Banking made easy

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)

1. Remember:

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.

12 comments for “Banking made easy

  1. john in cheshire
    May 23, 2011 at 8:39 pm

    Sorry, not clear at all.
    My understanding :
    I have £100 which I deposit in a bank.
    The bank then lends £90 of that money to a third party, who, for simplicity, deposit it into their bank account(same bank).
    the Bank then lends £81 of that money to someone else; person number four. And in doing so, they have created money, based on a gamble that the third and fourth parties will repay in full. And I have to take it on trust that when I want my £100, the bank can repay me. When Mr 3 and Mr 4 can’t repay then the bank has a very large hole in its deposits and I’m left with 10% of what I trusted to be a secure deposit, if I’m lucky.

  2. May 23, 2011 at 8:55 pm

    JIC, that’s exactly the point – somehow this myth has become established that banks work that way when they don’t – neither in theory nor in practice.

    For simplicity, let’s assume there is only one bank. You can only possibly have £100 in cash because somebody somewhere else has a debt of £100. All financial assets and liabilities net off to zero – see Rule 1 b). So by the time you deposit your money the bank has already lent it to somebody else!!.

    e.g. the simplest form of money is an IOU; you forget your wallet when you go to the shops, so you get the packet of fags and scribble “IOU £7, signed JIC” on a bit of paper and that is like a bank note from the shop’s point of view and is a liability from your point of view.

    Of course, if you default, then the shop makes a loss but, in a roundabout and perverse way, you the defaulter make an equal and opposite profit, because you know longer owe the £7 (having e.g. fled the country).

    (And yes, gold coins are an actual asset, but they are not money in themselves, they are just a measure of value – you can have fiat money even with a gold standard, and let’s forget about this old hat, shall we?)

    • May 23, 2011 at 11:33 pm

      JIC, if I may rephrase my reply to make it even simpler:

      The chances are, the spare £100 you have is the wages your employer paid you. Let’s assume he’s in credit with the bank, and he withdraws £100 and pays it to you. So if you add his balance and your balance, they will still add up to the same amount.

      So even if it were the case (which it isn’t) that the bank can lend out 90% of your new increased deposit, it would similarly have to reduce the loans it made on the back of your employer’s deposit by £90.

      Either way, the total credit balances (taking you and employer together) and the total loans the bank makes stay the same.

  3. john in cheshire
    May 23, 2011 at 9:04 pm

    Sorry Mark, to be stupid, but taking your IOU example, you wouldn’t expect the shopkeeper to lend someone £7 on the expectation that I will return with the money. But that is what the bank does; doesn’t it?

    • May 23, 2011 at 9:50 pm

      JIC, yes and no.

      The bank lends borrower the money on the expectation that the borrower will repay with interest (step 9a).

      Unless of course you have such a good reputation with the shop that impecunious friends pop round to your house first and ask you to scribble them an IOU saying “I. JIC, owe shopkeeper £7, please give my mate Dave a packet of fags”, but then you yourself are acting as a bank – you promise to pay the shopkeeper and your friend Dave promises to pay you, it always all nets off to £nil.

  4. Moonrakin
    May 23, 2011 at 9:11 pm

    Sooo.. wassall the stuff about gearing and the toxic 32x for Northern Crock and terminal 64x for Bradford and Bingley then?

    And – O/T mildly – why is the state owned Bank of Omaha such a success?

    I know it is all a little more complex but complexity is usually susceptible to simplification – is there a definitive Dummy’s Guide?

    Have you seen this documentary?

    • May 23, 2011 at 9:53 pm

      I just wrote the definitive Dummy’s Guide. People fall into two categories – those who understand things and those who don’t want to understand things, make up your mind which category you are in.

      Gearing is merely a technical terms to describe the ratio of total assets to shareholders’ capital. In theory, a really well run bank can operate with a ratio of infinity, i.e. with zero own capital. In practice, that never happens as humans are fallible and greedy.

    • May 23, 2011 at 11:39 pm

      JH, it’s good to see Abraham Lincoln’s face flashing up in the videos on the first link – he was of course somebody who took it for granted that the main source of revenue for ‘the state’ would be taxes on land values.

  5. PPS
    May 23, 2011 at 10:24 pm

    Excellent Post!

  6. November 25, 2011 at 4:43 pm

    Missed this one when you wrote it; but if you’re interested… this is the article Mark refers to

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