Sunday 13 April 2008

Fractional reserve banking for beginners

A lot of people accuse banks of creating money or printing money, and then a debate ensues about the wisdom of allowing fractional reserve banking, and some of the explanations are really long winded.

It's actually dead simple...
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Mr A agrees to sell his house to Mr B. The bank lends Mr B the money (which it shows as an asset in its accounts) and Mr A of course deposits the proceeds with the bank (which it shows as a liability in its accounts)*. The bank of course is just a middleman, it charges Mr B sufficient interest to cover the interest it has to pay Mr A, plus its running costs and a retention to cover possible bad debts. If there's anything left over, the bank makes a profit.

As soon as the sale goes through, by magic, there's an additional £x00,000 of 'money' in the system. In reality, that money nets off to nothing, mathematically.
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So provided the house is sold for a fair amount that Mr B can afford to repay, all is well with the world. Problems only arise when their is a spiral of easier lending, which leads to higher house prices, which leads to over-confidence and even easier lending and so on. This is how the house price bubble and the credit bubble are self-perpetuating. Until they go *pop* of course, as they do every 18 years or so.

In which case...
Mr B is in a mess, because his house is falling in value and he can't afford the mortgage any more;
Mr B's mortgage lender is in a mess because it has to write down the value of its assets (the irrecoverable part of Mr B's mortgage);
Mr A's bank is in a mess because it might not be able to recover all its money from Mr B's mortgage lender; and
Mr A has to worry about there being a bank run on the bank where he deposited his money.
Somehow or other, the loss will be shared out between the various parties who based their original transaction on an inflated house price/unrealistic expectation of Mr B's ability to service the mortgage.

That's all, really!

See also Banking supervision for beginners; the Bank of England predicted the Northern Rock failure ten years ago!

* You can invent infinite complications to add to this, such as, it might be Bank C that lends the money to Mr B, so Bank C has an asset, and Mr A deposits the money with Bank D, so Bank D has the liability. But Bank C in turn owes the money to Bank D, so it all evens out. The so-called Tier One Basel capital requirements just means that banks have to be able to finance about one-eighth of their total lending out of their own money, i.e. share capital and retained profits. They got round this eminently sensible rule by shifting assets and liabilities off-balance sheet, aka 'securitisation'.

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