of thought, until today I doubt very much whether you would get many prominent bankers to attempt to deny that banks create it." H W White, Chairman of the Associated Banks of New Zealand, to the New Zealand Monetary Commission, 1955.

 

Governor Eccles, one time head of the Federal Reserve Bank Board of the United States, said:

"The banks can create and destroy money. Bank credit is money. It's the money we do most of our business with, not with that currency which we usually think of as money".

(Given in evidence before a Congressional Committee) Mr. R. G. Hawtrey, previously Assistant Under-Secretary to the British Treasury, in his "Trade Depression and the Way Out" says:

"When a bank lends it creates money out of nothing "

In his book, The Art of Central Banking, Hawtrey also wrote:-

"When a bank lends, it creates credit. Against the advance, which it enters amongst its assets, there is a deposit entered in its liabilities. But other lenders have not this mystical power of creating the means of payment out of nothing. What they lend must be money that they have acquired through their economic activities."

Lord Keynes, the economist, and wartime Governor of the Bank of England states: "There can be no doubt that all deposits are created by the banks."

Professor A. L. G. Mackay, the well known Australian economist, has stated in his text book on Economics, that:

"In this way, by means of a loan, an advance, an overdraft, or by the cashing of bills, the banks are able to increase the volume of deposits in the community, and because of this process it is not correct to say that a bank loans out deposits which people make with it. It is clear that it creates the deposit by the issue of the loan; the loan travels back to the banks or to another bank and assumes the form of a deposit."

In 1939 the Canadian Government's Committee on Banking and Commerce exhaustively questioned Mr. Graham F. Towers, at that time Governor of the Central Bank of Canada, on banking practices. The following are extracts from the Minutes of Proceedings and Evidence Respecting the Bank of Canada.

Question: But there is no question about it that banks create the medium of exchange?

Towers: That is right, That is what they are for … that is the Banking business, just in the same way that a steel plant makes steel.

The following are further statements by Governor Towers: "Each and every time a bank makes a loan (or purchases securities), new bank credit is created new deposits brand new money".

"Broadly speaking, all new money comes out of a Bank in the form of loans."

BankWatch Yarra Glen Report

And lastly -

 

As Robert Hemphill, one-time Credit Manager of the Federal Reserve Bank of Atlanta said: “If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible -- but there it is.”

They take Mrs A's deposit. Then they lend to Mr B, C and D, and this lending can be and is a larger amount than that of Mrs. A's deposit.

 

As you say, a reserve is kept on the basis that Mrs. A or her cohorts might want some of their money back and a run on the bank would bankrupt it.

 

I can only go on what I am reading. I appreciate your skepticism but given the amount of information out there which seems to confirm my understanding, have you any alternative sources I can go to which would refute the argument that banks do in fact create and destroy money?

 

Thanks,

 

Alex/

[My Real Name]

I can see your point of view, but the links I reference state categorically that in fact the banks do create money (or 'credit' which has come to mean the same thing).

The links are hardly what one might call being robust academic sources.

 

Notwithstanding that, credit does not equate to money. The terms are not interchangeable.

 

An easing of available credit does not equate to an increase in money supply.

 

Banks do not create money. The lend (and borrow), often as a multiple of deposits (maintaining regulated capital adequacy ratios), and often leveraging this with derivative instruments.

 

If you Google there is much much more out there that confirms this:

 

And lastly -

Your choice of quotes is inconsistent and contradictory. Again, there is a paucity of reliable sources.

 

They take Mrs A's deposit. Then they lend to Mr B, C and D, and this lending can be and is a larger amount than that of Mrs. A's deposit.

 

As you say, a reserve is kept on the basis that Mrs. A or her cohorts might want some of their money back and a run on the bank would bankrupt it.

 

I can only go on what I am reading. I appreciate your skepticism but given the amount of information out there which seems to confirm my understanding, have you any alternative sources I can go to which would refute the argument that banks do in fact create and destroy money?

There is no argument that banks create and destroy money, only a few quotes taken out of context.

[ajlennon]

My Real Name - many thanks for your statements.

 

Perhaps you could direct me to the sources (robust, academic and so forth) which inform you?

 

I would be grateful if you would also enlighten me as to the contradictions in the quotes I included above.

 

Many thanks

[ajlennon]

My Real Name - I'm not an economist, as no doubt is obvious! I'm also not interested in flights of fantasy (if quotes above are such). I do want to get to a point where I have a reasonably correct layman's understanding of the rough cost to a bank of lending me money (or providing credit to me in the form of a mortgage if that is more correct?).

 

Stepping back from the quotes, a quick look at Wikipedia shows material which seems helpful to us:

 

Fractional-reserve banking creates money whenever a new loan is created. In short, there are two types of money in a fractional-reserve banking system[1][2]:

1. central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
   
2. commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money[3]
   

When a loan is supplied with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. The table below displays how central bank money is used to produce commercial bank money.

ref: Money creation - Wikipedia, the free encyclopedia

 

As you'll see on the Wikipedia page that section references material from the Bank for International Settlements, the European Central Bank and the Chicago Fed.

 

 

In terms of bank lending, you seem to concur that banks lend multiples of deposits, although whilst Wikipedia refers to this as 'commercial bank money' you refer to it as 'credit' ? (or do I misunderstand?)

 

 

Getting back to the original question, essentially if I take out that example mortgage of 95K, there is no requirement for the bank to have deposits of 95K to lend to me.

 

Presumably the constraint is that they must maintain adequate reserves to comply with the required "capital adequacy ratios" you mention. Can you give me an idea of what this would be? e.g. Perhaps a rough figure would be 10% in the US?

 

So then is it fair to estimate that they require to have 9K5 held as a deposit in order to 'create commercial bank money' to lend me the 95K?

 

Thanks

[ajlennon]

Hi Bedlington83

 

Every building society for certain. Nationwide for example is proud of the fact that all its lending for 2007 was funded completely via investor's deposits. That's one of the main reasons that (IMHO) its one of the strongest financial institutions in the UK at the moment

 

Could you give me the source for this please? There's a thread on HousePriceCrash regarding mortgages and fractional reserve lending:

 

ref: House Price Crash forum > Uk Building Societies - Fractional Reserve Banking?

 

The responder indicates that Nationwide's annual report (2007) gives a solvency ratio of 11% which apparently indicates they hold reserves equivalent to 11% of loans, and thus do practise fractional reserve lending.

Further posts seem to indicate they would have to simply to operate within the market.

 

The report itself is here:

 

ref: http://www.nationwide.co.uk/pdf/about_nationwide/FinalAnnualReport2007.pdf

[bedlington83]

Could you give me the source for this please?

The phrase "all net lending was funded by retail deposits" is under the heading "About Nationwide" in this link

Media Centre - 8 Sep 2008 - MERGERS OF NATIONWIDE WITH THE DERBYSHIRE AND THE CHESHIRE BUILDING SOCIETIES

[ajlennon]

Thanks Bedlington83 - I'll follow it up.

 

As an aside, looking further into 'fractional reserve banking' following My Real Name's comments this does seem to be very contentious, with overtones of 'conspiracy theory', which is surprising.

 

There appears to be a consensus that FRB is a system where banks hold a reserve much less than the deposits they've taken (as the deposits have been lent out).

 

However there are two incompatible mechanisms by which this could work and there appears to be much dispute about which mechanism is actually practised by banks. Surprising given this should be a straightforward question.

 

Regarding FRB vs full reserve lending, I'll come back on that when I have something confirming either way from Nationwide

[bedlington83]

There appears to be a consensus that FRB is a system where banks hold a reserve much less than the deposits they've taken (as the deposits have been lent out).

Exactly! They don't lend multiple amounts of their deposits unless they've borrowed the extra. E.g the bank takes in 10bn in deposits and lends out 8bn, keeping 2bn to cover customer withdrawals. If it wants to lend more money it has to borrow it on the open market. Why are you trying to make it more complicated than it is?

[ajlennon]

Exactly! They don't lend multiple amounts of their deposits unless they've borrowed the extra. E.g the bank takes in 10bn in deposits and lends out 8bn, keeping 2bn to cover customer withdrawals. If it wants to lend more money it has to borrow it on the open market. Why are you trying to make it more complicated than it is?

That is one of the methods by which FRB could operate, yes. As I wrote, I can now see there are at least two schools of thought on this.

 

This page covers the discussion more fully than my comments would:

 

Criticism of fractional-reserve banking - Wikipedia, the free encyclopedia

If you have sources showing that the 'debt based' analysis of FRB is incorrect I'd be grateful for the links.

 

Thanks, Alex

[bedlington83]

That is one of the methods by which FRB could operate, yes. As I wrote, I can now see there are at least two schools of thought on this.

Then please enlighten me as to the second

 

If you have sources showing that the 'debt based' analysis of FRB is incorrect

At a technical level, its all debt based! What's your point? In my earlier example Mr A's deposit was a debt that the bank owes to Mr A. Mr B's loan was a debt that Mr B owed to the bank.

[ajlennon]

Then please enlighten me as to the second

..

 

This page covers the discussion more fully than my comments would:

Quote:

Criticism of fractional-reserve banking - Wikipedia, the free encyclopedia

[bedlington83]

You've linked to a wikipedia article about criticisms of fractional reserve banking. As I've now read the corresponding wikipedia article on fractional reserve banking I now know its exactly as I described above. I.e. a fraction of the banks reserves are retained, the remainder lent out. You have conceded that this is one way in which fractional reserve banking works but claim that there is another. What is this other way that fractional reserve banking works?

 

The link that you've given is a criticism of increasing the money supply in this way as opposed to governments printing money but government increasing the money supply by printing new notes is irrelevant to this discussion. The article certainly doesn't redefine fractional reserve banking in a second way.

 

How about answering in your own words?

[ajlennon]

Bedlington83

 

Every building society for certain. Nationwide for example is proud of the fact that all its lending for 2007 was funded completely via investor's deposits. That's one of the main reasons that (IMHO) its one of the strongest financial institutions in the UK at the moment

 

This seems not to be the case. I've had a very helpful response from a chap at Nationwide who makes things clearer:

 

Nationwide does operate on a fractional reserve system, in fact this is now universally the way that banks and building societies operate. To illustrate this, Nationwide currently holds £118 billion of deposits from members (retail deposits). If you add to this our deposits from other banks and institutions, this rises to more than £175 billion. Under a full reserve system (as I understand the terminology) we would therefore hold reserves of £175 billion. In fact, our total reserves are approximately £6 billion.

 

I suggested to him that a solvency ratio of around 11% seemed strong in comparison to other organisations and he concurs, saying:

 

This figure is then divided by the lending we have done - our lending assets. For Nationwide, this figure is £144 million. However, this figure is "risk weighted" - i.e. the Financial Services Authority tells organisations how risky each type of lending is, and a weighting is applied. After doing this, our "risk weighted assets" comes out as £77 million.

 

He also seems to concur with my understanding of the two ways that lending can occur, saying:

 

Organisations which lend can fund that lending from two fundamental sources - retail deposits or wholesale funding - the latter being money from institutional investors in the credit markets. The over-reliance on wholesale funding from some institutions has been well documented and forms a significant element of the credit crunch, so I won't go into that here. Building Societies are legally bound to source 50% of their funding from retail deposits, which has led to them being seen as a safer option during the crunch. Nationwide's funding ratio is 31.3% - i.e. this percentage of our overall funding comes from the wholesale markets, with the remaining 68.7% coming from retail deposits.

I have to say I really do appreciate the time and trouble to which he went in answering my queries and will be considering Nationwide when my mortgage comes up for renewal

[bedlington83]

This seems not to be the case

Selective and grossly misleading. You asked which bank or building society funded lending from investors savings and I answered that all building societies did that. I provided you with proof that this was the case and Nationwide have confirmed it.

I really don't understand why you won't answer in your own words but suspect its probably that you don't really understand. Nothing you've quoted demonstrates that there are two ways that fractional reserve banking works. There are two ways for banks to fund their lending; from people's savings (retail deposits in Nationwide language) or by borrowing it on the open market (wholesale funding). But fractional reserve banking still works in only one way. If this is what you mean then why not say it?

 

As far as I'm aware you still believe that fractional reserve banking is where the financial institution borrows a small percentage of the money that its lending from the central bank (although you've yet to tell me where you think the rest of it comes from as you won't accept that its savers deposits). Fractional reserve banking is just a very fancy way of saying that the financial institution lends its depositors money out. And "fractional reserve banking" doesn't mean that the financial institution "creates" money, which is another of your claims

 

There is one interesting thing to come out of your correspondence with Nationwide: They say they have deposits totalling £175bn, that they've lent out £144 million and that they have £6bn on deposit. So where's the other 168 billion 856 million gone?

[ajlennon]

Bedlington83,

 

Apologies, I linked to criticism of fractional reserve banking, rather than the main fractional reserve banking page. The page, and specifically the discussion of the page holds more relevant information I believe.

 

Fractional-reserve banking - Wikipedia, the free encyclopedia

Talk:Fractional-reserve banking - Wikipedia, the free encyclopedia

However, and in light of the previous email, here's my understanding of the methods (no doubt to be revised as my understanding improves):

 

a) The "It's a Wonderful Life" scenario

 

George runs a bank, which I envision as having a big safe out the back.

Bob brings him a deposit of £100 which George puts in the safe. Bob has now effectively lent George some money, for which George has agreed to pay him interest on top of the original deposit, over time, and return the original deposit upon demand. Tom does the same, depositing £800, and then Fred also deposits £100.

 

This means that George now has £1000 in the safe.

 

Next, Jim comes in and asks for a loan to fund the purchase of a car. George knows Jim will be good for it and so lends him 90% of the money in his safe (£900).

 

George does this because he's operating on a 10% reserve ratio which means he must keep 10% of the amount deposited with the bank, in relation to his lending.

 

Jim, having signed the paperwork agreeing to a monthly repayment consisting of both a proportion of the principal sum, and also a related amount in interest, heads off to buy the car.

 

George now has £100 left in the safe and can't make any more loans until he has more deposits.

 

Jim goes to Phil's Used Car Emporium and pays for a new car. Phil goes to his bank and deposits the £900 with George.

 

George now has an additional £900 deposited with him and so can make another loan of up to £810.

 

It should be noted here that George is still keeping the original £1000 on his books as a deposit, although he doesn't actually have the money deposited any more.

 

The cycle can, of course, repeat with George making new loans, and so there is an increase in the 'money supply'. George has been creating new 'commercial bank money' with his loans. For a 10% reserve ratio there will be a corresponding increase in the money supply of up to x10 (i.e. The original £1000 has now become £10,000.

 

George is now left with the problem that if his depositors wish to withdraw more than the original £1000 he hasn't enough money in the safe to pay them and so his bank may become bankrupt.

 

I think this example is essentially the same as the one you use and is referred to as funding through 'retail deposits' in the previous post.

 

Obviously this example doesn't adequately discuss the systemic nature of money creation, as deposits will be made into and loans received from other banks, not just George's.

 

We also don't go on to discuss the effects on the economy (if any) of an increase of this magnitude of the money supply - privately created 'money'. Lastly we don't discuss whether this is indeed 'money' as we would commonly use the term as previously pointed out by My Real Name.

 

b) Big Money, High Risk Lending

 

George sets up a bank. He's an extreme case so he doesn't invest any of his own money in starting up the bank, or worry too much about attracting depositors, which means his bank has £0 on its balance sheet to start.

 

The bank is in the business of lending money, so George has some friends run a mixed media advertising campaign which leads to lots of people seeing offers for his loans on television and in the local newspaper.

 

Jim sees the adverts and decides that he's going to take out a loan to buy a car. He goes to meet with George and thinks that the interest rate offered on the loan seems reasonable enough to borrow £900 of the deposits he thinks George has in the safe.

 

Jim signs a promissory note which guarantees to George that Jim will labour over the next few years to ensure that he can make payments on the principal borrowed plus the interest repayments he has agreed.

 

George tells Jim the money will be available to him in the next few days and Jim goes home.

 

George now phones up Nathan who's a rich landowner. George tells Nathan that he has a promissory note from Jim, and that a guy he met in the pub, Charlie, has assessed Jim as a good risk.

 

George says he needs to borrow £90 from Nathan to ensure he meets his reserve asset ratio of 10%. For this he will pay Nathan a fee and an interest repayment on the money borrowed, which he'll repay at a set date in the future.

 

Nathan is more than happy to loan the money to George, as he's heard Charlie is good at weighing people up and he's getting a good rate of interest on his money.

 

George has now got £90 on his balance sheet and so can lend the £900 to Jim by writing him a cheque.

 

Now we leave out the issue of how long the £90 has been borrowed for, as if the loan of the £90 needs to be refinanced in the short term, and the lenders don't want to lend, then George would have a problem.

 

There are a number questions in my mind.

 

e.g.

 

- the valuation on the promissory note (if this is indeed used)

- how valuations are made on negotiable instruments such as this

- how Charlie's credit rating system is validated by the FSA,

- and whether in George can put the borrowing from Nathan directly on his balance sheet or needs to leverage the borrowing through the creation of some kind of structured investment vehicle.

 

Alex/

[ajlennon]

Selective and grossly misleading.

 

I can't agree. I believe the quotes speak for themselves which is that

 

Nationwide's funding ratio is 31.3% - i.e. this percentage of our overall funding comes from the wholesale markets, with the remaining 68.7% coming from retail deposits.

 

I really don't understand why you won't answer in your own words ... But fractional reserve banking still works in only one way. If this is what you mean then why not say it?

 

As you'll now understand, I was responding in my own words as you were writing this. It boils down to the multiplier. With a 10% asset ratio we agree banks can lend £90 for every £100 deposited. There is also a view (rightly or wrongly) that with a 10% asset ratio banks can lend £100 for every £10 of assets.

 

financial institution "creates" money, which is another of your claims

 

Would you agree or disagree with this quote from Wikipedia?

 

When a loan is funded with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

Fractional-reserve banking - Wikipedia, the free encyclopedia

[bedlington83]

There is also a view (rightly or wrongly) that with a 10% asset ratio banks can lend £100 for every £10 of assets.

This doesn't happen

 

I disagree that the wikipedia quote evidences your claim that banks create money to lend out. It has to exist before they lend it. How else do you explain the banks being in financial difficulty? If they could just magic money out of thin air they'd have done it to prevent themselves failing. Instead, they had to be either bailed out by the government (Northern Rock) or bought out by a rival (HBOS).

 

Yes, the same money exists in two accounts at the same time (the depositors accounts and the garage's account in your "wonderful life" scenario) but the effect is transitory. As the loan is repaid the bank acquires the funds to honour all its commitments. I.e. when the loan is repaid the bank will actually have on deposit the full balance of all accounts. It is this transitory effect that wikipedia (and I suspect the other sources that you've quoted) are describing as "creating" money.

[ajlennon]

This doesn't happen

I'm glad that's settled then...

 

Yes, the same money exists in two accounts at the same time (the depositors accounts and the garage's account in your "wonderful life" scenario) but the effect is transitory.

When you write that the effect is 'transitory' you are agreeing that the effect occurs.

 

Yes, the 'commercial bank money' which is created when the loan is made will be destroyed when the loan is repaid.

 

Your argument does not refute the point that the 'commercial bank money' is created when loans are made.

 

How else do you explain the banks being in financial difficulty?

It's a multiplier effect so in this context you have to have some 'money' from some source to make loans. You either have to get more people to deposit or you have to be able to refinance your existing loans or take out new ones at a rate that works for you.

 

As I understand it the problem with the banks was/is was that they either couldn't refinance existing loans or get the rates anticipated on new loans.

Edited February 16, 2009 by ajlennon
Grammar