Question re Mechanics of Fractional Reserve Banking

[leegs]

The following question was posed in the Can the Fed stop QE? thread recently.

I've seen two descriptions of "fractional reserve banking".

-->One like yours: A bank has $1 billion in reserves, it can loan $9 billion of new money.

-->The other (Chris Martenson, for example), explains that the bank takes a percentage of reserves for each deposit and lends the remaining. The money grows because the money lent eventually finishes in another deposit in the same or a different bank and is lent again (minus reserve).

Which is the correct answer? Does it depend on the bank, i.e. the Central Banks (the Fed plus the 12 district banks, versus say Wachovia.
I would be very interested in the answer.

Thanks

[ThePythonicCow]

Re: Question re Mechanics of Fractional Reserve Banking

The following question was posed in the Can the Fed stop QE? thread recently.

I've seen two descriptions of "fractional reserve banking".

-->One like yours: A bank has $1 billion in reserves, it can loan $9 billion of new money.

-->The other (Chris Martenson, for example), explains that the bank takes a percentage of reserves for each deposit and lends the remaining. The money grows because the money lent eventually finishes in another deposit in the same or a different bank and is lent again (minus reserve).

Which is the correct answer? Does it depend on the bank, i.e. the Central Banks (the Fed plus the 12 district banks, versus say Wachovia.
I would be very interested in the answer.

Thanks

As noted on the other thread, I don't have a useful answer.

But I do have another thought on this (perhaps just a justification for my ignorance ).

I suspect that the premise behind this question is that the first description above seems to allow for more leverage than the second. So hopefully the second applies, as that would be "safer" (less leverage.)

However this seems to presume two things: (1) that these are the two possible ways to leverage a bank, and (2) that one leads to less leverage than the other.

My speculation is that banks, especially big money center banks, have more ways to lever up than a leopard has spots. I'd further speculate that even constrained to just the second description above, (so-called) banks such as Goldman Sachs could find ways to leverage further up than I like, if by no other way than their investment activities which are now not firewalled from their banking activities.

What matters in the end, in my view, is not by what method the bank levered up, but how far they levered. The higher the leverage, the less robust they are in the face of adversity.

[leegs]

Re: Question re Mechanics of Fractional Reserve Banking

My question is less motivated by 'which is scarier', because as you say, the right answer to that question is 'yes'. I'm more interested in the mechanics. I have a hard time understanding how the Bank of BumF*k can create money out of thin air. Of course as I write this I'm conscious of the quote (by ?) containing the phrase ' . . . the mind is repelled . . .'

BTW, I found your comments in the other thread regarding securitization to be very helpful.

[*T*]

Re: Question re Mechanics of Fractional Reserve Banking

Money Creation
(From Wikipedia)

Please do follow the reference.

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, the two types being legally equivalent

central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))

commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money

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

Mainstream_economics theory of monetary creation is that commercial bank money is created by commercial banks re-lending central bank money: the central bank lends money to a commercial bank, which re-loans part of it, due to fractional reserves, and this portion is in turn itself re-lent (it is re-re-lent central bank money). This theory is disputed by some schools of heterodox economics such as onetary_circuit_theory.

The table below displays how central bank money is used to produce commercial bank money via successive re-lending in this theory.

Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate

individual bank	amount deposited	amount loaned out	reserves
A	100	80	20
B	80	64	16
C	64	51.20	12.80
D	51.20	40.96	10.24
E	40.96	32.77	8.19
F	32.77	26.21	6.55
G	26.21	20.97	5.24
H	20.97	16.78	4.19
I	16.78	13.42	3.36
J	13.42	10.74	2.68
K	10.74
			total reserves:
			89.26
	total amount deposited:	total amount loaned out:	total reserves + last amount deposited:
	457.05	357.05	100
	commercial bank money created + central bank money:	commercial bank money created:	central bank money:
	457.05	357.05	100

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. For more information on how this system works, see ractional-reserve_banking

[ricket]

Re: Question re Mechanics of Fractional Reserve Banking

-->One like yours: A bank has $1 billion in reserves, it can loan $9 billion of new money.

-->The other (Chris Martenson, for example), explains that the bank takes a percentage of reserves for each deposit and lends the remaining. The money grows because the money lent eventually finishes in another deposit in the same or a different bank and is lent again (minus reserve).

These are both correct (as *T*'s link to Wikipedia explains if you follow it).

The way that I understand it is this: when a bank is "chartered", a bank "buys" a certain portion of shares in the Federal Reserve bank. In exchange, the bank receives a certain amount of central bank credit. They actually receive the shares and the credit in a double book-keeping style entry on both sides. They can take this initial "high powered money" and loan out 10x the amount. If they receive $1 million in central bank credit, they can create $9 million more in loans instantly (say for CRE).

Once they have ballooned the money supply 10x initially from the central bank credit, the rest is created as commercial bank credit, with which a bank has to keep 10% in reserves.

Say a commercial bank is chartered with 1 million in central bank credit. The commercial bank can take this 1 million and create 9 million from the initial high powered central bank credit. This makes a total of 9 million dollars that has been created out of thin air. Once that money goes into other banks (ie it enters into the economy), those banks have to keep 10% of the deposited amount and can loan out the rest. Once this happens over and over again, this initial 1 million dollars can be turned into almost 100 million (to create an essential 100:1 lending ratio).

ORIGINAL 1 million * 10 = 10 million (+9 million)
------------------------------------------------------------------------------------
10 million * .10 = +9 million lent out and added to balance sheets (1 million kept in reserves)
9 million * .10 = +8.1 million
...
...
------------------------------------------------------------------------------------


The process continues until eventually they turn 1 million roughly into 100 million.

There's a pretty good explanation of this in the "Money as Debt" video series (which I highly recommend).

Money as Debt (original):
http://video.google.com/videoplay?do...6453790090544#

Money as Debt II - Promises Unleased (8 videos, this link will play them all in order):
http://www.youtube.com/watch?v=_doYl...x=0&playnext=1

[Nivelles]

Re: Question re Mechanics of Fractional Reserve Banking

I've seen two descriptions of "fractional reserve banking".

-->... A bank has $1 billion in reserves, it can loan $9 billion of new money.

-->... the bank takes a percentage of reserves for each deposit and lends the remaining. The money grows because the money lent eventually finishes in another deposit in the same or a different bank and is lent again (minus reserve).

Which is the correct answer?

There's no actual difference between those two. The first simply results from the second.

[leegs]

Re: Question re Mechanics of Fractional Reserve Banking

Thanks all for the responses.

Nivelles, I don't think you are correct. Say my friend Bob gives me $100 to keep safe for him. I can choose to lend out $90 (or $100) of it to Tom. I can't lend $900 to Tom, because I don't have it to lend. Now Tom can generate $90 of activity in the economy, or perhaps even more, as much as $450, as per T's reference. I'd say that's quite a lot different than if Tom had $900 burning a hole in his pocket.

[*T*]

Re: Question re Mechanics of Fractional Reserve Banking

I forgot to say, reserve requirements were effectively eliminated in the US with the sweep account rules. There was an akrowne post that I can't find that explains it.