Fractional Reserve Banking

[AndyZ]

http://en.wikipedia.org/wiki/Fractional_reserve_banking

I've been reading through this and I'm not sure I understand a lot of it.  Maybe somebody can help me out and see if I'm correct.

When a bank loans out money, it can manifest currency out of thin air based on how much it already has in reserves, rather than simply lending currency that already exists.  This steady creation of currency allows for expansion but also causes inflation, and can easily cause for runs on the bank when people try to withdraw currency that no longer exists.

Although this makes it very easy to expand, contractions are much more difficult, because foreclosures and bankruptcies cause currency to simply cease to be.  Other sources have told me that this is part of what caused the Great Depression, when a whole lot of currency vanished and took peoples' life savings with it.  If that's true, it would suggest that the housing bubble is causing the current recession as well.

If I'm right about how this works, it all seems really crazy and unstable to me.  Can someone tell me if I'm correct, and if not, what I'm getting wrong?

[Oniya]

I know that banks do use money that they have to finance the loans that they make.  This is one of the reasons for interest (both on loan repayments and on accounts) - as a form of payment for the use of another person's money.  As a result, the bank vaults most likely don't contain the physical amount of money necessary to pay up if everybody were to pull their funds out at one time.

I have also heard that the housing bubble is one of the things responsible for the current economic situation:  In an effort to make good on one president or other's promise of 'housing for all', banks made loans that they probably wouldn't have made before then.  Some people bought homes that would have been better off renting.  There were mortgages that had monthly payments that a) were too high for them to sustain, b) had an adjustable rate (which can cause payments to balloon when the rate goes up), or c) didn't exceed the amount of interest on the loan by enough to put a dent in the principle.  These people eventually ended up defaulting, ending up either in bankruptcies or foreclosures.

The truth is that sub-prime lending was crazy and unstable - and the question is why no one seems to have had the spine to stop it.

[gaggedLouise]

I know that banks do use money that they have to finance the loans that they make.  This is one of the reasons for interest (both on loan repayments and on accounts) - as a form of payment for the use of another person's money.  As a result, the bank vaults most likely don't contain the physical amount of money necessary to pay up if everybody were to pull their funds out at one time.

I have also heard that the housing bubble is one of the things responsible for the current economic situation:  In an effort to make good on one president or other's promise of 'housing for all', banks made loans that they probably wouldn't have made before then.  Some people bought homes that would have been better off renting.  There were mortgages that had monthly payments that a) were too high for them to sustain, b) had an adjustable rate (which can cause payments to balloon when the rate goes up), or c) didn't exceed the amount of interest on the loan by enough to put a dent in the principle.  These people eventually ended up defaulting, ending up either in bankruptcies or foreclosures.

The truth is that sub-prime lending was crazy and unstable - and the question is why no one seems to have had the spine to stop it.

Completely agree, but isn't part of the root trouble here that by the nineties there wasn't much of a market for renting your house or apartment at rates that would be affordable to people who didn't have huge amounts ogf money to spend, who didn't have real high-income jobs? At least not in US urban areas. If there are simply no flats around at reasonable prices, and if everything that isn't fifty years old and run down is being redeveloped into expensive new condos (for which you have to toss up half a million dollars to even be a bidder) then a vast amount of people won't really have the options to get on the ladder. And without a somehow decent place to live your choices of work, higher education, or of raising a family, remain limited.

It's a similar situation here in Sweden, and in Scandinavia in general, probably also in the UK. If you want to move out at twenty or twenty-five, you pretty much have to get a condo or even buy an apartment and this costs at least eq. of 200k dollars (for a small flat, like two rooms and a tiny kitchen), often twice as much. I am not talking of the capital cities, just middle-range university and industrial cities. There are almost no ordinary apartment (without a share in the condo association or a big deposition) on the legal market; the queues for those attractive flats that are owned by public housing are ridiculously long. Wanting to swap flat contracts in a private transaction, to bypass queues at the landlord's desk, often implies big stashes of underhand money

Universities here are not good at providing housing (even corridor rooms) for their students; once they were, but now they tend to rely on the commercial market a great deal, and wash their hands, so quite a few people even have to get a condo as soon as they begin studying for a degree, at 19 or something. Most of the time, of course, it's their parents that will vouch for the loans: banks here don't count studying grants as actual income so they don't see students as worthy of credit on their own terms, and anyway, those grants are not near high enough to allow for the kind of loan weight we're talking about. This is fucking insane, and it completely leaves the market in the hands of building companies and property lords who want to build posh apartments and banks that are eager to speculate on housing loans, properties and mortgages.

So yes, you could say the mortgage circus was built on loans that should never have been given, but beyond that the trouble would be that by let's say 1995, half the demand for housing simply didn't have anywhere to turn except for old and unreliable junk housing, trailer parks (bad and expensive, too) OR new building/renovation that was completely out of range for those people..

[Jude]

The ugly truth that no one seems to be saying is that banks realized sub-prime mortgages were risky all along, they just didn't care because the worst case scenario was that the homeowner would default and they'd take their property back, give them absolutely nothing in return, and then flip the house again to another person who would either successfully purchase it or become the next victim in the chain.

The problem is, this model only works when houses are glorious assets that are the foundation of our society.  We put making enough housing for everyone to buy at the top of our list of priorities and financial advisers spent decades telling people that homeownership was the only way to go (renting is just throwing your money out, they said) and a damn good investment to boot.  So housing prices became ridiculously invested (artificially so) then when the bubble burst, all of the debt on top of it resulted in a catastrophic outcome for the real estate business and bankers alike (especially with how they sold these mortgage back securities to each other stupidly, ratcheting up the problem).

This is also how the great depressing started off with a bang in the US, only you exchange people taking out risky loans to buy stock instead of houses.  Then there was a stock market crash (investment bubble burst, just like with houses) and the economy was instantly plunged into a recession.

You'll notice that for as bad as things are, we didn't take the path of the Great Depression.  You can thank the Federal Reserve Bank's monetary policy and other Keynesian initiatives (such as the stimulus and TARP) for that.

[Oniya]

I think I did mention that subprime lending was known to be risky (as they wouldn't have made those loans before the start of the bubble), but you explained the nuts and bolts of it a lot better than I did. 

[AndyZ]

It really baffles me that people would take loans when they wouldn't be able to pay them back, but that's more a digression of the topic.

Am I right that it's crazy that they can just manifest money out of nowhere?  Or is it only the Federal Reserve that can do that?

[Jude]

The people taking the sub prime loans didn't know that, though.  Most people don't read fine print.  They made stupid decisions and especially didn't understand what an ARM (adjustable rate mortgage) was.

[Oniya]

The people taking the sub prime loans didn't know that, though.  Most people don't read fine print.  They made stupid decisions and especially didn't understand what an ARM (adjustable rate mortgage) was.

That, and a commission-hungry real-estate agent can be rather convincing.

[AndyZ]

So no one knows about my original question?

[Jude]

The Federal Reserve has never caused an economic crisis to my knowledge.  They didn't exist before the Great Depression, only after.

[AndyZ]

Incorrect.  The Federal Reserve was created in 1913, well before the Great Depression.

http://en.wikipedia.org/wiki/Federal_reserve

[Jude]

Wow, I... can't believe I got that wrong.  Thanks for the correction, I'll read up and come back with better information.

[AndyZ]

No worries ^_^ One of the major reasons I post on here all the time is so that folks can correct me and show me where I'm goofing up.  This thread is pretty blatant proof of that.

[gaggedLouise]

The ugly truth that no one seems to be saying is that banks realized sub-prime mortgages were risky all along, they just didn't care because the worst case scenario was that the homeowner would default and they'd take their property back, give them absolutely nothing in return, and then flip the house again to another person who would either successfully purchase it or become the next victim in the chain.

The same thing went on during the dotcom boom a dozen years ago, and into the subsequent nosedive. Many brokers and asset managers privately realized that a large number of the venture companies that were being hailed as "the new economy" were gonna go bust, or would never get close to black figures without some tough restructuring, but they knew the buzz around the proliferating web business was generating fresh credit and driving stocks upwards. Many of those companies were using their own hyped-up stock to finance buying themselves into other similarly inflated companies, ultimately riding on money borrowed from starstruck banks, investors and insurance companies, a classic "bubble move".Those who were trading in this figured, I'll come  out on top anyway, it's not *our* money. There was too much to sell in the dream market to bother about if those web companies were actually making any kind of profit, so all the while more hot air would get pumped into the system.
'
The people involved in the marketplace would act like, "Money? Hell, not an issue. There's always gonna be all the venture capital we need!"

[Vekseid]

It really baffles me that people would take loans when they wouldn't be able to pay them back, but that's more a digression of the topic.

Am I right that it's crazy that they can just manifest money out of nowhere?  Or is it only the Federal Reserve that can do that?

It isn't 'out of nowhere'.

You deposit $100 into a bank. The Federal Government lets them lend out $90 of it (one of those evil 'regulations' that some of them want to get rid of). But most of that $90 is going to end up in a merchant account or another bank account somewhere. So $80 of it gets lent out to person B... $70 to person C, and so on. Your $100 deposit has turned into several hundred dollars worth of money supply. You can think of it as the liquidity that $100 can purchase, had you spent it instead.

This works because there are millions of people depositing said money, and only so much is going to be withdrawn at a time short of a bank run, and the FDIC insures most small depositors anyway. You withdraw your $100, and someone else's deposits cover it. As long as the reserve limit is set high enough, it's rather difficult for a bank run condition to take effect because the withdrawn money is most likely to get deposited sometime anyway. A single bank can earn a bad reputation and get targeted, but the FDIC can step in and prevent the damage from spreading, as seen at the beginning of the last recession.

[Asuras]

When a bank loans out money, it can manifest currency out of thin air based on how much it already has in reserves, rather than simply lending currency that already exists.

It's not quite out of thin air - banks have to give cash to anyone with an account at the bank. The reason they can do this is because in general people and businesses keep pretty large balances in their accounts.

Really it's about keeping money in circulation. If I put $100 in a bank account, I'm not likely to take it all out. So it sits there. The bank lends it out and puts it back in circulation.

This steady creation of currency allows for expansion but also causes inflation,

In the strictest terms, banks don't create currency, they just lend out money they have on hand. But your point is well taken.

The thing is that under the current regime there are ways to manage inflation in a fiat, fractional reserve currency, but the Fed. Starting with Paul Volcker under Carter - now one of Obama's advisors, who did it most famously, spectaculorly and catastrophically - and his successors Greenspan and Bernanke controlled it too.

Under the current system the US can control the money supply and stimulate the economy, but with a full-reserve standard there's no way to do that. The United States would be (as it was in the late 1800s, before the Fed) driven by the vicissitudes of the price of gold.

and can easily cause for runs on the bank when people try to withdraw currency that no longer exists.

We have the FDIC for prevention of bank runs like we had in 1929. Full reserve banking is quite different but I don't think that it offers any new protections.

[Rachubka]

Yay! Good thing I work in a bank (And go to school for economics, but we'll ignore that part because I really don't want to think about it. Haha)! I work, live, and educate myself in Canada, though... but the principles are the same!

Baaaaaaaaaasically, money supply is determined by the country's government, or a derivative of that (like the Bank of Canada!) How much of it in the world determines its value (exchange rates and inflation run along with the monetary policy of a particular country). If there's more money around for no good reason at all, it's going to cost more of that same money to buy something that was cheaper when there was less money around. That's more or less a whole 'nother topic in itself so I'm not gonna get into it.

For the topic at hand, let's say that there are like, a hundred people in a community, which in turn has one bank. These people have jobs and such have bank accounts at this one particular bank where their pay ALWAYS goes into the account in full. Now, everyone has different needs and such, buy more expensive things than others and don't have the means to buy them just yet. The bank needs to generate some sort of revenue, so by issuing loans and attaching interest to it, it can do just that! Thanks to all the deposits of its community, we can say that the bank has a million bucks in it. Assuming that no one is going to withdraw all at once (which is an act that is partially to blame for the infamous GD), it can safely loan out a percentage of its stores (which, again, is determined by the bank) Let's say it's 80%.

So, with $1,000,000 in the 'vault', the bank loans out $800,000, expecting it to come back in some form at a later date with interest on top (an irrelevant detail right now). Which, in theory, would mean that there is $1,800,000 floating around in the community! Money is not created, it's just that the bank uses its 'money' to make them some revenue. The $200,000 buffer that the bank keeps would be for those day-to-day withdraws and such.

I'm not entirely sure I explained that alright... or if I'm even addressing your question. I tend to run-off sometimes. D:

[AndyZ]

Money is not created, it's just that the bank uses its 'money' to make them some revenue. The $200,000 buffer that the bank keeps would be for those day-to-day withdraws and such.

This was the answer to my question.  Thank you kindly.

Other people have responded as well, and thank you as well; I just forgot about this thread for a while.

Next question then.  Let's say that the bank only has to keep 20% of the money that it's loaned out.  This bank had 100 million dollars (for easy math) and therefore can loan out 80, leaving 20 million on hand.  However, let's say that after it's loaned out 80, people come and withdraw 10 million of the money, so that they only have 10 million on hand.  Do they then have to get more money on hand, reclaiming loans and such?  Or do they just have to stop giving loans until they're back at an equilibrium?

[Rachubka]

They woooooould, but an incentive for people NOT to make mass withdraws like that is interest on the other side - SAVINGS ACCOUNTS! :D

It's this constant mix that funds (people making deposits, people making payments on loans, people leaving money sitting around for interest) that makes sure it doesn't happen! And yeah... actually bothering to read the other posts (I read the first five!), FDIC would cover any banks going down the hole. In Canada, we have CDIC, and far, far less individual banks than the USA, so we're more boring and secure.

That 20% is more of a case of a safety blanket than a set in stone rule. Besides, not one person can really withdraw a crazy amount in a single day, anyway, without advance notice (or at least my bank does that), so it's kinda moot.

[gaggedLouise]

But isn't the point that banks, these days, don't keep most of their assets in the shape of huge piles of ready cash (or liquidity, to put it in a more scholarly way)? I'm not saying a bank would need to have something like Uncle Scrooge's big money bin, physically; of course most of its money is electronical. But because much of their assets are stock shares, hedgefunds, future buying options, composite debt letters, bonds and other kinds of instruments, which do not have any kind of fixed value even for a few days, there is often no real way you could control on a daily basis that the bank has a safe 20% liquidity or whatever. In theory any bank will tell you that they are honest players who recruit the most skilled people and keep tabs on their brokers and investment managers to make sure these do not make overly risky transactions and don't get near the limits of risking too much money, In reality, that's not how it functions, the routines of control are sometimes sloppy and it's not considered sexy or profitable to always play it safe.

Most people who have been closely in touch with Wall Street, or the equal place wherever one is living, do know that the banking and trading sector has an element of gambling to it, sometimes high-risk gambling, and that the question "whose money is it I am putting in motion, ultimately?" isn't at the front of the committed trader's mind. And this is hard to make a firm stand against for any individual trader or manager if they feel a chain of business deals they're engaged in is getting into risky territory, or is even doomed to fail, because banking and finance is a very competitive business, where the result, and the promises of profitable result, will often be the only thing that counts. You do not get promoted or recognized for standing up and saying "these shares you're hyping up, they're trash, and these guys you're doing business with are rogues" or "those people will never be able to pay back" - more likely you do get fired or sneered at, or will see your salary stagnating. Banks and trader gangs have their pet ideas just like any environment; cold and rational weighing of risks is not enough to make a career.

[Rachubka]

Yeah, that's part of the other bit of banking world, but as banks, they do keep everything under wraps and safe. At least the Canadian banks, anyway. That's why our banking system is seen as so boring, but secure!

I don't think I can really get into any sort of detailed analysis or anything right now. Just got back from homecoming festivities and I'm lucky enough that I can still type properly! Even if it is taking me like, twenty minutes to write this. Aaaha. :D

[Vekseid]

This was the answer to my question.  Thank you kindly.

Other people have responded as well, and thank you as well; I just forgot about this thread for a while.

Next question then.  Let's say that the bank only has to keep 20% of the money that it's loaned out.  This bank had 100 million dollars (for easy math) and therefore can loan out 80, leaving 20 million on hand.  However, let's say that after it's loaned out 80, people come and withdraw 10 million of the money, so that they only have 10 million on hand.  Do they then have to get more money on hand, reclaiming loans and such?  Or do they just have to stop giving loans until they're back at an equilibrium?

This is also what the interbank loan system is for. It allows all of the banks to, effectively, operate as one single giant bank. So long as there are good regulations in place, you're basically playing a statistical game where the chances of the system crashing are like winning the lottery several times in a row - you need the population to suddenly withdraw 20% of their funds, to cash, without depositing it anywhere. Not bloody likely.

One of the consequences of deregulation in the 80's-90's was a way for banks to operate with ridiculously low leverages, like 3% or less - they made more money, but once they lost what leverage they had, they required the US government to bail them out. To the tune of some 16 trillion. But this is also why those loans could be paid back to the US government - they just needed time to releverage. It involves, of course, a ridiculous degree of cronyism, but many politicians probably believe they did the right thing.

It does make me wonder if banking is something a sufficiently transparent government would handle better, though. The alternative is to dismember all of the big banks again, so that if one gets stupid we can let them die.

[Beguile's Mistress]

In 1980 the Prime Interest Rate, the rate at which the Federal Government charges interest to banks, reached a record high of 21.5%.  Banks and other lenders use this as an index for charging interest on loans to borrowers.  The Federal Reserve began lowering the Prime Rate over the next 5-7 years and it gradually became feasible for lenders to offer refinancing packages in order to encourage borrowers to change banks.  It also became easier for borrowers to get approved for first time mortgages, second mortgages, mortgages on second homes and investment property, Home Equity Loans and upward moves to larger, more expensive homes.

To free up money to make new loans and to get an immediate return on the investments banks made in their borrowers mortgages were sold off to other financial institutions, or "assigned" to them, in exchange for an amount that returned the principal plus a negotiated profit based on interest that would accrue over the life of the loan.**  Over time the refinance market began to dry up and lenders looked for other ways to generate revenue and grow their customer base.  Sub-prime Loans, Variable Rate Loans and Adjustable Rate Mortgages came into vogue along with the ability given to borrowers to take out loans for more than their property was worth based on rising property values in their communities.  Equity plus mortgages were offered at this point.

We all know that escalating fuel costs and rising prices for consumer goods began a downturn in the economy resulting in a rise in unemployment.  Many people who found themselves mortgaged to the hilt were now finding themselves without the second income they depended on to make ends meet.  As they restructured their lives and sold their homes to escape the financial burden they were in property values began to fall.  Home owners wishing to sell found themselves between a rock and a hard place.  They couldn't afford the home they wanted to sell and the lenders weren't allowing them to sell the homes they couldn't afford because the proceeds from the sale wouldn't cover the payoff amount of the mortgage.  Foreclosures became more prevalent.

There are other more esoteric factors involved in what has happened over the last 25 years to put us in the position we're in now.  However, from my time working for a title insurance company this is basically what happened.  (Title insurance is coverage lenders hold to indemnify themselves against unforeseen adverse financial conditions attached to a property on which they hold the collateral for a mortgage or loan.)

**It was at this point in time that companies were set up for the purpose of purchasing mortgages from lenders and reassigning them to other financial institutions.  Sometimes these companies did involve themselves in refinancing existing mortgages but these were also assigned to others immediately.  A closing package would include the original mortgage for the borrowers to sign and an already signed assignment of that mortgage to another company.

[Asuras]

But because much of their assets are stock shares, hedgefunds, future buying options, composite debt letters, bonds and other kinds of instruments, which do not have any kind of fixed value even for a few days, there is often no real way you could control on a daily basis that the bank has a safe 20% liquidity or whatever.

To some extent yes, but:

Banks are required to hold a minimum level of "tier 1 capital", in other words they're required to hold a certain level of relatively low-risk assets (cash, government bonds) relative to risky assets (stocks and derivatives).

On top of this, banks almost universally use some kind of value at risk model to figure out what kind of losses they're exposed to in all the risky investments (like stocks and derivatives) they're involved in. VAR is basically asking "if the worst case scenario happens tomorrow, how much do we stand to lose?". If their VAR is high, banks will tend to deleverage and recapitalize (in other words, sell risky assets and buy safer ones). They also tend to hedge their bets in various ways.

You do not get promoted or recognized for standing up and saying "these shares you're hyping up, they're trash, and these guys you're doing business with are rogues" or "those people will never be able to pay back" - more likely you do get fired or sneered at, or will see your salary stagnating. Banks and trader gangs have their pet ideas just like any environment; cold and rational weighing of risks is not enough to make a career.

There is truth to this - compensation on Wall Street is tied to short term performance and generally not well adjusted for risk - but there are a lot of people who were sounding alarms about subprime mortgages and European sovereign debt that banks are paying more attention to now too. Banks lost money there and they don't like losing money. After the UBS scandal last week people are looking at risk management a lot more closely too.

It does make me wonder if banking is something a sufficiently transparent government would handle better, though. The alternative is to dismember all of the big banks again, so that if one gets stupid we can let them die.

No one likes bankers except bankers, and bankers truly love themselves.

The thing is that banking is about deciding where the vast majority of investment goes in the economy, and putting all of that in the hands of government is really socialism on the level of the Soviets. The government would be deciding where investment goes, with all the cronyism and corruption that comes with it. I don't defend the catastrophes the financial system has wrought over the last several years, but on the other hand I think that government control may be an even worse solution.

I prefer a middle ground - stronger and smarter regulation. I think Dodd-Frank was a good step in that direction, for instance.

(history of the subprime loan)

I agree with your assessment of the crisis and how it came about, but I'd like to opine about what the banks did.

The banks started creating CDOs that transformed subprime loans into low-risk loans (through tranching). The basic idea of a CDO is not a bad one - it creates liquidity, it allows banks to move risk around, it creates a market where one otherwise would not have existed. With CDOs people can get loans to buy homes that would otherwise not be possible.

If they had gauged the risk correctly, there would have been no problem. In fact, there would have been millions of Americans in homes that otherwise wouldn't have had them - they couldn't have gotten the loans if banks hadn't been able to trade these mortgages.

The key problem was that banks and credit ratings agencies failed to assess the risk correctly. They should have been much more conservative. Unfounded assumptions about the prices of homes were made.

So the point I want to make is that we shouldn't blame derivatives like CDOs for the problem. There is nothing fundamentally wrong with them. We should blame overleveraging and a failure of risk management for it.