Posts Tagged ‘fractional reserve banking system’

Banking for dummies

Wednesday, April 23rd, 2008

One of the most lucrative business in the world is banking. This is especially true in a world of fiat money and fractional reserve banking system, where money that is backed by nothing can be created from thin air. As we have seen previously in Reserve Bank of Australia entering the landlord business, the central bank can always prevent or prempt a shorter term financial meltdown by pumping liquidity into the system (that is,’printing’ money and then followed by lending them or buying up bad debts or some other tricks- see Recipe for hyperinflation) and introducing moral hazard. But in the longer term, the people have to pay for these moral hazards via inflation.

Today, we will take an introductory look at the business of banking.

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank’s liability but your asset. In accounting technicalities, your money goes into the bank’s balance sheet as an asset with a corresponding liability.

Currently, today’s banking system is a fractional reserve banking system. That means banks do not have to keep all your deposit money in its ‘vault.’ Since it is unlikely that you will recall most of your deposit money at any one time, it can lend out the vast majority of your deposit money while simultaneously maintaining the full balance in your bank statements. Legally, banks have to keep a minimum ratio of deposit money in its ‘vault’ to deposit money. This ratio is the reserve ratio, which is 10% in the US. Countries like Australia do not have formal reserve ratio requirement. The implication is that if every bank customer decides to recall all their deposit money simultaneously, the bank is insolvent instantaneously. That is, there is a run on the bank.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ‘vault,’ it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default. Side note: With the rise of securitisation (see Collateral Debt Obligation?turning rotten meat into delicious beef steak), banks (and non-banks as well) are able to lend and re-lend money many times over, spewing out massive amount of credit into the financial system.

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act. For example, there are government regulations that require banks to keep a certain ratio between risky assets (loans and bonds) and equity capital (excess of assets over its liabilities). The upcoming Basel II accord is another such example.

The global credit crisis has thrown many spanners in the works of many banks’ portfolio and by extension, the global financial system. As you can see, bad debts is causing the mayhem in banks’ portfolio (see Is this sub-prime or solvency crisis?). When the financial system realised that the price of money was too low for too long (see Prepare for asset repricing, warns Trichet, which is written back in January last year), banks (as well as non-bank) become very much risk averse and hoarded money as a result. In other words, money suddenly becomes scarce (which implies its price, the interest rates has risen).

So, as we asked before in Reserve Bank of Australia entering the landlord business, what might be the “possible repercussions if the RBA had not [got into the landord business]?” When money becomes scarce and banks (as well as non-banks) become more scared, lending seizes up and credit standards become tighter (see Rising price of money through the demise of ?shadow? banking system). For economies that are drugged up by credit (e.g. Australia, UK and the US), this can cause the economic activity to seize up. The fact that the RBA is temporarily swapping risky assets (mortgage bonds) for thin air money at a bargain price is a very telling sign. And it is not only the RBA that is doing this- it looks that other central bankers are coordinating their efforts in pumping liquidity into the financial system. At least this is the official reason. Since the RBA did not reveal who they get their mortgage bonds from, other conspiracy theorists believe that the RBA are bailing out some financial institutions (which include banks and the non-bank lenders).

For bankers, there is such a thing as free lunch.