Fractional Reserve Banking And Fiat Money Questions

[SilentBull]

I've been reading a lot about the Fed. "The Creature from Jekyll Island" is the most amazing book I've ever read.

There is one thing that I am a little confused about. When a bank lends someone 100,000 from someone else's deposits and they consider that loan an asset because it will be paid back at a future date, they "create" money by lending money (via a check) they don't have, based on the promise of that original person to pay back the 100,000.

My question is: when the bank lends someone 90,000 (assuming 10% reserve requirement) because it considered the 100,000 debt to be an asset , the bank does not have the 90,000. So what happens when the person they loaned the money to via a check, actually spends that money? If that check is deposited in another bank, the original bank who did not have the 90,000 to begin with, has to come up with that money to give it to the new bank. How can the bank do this if it doesn't have it??


My second question is this: When is the money ACTUALLY printed/created? I know banks create money out of nothing by lending checkbook money. But when are the federal reserve notes ACTUALLY created?? I'm assuming the Fed is the only one who does this, right? When does it do it? Does it only do it when it needs to lend money to other banks and the government? At which point does the fed create "real" paper money instead of "creating" checkbook money?

 

[forsmant]

http://www.youtube.com/watch?v=xNehYxy77RI


This video by AceNZ will help a little in your quest for answers.

 

[Tom228]

I've been reading a lot about the Fed. "The Creature from Jekyll Island" is the most amazing book I've ever read.

There is one thing that I am a little confused about. When a bank lends someone 100,000 from someone else's deposits and they consider that loan an asset because it will be paid back at a future date, they "create" money by lending money (via a check) they don't have, based on the promise of that original person to pay back the 100,000.

My question is: when the bank lends someone 90,000 (assuming 10% reserve requirement) because it considered the 100,000 debt to be an asset , the bank does not have the 90,000. So what happens when the person they loaned the money to via a check, actually spends that money? If that check is deposited in another bank, the original bank who did not have the 90,000 to begin with, has to come up with that money to give it to the new bank. How can the bank do this if it doesn't have it??


My second question is this: When is the money ACTUALLY printed/created? I know banks create money out of nothing by lending checkbook money. But when are the federal reserve notes ACTUALLY created?? I'm assuming the Fed is the only one who does this, right? When does it do it? Does it only do it when it needs to lend money to other banks and the government? At which point does the fed create "real" paper money instead of "creating" checkbook money?

You need to keep in mind that when that money is paid back, the money is "destroyed." and when a loan is made money is "created." Whenever money is deposited the bank is required to hold and x% of it. So lets say you deposit $100 and lets say the reserve requirement is 10%. So then now the bank holds onto $10 in reserves and CANNOT lend that money. But now it has $90 of excess reserves that it can lend out. The bank can't lend more than it has. Now this is assuming there is $0 to begin with in excess reserves.
When a person takes out a loan they have to pay it back regardless of what they do with it otherwise you get in a lot of trouble.

Now your second question. Printing and creating money are not the same. Printing is say that the US mint goes and physically prints dollar bills and makes coins. Creating money is done through LOANING/ LENDING by banks. Contrary to forum belief the Fed does not physically print dollar bills the US Mint does that and usually only does it to replace old worn out bills and coins.

Edit: I just remembered I left out something called the multiplier effect. I'm not sure how the explain it since it's been a while since I've thought back to Money and Banking.
I think this would do a better job of explaining it.

Multiplier Effect

What does it Mean? The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

Investopedia Says... The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

 

[efiniti]

As far as your second question, AceNZ answers it pretty well.

Your first question is kinda confusing. I'll highlight the bolded part that might be the cause of the confusion.

There is one thing that I am a little confused about. When a bank lends someone 100,000 from someone else's deposits and they consider that loan an asset because it will be paid back at a future date, they "create" money by lending money (via a check) they don't have, based on the promise of that original person to pay back the 100,000.

My question is: when the bank lends someone 90,000 (assuming 10% reserve requirement) because it considered the 100,000 debt to be an asset , the bank does not have the 90,000. So what happens when the person they loaned the money to via a check, actually spends that money? If that check is deposited in another bank, the original bank who did not have the 90,000 to begin with, has to come up with that money to give it to the new bank. How can the bank do this if it doesn't have it??

They do have the 90,000. It came from the person who deposited the 100,000. So the person who was issued a check from the bank can spend this money. However, if the original person who deposited the money tries to withdraw it there becomes a problem. The bank has to take money from another person to pay the original depositor because its already loaned out the original depositor's money.

Normally what happens with these big $ amounts is that banks loan out the money to other banks which can loan out to other banks and et cetera. This is my understanding of how banks can potentially create money.

 

[SilentBull]

As far as your second question, AceNZ answers it pretty well.

Your first question is kinda confusing. I'll highlight the bolded part that might be the cause of the confusion.



They do have the 90,000. It came from the person who deposited the 100,000. So the person who was issued a check from the bank can spend this money. However, if the original person who deposited the money tries to withdraw it there becomes a problem. The bank has to take money from another person to pay the original depositor because its already loaned out the original depositor's money.

Normally what happens with these big $ amounts is that banks loan out the money to other banks which can loan out to other banks and et cetera. This is my understanding of how banks can potentially create money.

Sorry if the way I explained it was confusing. I'm not talking about the original loan that was deposited. I'm talking about the loan that occurs as a result of the bank having considered an asset a loan that they ALREADY LENT OUT with that initial money.

 

[efiniti]

Sorry if the way I explained it was confusing. I'm not talking about the original loan that was deposited. I'm talking about the loan that occurs as a result of the bank having considered an asset a loan that they ALREADY LENT OUT with that initial money.

The bank can only loan out what it has.

Let me give you an example to see if things might clear up:

Let's say all banks have a 10% fractional reserve ratio.

Person1 decides to deposit $100,000 into a Bank1.

Bank1 sets aside $10,000 due to the fractional reserve ratio and decides to loan out $90,000 to Person2.

Person2 is actually using Person1's money and can spend in cash. He's now indebted to Bank1.

Person2 decides to deposit $90,000 to Bank2.

Bank2 sets aside $9,000 due to the fractional reserve ratio and decides to loan out $81,000 to Person3.

The cycle then continues. From my example, the bank just created $90,000 + $81,000 = $171,000 through loans which is actually more than the initial amount.

Now normally Person2 wouldn't just get a loan to go deposit it in another bank. Person2 would just spend it and the people that get the money he spends would deposit that back into the banks, but you get the idea.

 

[shocker315]

This is more technical... but basically spells it out straight from the "horse's mouth" so to speak. This publication was taken out of circulation by the Fed. Perhaps they felt it explained a bit too much.

BTW it is a direct source listed in the Creature from Jekyll Island.

http://reinventingmoney.com/documents/ModernMoneyMechanics.pdf


See pages 6-14 for explaination of the banks ability to expand the money supply through the multiplier effect. The graph on page 12 shows the effect pretty clearly.

 

[kyleAF]

Sorry if the way I explained it was confusing. I'm not talking about the original loan that was deposited. I'm talking about the loan that occurs as a result of the bank having considered an asset a loan that they ALREADY LENT OUT with that initial money.

The answer to your question is the multiplier effect that everyone's mentioned. Basically, for every $1,000,000,000.00 (Billion) in the economy, there is only $100,000,000.00 (Million) in reserves (assuming 10%... the number is actually lower than that). That means $900,000,000.00 (Million) does not actually exist. If a systemic bank run were to occur, that would mean A LOT of very disappointed people who thought they had money, but didn't. In fact, on average, 9 out of 10 people would not get their money, if all money were withdrawn en masse today.

The banks in toto act as one giant bank under the Federal Reserve system, so the reserves need not be physically passed between banks, and can exist in terms of notes of credit or deposit. Most actual banks where you would deposit your money have very little cash on hand. They satisfy the reserve requirement, but that doesn't mean they have the cash in that actual bank vault... it might be on reserve with their local Fed Reserve branch, which allows for easier sharing of reserves. This is why you'll see bank managers sweat bullets if you walk in and demand to withdraw 10,000.00 in certain denominations. In fact, if you have 10,000.00 in your account, you might find this to be a fun exercise in social mischief: withdraw it all in cash in 5s and 10s... walk out the door, then walk back in 20 minutes later and redeposit it as if nothing ever happened. The manager will likely be on the phone trying to scrounge physical reserves for his vault.

 

[AceNZ]

There is one thing that I am a little confused about. When a bank lends someone 100,000 from someone else's deposits and they consider that loan an asset because it will be paid back at a future date, they "create" money by lending money (via a check) they don't have, based on the promise of that original person to pay back the 100,000.

Loans are not made "from someone else's deposits". The money to fund loans is newly created when the loan is funded.

My question is: when the bank lends someone 90,000 (assuming 10% reserve requirement) because it considered the 100,000 debt to be an asset , the bank does not have the 90,000. So what happens when the person they loaned the money to via a check, actually spends that money? If that check is deposited in another bank, the original bank who did not have the 90,000 to begin with, has to come up with that money to give it to the new bank. How can the bank do this if it doesn't have it??

Let me try to restate what you're asking.

A bank starts with $21,111 in total reserves, which it keeps on deposit with the Fed in their reserve account. 90% of the reserves ($19,000) are considered "excess", and can be used as the foundation for new loans. However, new loans are not made from reserves -- they are newly created money.

Normally a bank wouldn't loan out more than 90% of their excess reserves at a time, because they can't be sure that the funds won't be withdrawn (see below).

However, in this case the bank makes a loan for $100,000, which results in an asset (the loan) and a liability (the money in the borrower's account). The loan would consume $10,000 in excess reserves (leaving $9,000) and would result in $100,000 in newly created money.

Next, the bank loans out another $90,000. The result is a new asset (the loan) and a new liability (the account). The remaining $9,000 in excess reserves are consumed, and there is $90,000 in newly created money.

If the borrower writes a check that's deposited to another bank, the check is processed through the Fed's check clearing system. The result is that the borrower's bank's reserve account at the Fed is debited for $90,000, and the destination bank's account is credited for the same amount. The borrower's bank is notified of the change, and debits the customer's account accordingly.

Since the bank doesn't have enough reserves in its account to pay the destination bank, then it would need to borrow the needed reserves from another bank through the Fed Funds mechanism, or from the Fed at the Discount Window (which requires pledging assets).

My second question is this: When is the money ACTUALLY printed/created? I know banks create money out of nothing by lending checkbook money. But when are the federal reserve notes ACTUALLY created?? I'm assuming the Fed is the only one who does this, right? When does it do it? Does it only do it when it needs to lend money to other banks and the government? At which point does the fed create "real" paper money instead of "creating" checkbook money?

The Bureau of Engraving and Printing (part of the US Treasury) prints FRNs and sells them to the Fed at cost (about $0.04 each).

When a bank places an order for FRNs with the Fed, money in their reserve account (which is held by the Fed) is exchanged for the FRNs at face value, and they are shipped to the bank. When a bank receives FRNs, they become "vault cash", and can be exchanged by the bank for checkbook money of their customers.

FRNs are not created or used for any other purpose. They are not used for lending, nor are they used by the government to pay bills, etc.

 

[scooter]

This is always a very misleading subject. Banks do not actually "create" money through the lending process. They just don't directly HAVE all of the money that they claim to have in your account. They only need to keep 10% (assuming that's the rate) in their vaults or on their books and the rest is loaned out. The people who say they wave a wand and generate new money are not being truthful. All loans come from the deposits they don't need to keep to maintain their reserves.

The multiplyer of money comes (as others have described) from a loan to someone becoming a deposit for someone else. For example, 90% of my deposit gets loaned to someone and the money gets deposited into the account of the company or person who sold the asset to the borrower. That money can then be divided again and loaned out again. So essentially the money multiplies some amount from the original deposit because it keeps getting put back in a bank and held as reserves.

This is still not entirely troublesome because eventually those loans get paid back and the multiplication is erased (or divided out). New money is created from the interest payments, which is the profits of the banks for providing their "service."

Think of loans from a bank as not new money being created, but as promises of future production. For example, a person wants to buy a house for $200,000. They don't have the money now, but they make a promise to the bank that they will have the money in say 30 years after a life's worth of actual production. The lending process allows banks to generate money now for production that will occur later. It's NOT money for nothing. It's money for future production.

The problem in the system is when rates are too low or reserve requirements are too low and people start borrowing beyond their limits. When the banking system allows this, they create far too much "future money" than will be made up by "future production." This is the point where we are at now. And rather than letting the banks and home owners take a huge hit for their mistakes, the Fed has decided that their goal will be to actually create the future money to bail those folks out even though their future production will not make up the difference.

The result is a big inflation boost to the folks holding "current money" and a benefit to those who need cheaper access to the "future money."

 

[Banana]

Ok, and how would banks prevent a run?

They blamed on gold standard, but some people in other threads said it was actually fractional reserve because bank didn't have the money in vault when too many people made withdrawal, leading to a run.

 

[scooter]

There is no way to prevent a run from happening. The financial companies are just banking on the very low probability of a widescale run happening.

This is essentially one of the supposed purposes of the Fed. To be the lender of last resort if a bank suffered a run on its capital. The Fed would step in and provide the liquidity needed to pay people who wanted out.

 

[Truth Warrior]

"It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." -- Henry Ford

 

[SilentBull]

The banks in toto act as one giant bank under the Federal Reserve system, so the reserves need not be physically passed between banks, and can exist in terms of notes of credit or deposit.

That is exactly the answer I was looking for and eventually found. I just wanted to make sure I understood that the bank DOES lend money it doesn't have! It does it in the form of credit.

 

[SilentBull]

Another question: If these banks are already allowed to "create" credit money, why don't they go all the way and allow them to create "real" paper money. That way, they would be immune to bank runs. They are already increasing the money supply with credit money. Why not just do it with paper money so that they don't have to worry about the "real" paper money not being there when someone wants it back?

 

[SilentBull]

The multiplyer of money comes (as others have described) from a loan to someone becoming a deposit for someone else. For example, 90% of my deposit gets loaned to someone and the money gets deposited into the account of the company or person who sold the asset to the borrower. That money can then be divided again and loaned out again. So essentially the money multiplies some amount from the original deposit because it keeps getting put back in a bank and held as reserves.

So here's the question that will clear everything up for me: When the money is deposited by person A, and 90% of that money is loaned out to person B, can the bank consider the loan to person B an asset EVEN IF THAT MONEY IS NOT DEPOSITED BACK IN THE SAME BANK?

This is exactly what the confusion is. Does the multiplier effect really only occur as a result of the loaned money being deposited again or can the bank pretend they have it just because someone will pay it back some day?

 

[AceNZ]

Banks do not actually "create" money through the lending process.

Sorry, that's not correct. Banks do create new money. If you don't believe me, perhaps you'll believe the Federal Reserve Bank of Chicago:

http://landru.i-link-2.net/monques/mmm2.html

The actual process of money creation takes place primarily in banks.

The people who say they wave a wand and generate new money are not being truthful. All loans come from the deposits they don't need to keep to maintain their reserves.

Banks don't wave a wand, but they do create bookkeeping entries. Loans are not made from reserves or from deposits. Loans are newly-created money. From the same document above:

Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions.

For example, 90% of my deposit gets loaned to someone and the money gets deposited into the account of the company or person who sold the asset to the borrower.

That is the myth, but it's not the way it works. If you make a deposit in a bank, part of your deposit isn't used to make new loans. Your account isn't debited when a new loan is made. Instead, a new asset (the loan) and a new liability (money in an account) are created. The result is newly-created money.

 

[scooter]

So here's the question that will clear everything up for me: When the money is deposited by person A, and 90% of that money is loaned out to person B, can the bank consider the loan to person B an asset EVEN IF THAT MONEY IS NOT DEPOSITED BACK IN THE SAME BANK?

This is exactly what the confusion is. Does the multiplier effect really only occur as a result of the loaned money being deposited again or can the bank pretend they have it just because someone will pay it back some day?

The money you deposit in a bank is not an "asset" of the bank. It is considered a liability on their books because they must pay you the money when you ask for it. The loans that they hold are held as assets, but they will have a depositor's liability on the other end to balance it out. The only positive marks on a bank's balance sheet are the interest payments, subtracting out all of the salaries they pay as well as interest they pay on money market accounts and other interest bearing liabilities.

Banks do NOT have the ability to infinitely create money and create for themselves an infinite profit. At some point when they have loaned out too much, the assets (loans) are not enough to cover the liabilities (deposits).

This is when you start getting banking issues like we have today. And believe me, the banks have lost a lot of money also, because they've had to erase bad loans (bad investments on their part) in order to maintain a stable amount of assets to cover the depositors.

 

[AceNZ]

Ok, and how would banks prevent a run?

Bank runs can't be 100% prevented. Their occurrence can be minimized by encouraging confidence in the banking system.

Another question: If these banks are already allowed to "create" credit money, why don't they go all the way and allow them to create "real" paper money. That way, they would be immune to bank runs. They are already increasing the money supply with credit money. Why not just do it with paper money so that they don't have to worry about the "real" paper money not being there when someone wants it back?

Paper money is part of a bank's reserves. If banks could create paper money, then they could create their own reserves -- which is something that isn't allowed by the current banking system. That is one of the aspects of the system that is designed to prevent banks from creating too much money.

So here's the question that will clear everything up for me: When the money is deposited by person A, and 90% of that money is loaned out to person B, can the bank consider the loan to person B an asset EVEN IF THAT MONEY IS NOT DEPOSITED BACK IN THE SAME BANK?

When money is deposited by person A, 90% of it is not loaned out to person B. Instead, an amount of money equal to 90% of person A's deposit can be created and then loaned by the bank.

When a new loan is created, it consists of an asset (the loan) and a liability (the borrower's account). If person B moves the money in their account to another bank, the asset (loan) remains with the original bank.

This is exactly what the confusion is. Does the multiplier effect really only occur as a result of the loaned money being deposited again or can the bank pretend they have it just because someone will pay it back some day?

Loans are created based on reserves, not based on assets such as other loans.

It sounds like the piece you might be missing is that when a borrower moves funds from the lending bank to another bank, the reserves of the lending bank (but not the system as a whole) are reduced, which then diminishes their ability to create new loans.

So the answer to your question is that the multiplier effect for a single bank does depend on the money being deposited back in the same bank. However, since the entire banking system behaves as though it was a single bank, then as long as the money is deposited into some other bank in the system, the multiplier effect still applies.

 

[Banana]

Bank runs can't be 100% prevented. Their occurrence can be minimized by encouraging confidence in the banking system.

Even if all banks didn't use fractional reserve at all?



As for the banking system "creating new money" to back the loan, is that same as expanding the credit, something that is impossible?