This post was prompted by a comment somebody left on another thread, saying that if he deposits £1 in the bank, that the bank can then lend out £10. This is basic Obanomics and completely untrue, of course.
Background (skip down to para 6 if you know this stuff, most people don’t)
a) A bank is a balance sheet exercise – assets are positive and liabilities are negative, and the two always net off to precisely zero. If asset values fall (because of reckless loans on land and buildings which fall in value) then the value of the liabilities fall as well (i.e. if you own shares or bonds in a bank which is making big losses, the value of your shares or bonds fall).
b) A financial asset is unlike a real asset (a building, a car, a television, a painting) because there can only be a financial asset (notes and coins in your pocket, cash in the bank, corporate or government bonds) if there is an equal and opposite financial liability. The two always net off to nil. So, for example, if you have a mortgage on your house, you have a liability but the bank records it as an asset.
2. The traditional books explain how banks started off using ‘fractional reserve banking’, i.e. they take 100 gold coins as deposits and lend out 90 of them, keeping 10 in the safe in case depositors come round to make a withdrawal.
3. So in the old fashioned view of banking regulation (or self-regulation), we look at the assets side: as long as the bank has a tenth* of its assets in liquid form (i.e. gold coins in the safe), it will probably do OK.
4. The modern view of banking regulation (i.e. Basel rules), we look at the liabilities side, and say that share capital (a non-repayable liability or source of finance) should be at least a tenth* of total assets; so if the value of assets falls by a tenth or less, there are still enough assets left to repay depositors and bondholders.
5. Quite how the myth that a bank can lend out ten times as much as it takes in deposits (or bonds) arose, I have no idea, it is quite simply not true. The Basel one-tenth* limit is imposed by regulators, so it might be accurate to say that “The total amount that a bank can lend out is no more than ten times its share capital”, but that is merely the upper limit, and depends on people wanting to borrow that much.
So much to the background
6. Modern banking, i.e. ‘how banks behave once the government takes its eye off the ball’ and which has been around for centuries, has very little to do with the old fashioned idea that the banks take deposits or otherwise raise money and then lend it out.
7. What actually happens is that bankers (i.e. employees of banks, who ultimately work on commission) just make loans willy nilly to all and sundry, usually ‘secured’ on land and buildings whether the bank has the cash in the metaphorical safe or not.
8. They do this because they know what happens after they hand over a cheque to the borrower to buy his house: the borrower in turn gives the cheque to the vendor and the vendor then takes the cheque and puts it back in the bank.
9. So before the transaction the bank had net assets of nil (or so little as makes no difference – see para 1 a) above).
a) It makes a loan to the borrower of £100,000 to buy a house (this is a liability to the borrower so it is an asset from the bank’s point of view – see para 1 b) above) and
b) accepts a cheque from the vendor (taking all banks to be part of a closed loop, which they are). The vendor clearly has a financial asset (a bank account with £100,000 in it) so again, referring to para 1 b) above, that deposit is a liability from the bank’s point of view, so
c) the new asset and liability of £100,000 each net off exactly to nil. The bank’s net assets do not increase or decrease as a result, but their gross assets do.
10. Having achieved this new state of affairs by ‘splitting the zero’ (TM Onus Probandy, I think) into a debit and a credit (in the same way as empty space sometimes splits into matter and anti-matter) the bank can then start making money by charging the borrower five per cent interest and paying the depositor three per cent interest, pocketing two per cent for itself.
11. Some refer to the process outlined in para 7 to 9 above as ‘printing money’, which it is – but the problem is that people don’t realise what money is, namely the physical or electronic record of who owes whom how much; ‘money’ is a liability as much as it is an asset; you can only have cash in the bank if somebody somewhere owes the bank money.
I hope that clears things up a bit!
* I’m using “a tenth” for illustration purposes only, it’s a bit more complicated than that.