J Thomas wrote:Try this thought experiment. You deposit a dollar into a bank account. You write your name on it, and you sort of imagine the bank is keeping it for you in their safe. But really, they lend your dollar to Anthony. Anthony spends it and Bob gets it. Bob deposits it in some bank. Now you can spend your dollar with your debit card, and so can Bob. The bank then lends your dollar to Carl, who spends it and Dan gets it. Dan deposits it in a bank. You, Bob, and Dan can spend it. The bank lends your dollar to Ed, who spends it and Frank deposits it in a bank. The bank lends it to George who spends it, and Harry deposits it in the bank. Ida spends it and Jerry deposits it, Katherine spends it and Larry deposits it. Soon ten people think they have your dollar, and any of them can spend it any time they want. Other things equal (like the speed that people spend money, and GDP, etc, other things never stay equal but what should we assume?) the banks have reduced the value of your dollar by 90%. For anything you want to buy, there are now 10 times as many people with the money to buy it. The effect is almost the same as if counterfeiters passed so much bad money that 90% of the money in circulation was bad.
I think what you're overlooking in this example, is you're ignoring the debt that is also being created. When the bank lends to Carl, then Carl owes the bank a dollar. Because the bank is owed a dollar, it can lend out another dollar and still maintain the same amount of money on its balance sheet. The problem with overleveraging is that the people who the bank owes money to (the depositors) have very liquid accounts--part of the deal with banking is that you are pretty much supposed to be able to get your money out whenever you want--whereas the debts the bank might be accumulating could be longer term things, like mortgages, which the bank can't just call in if it needs to pay out some creditors. So the bank needs to keep enough on hand to deal with typical transactions of this nature.
In today's economy, a bank usually needs around 0.1% cash on hand to deal with that kind of thing. The large majority of transactions are with plastic. The rest tend to average out. And if somebody does try to withdraw enough cash that it might possibly not average out, the bank can tip off the police who can then catch him with the money, accuse him of being a drug dealer, confiscate the cash, and deposit it in the bank.
But if it needed to actually pay all of its creditors simultaneously, the only way it could do it would be to start demanding people repay their entire mortgages on the spot. This is the problem with bank runs. The bank has, in principle, enough assets to cover all of its liabilities, but it has a hard time calling all of those assets in on short notice.
Yes, but mostly there are no bank runs. After all, the money is insured. And if a bank goes bad, the central bank arranges for other banks to take on the obligations (and whatever rewards there are) so that depositors usually do not suffer at all. If that fails, the government will bail out depositors. It's only when the whole country is in trouble that things go bad for depositors.
The other problem with this type of overleveraging is that it multiplies the risk if someone defaults. In your example, if one person were to default on the loan, the bank would be completely out of money. If two people were to default on their loans, the bank would be insolvent because it would owe 10 and only have assets of 9. This is what happened in the bank failures in the subprime crisis.
Normally it isn't as bad as that. If the bank can get, say, 6% simple interest, then 9 identical loans will bring in 0.54 of one loan in a year. So the bank comes out almost OK if 5% of the loans go bad in a year. And often the loans don't go completely bad. If the bank can average 50% collateral on bad loans then it can break even with 10% failures. It isn't many years that it gets 10% failure.
If things do go bad then the central bank steps in. It examines the situation and decides whether the problem is imprudent loans or just bad luck. If it sees nothing wrong, it may choose to prop up the bank for awhile, putting it on probation while it sees whether things turn around.
Then if the bank does fail, the bank owners lose their money but the depositors may hardly notice. The name of the bank changes, but things go on pretty much as before for them.
Things have to get very bad for the public to notice, and that hardly happens once a generation.
Alexius wrote: J Thomas wrote: Alexius wrote: jules.LT wrote:
- The bank's deposit at the reserve bank ("high-powered money") allows it to lend 9 times that money (10% of the money is "in reserve"). So theoretically a bank could raise $100M of capital, deposit it at the reserve bank and immediately turn around and lend out $900M, couldn't it?
Yes, that's wrong.
In a 10% reserve system, to lend out $900M a bank needs to have a billion dollars
of which $100M is deposited at the reserve bank.
So, do it gradually. Lend $10M, and send $1M to the reserve bank. Now you have assets of $110M. If you get your share of bank deposits, as fast as your debtors spend their $10M, other depositors will put $10M in your bank. Lend $20M, and send $2M to the reserve bank. Lend $30M and send $3M to the reserve bank. Unless too many people withdraw money and deposit it in other banks, you'll be fine. Eventually you will get to $100M in the central bank and a billion dollars of assets.
And if other banks get the deposits instead of you? Then they will make the loans, and will eventually bring it up to a billion dollars of assets based off $100 million in capital.
Yes, that is partly how banks are set up (I think). The exception being when you say
Lend $10M, and send $1M to the reserve bank. Now you have assets of $110M
which is flat-out wrong, and I have no idea how you got there.
When you first make the loan, you have assets of $100M capital and $10M loans. You give your debtor a bank account with $10M in it. On average, people deposit money into banks as fast as other people withdraw it, so if that holds true for you, you will get $10M deposits about as fast as your debtors spend their $10M. So you can hope to continue to have $100M capital, $10 million deposits, and $10M loans.
If that doesn't work for you, it will work for the banks your money is draining to. Your $100M capital will result in $900M in loans, if banks can find $900M in loans they are willing to make.
And yes, it is a billion dollars of assets based off $100 million in capital- but the bank still only has $100M of equity because it also has $900M worth of liabilities to its depositors.
Agreed. Of course, we should also count something for the fees, and vigorish the bank charges.
A bank that can get 6% on $900M in loans is getting 54% on its capital, minus expenses. That looks like a good deal, and explains why so many people wanted bank stock before 2008.
Now we have a lot of things that are not banks that get to basicly do banking without getting regulated like banks. The more of the money they handle, the harder it gets for official banks.
Derek wrote:Ten people think they have your dollar, but only Larry can spend it. Why is this? Because only Larry's bank has any reserve left. The other banks have lent out their entire reserves. If anyone other than Larry tries to withdraw or spend their dollar, their bank will immediately default because it has no reserves to give back.
Not necessarily. If the dollar is sent to the central bank and everybody has debit cards, they can each spend their dollar. You buy something from Joe, and the dollar is subtracted from your account and added to Joe's. Bob buys something from Anthony, and a dollar is subtracted from Bob's account and added to Anthony's. Etc etc etc. The problem only comes when somebody tries to withdraw a dollar in cash. When that happens, the central bank can quick lend the dollar to whichever bank needs it. Then they hold their breath hoping nobody will withdraw a second dollar. When the withdrawer spends the money and somebody deposits it, then they all start breathing again.
In real situations they can depend on statistics. Nobody withdraws 10% of the cash. Nobody withdraws 1% of the cash.
If the government was running the banking system, it would not need to have any cash. Paper money has no use any longer except to let people do transactions without keeping records.
The Law of Fives is true. I see it everywhere I look for it.