Posted on 06/25/2011 10:50:30 AM PDT by Nanomaker
The Mechanics of Fractional Reserve Banking
Imagine Jack wants to by Jill’s house for $100,000 and he has no money to buy it so he goes to his local bank and asks for a mortgage which is approved. The bank will ask Jack for a promissory note, an IOU, for the $100,000 and once he signs it, they open an account in which they create from nothing $100,000 for Jack in exchange for his IOU. That $100,000 is a liability for the bank, their asset is the IOU. The bank just ‘created’ $100,000 which is backed by the good faith of Jack to pay it back as well as the deed to the house he bought. Now the bank loans that money to Jack, with compound interest. The interest is the fee the bank charges for monetizing the debt. Jill would not have wanted an IOU from Jack for the 100K, so the bank did him the service of converting his IOU into dollars, and for this service they charge him interest. As Jack pays down his mortgage principal, the value of the IOU will be drawn down as well, until all the money ‘created’ is destroyed, and the IOU is worthless.
The money never existed before Jack signed his IOU. It was created entirely and only as an expression of his promissory note...
(Excerpt) Read more at thecactusland.com ...
Well...not quite. The bank takes in an IOU from Jack, which is an asset on their books. However, to obtain that asset, the bank must take $100,000 in cash from the vault and give it to Jill. There is no creation by the bank. It simply exchanges one asset (cash) for a different one (Jack’s IOU).
For later.
And as you know, it’s even worse than that. The bank has to raise the 100k that was in the vault in cash as deposits which they cant raise unless they’ve got $10 in equity to start with. It costs to a lot to get started up in the first place. We shouldn’t let the tried and true Goldsmith’s principle of actual banking be besmirched by the phony Fed methods. A bank earns a spread on real money, not a windfall on fake money.
No, the $100,000 is created when that IOU circulates like cash. You have the cash circulating and you have the IOU circulating (though generally at a discount from the face value because of the risk).
The only problem I see with the OPs point is that he limits it to banks. ANYONE with any credibility can create money by taking in IOUs in exchange for cash and then using that credibility to make the IOUs circulate.
This is why CONFIDENCE is the key to the economy. In uncertain times, pieces of paper stop circulating and everyone loses. Someone needs to remind turbo tax Timmy Geithner of this fundamental law of economics.
No. Jill takes 100K cash.
The Bank, has an IOU worth approx 2.5 times the 100K,(Risk/reward) which is then serviced by capital created by Jack trading his goods and services for CASH, which goes back to the bank...
It’s a poor example for the point they’re trying to make.
Exactly. At some point in such a transaction real cash changes hands to Jill and goes off the bank’s cash reserves.
Jack’s note replaces the cash as an asset which now includes the interest attached to the note, giving the bank a net profit on paper.
I don’t know how these crackpot ideas get started.
The root fallacy of supply-side economics.
The repaid funds are not destroyed. They are quickly loaned out again. The result of any increase in the banks' authority to create new credit is a general increase in the money supply. The same ill effects expected from printing new money will occur.
And a second asset, a lien on the real estate to back up the IOU.
Mark
Correct. The flaw in the analysis is the source of the money, the depositors (the vault cash), which has been totally ignored. The bank pays the depositors an interest rate on the deposits (a bank liability)and lends the money at a higher rate booking the loan as an asset and taking the spread between the two interest rates as income. They can't lend the deposits dollar for dollar because they have to place a fraction of the deposits in their reserve account with the Fed. When the borrower spends the money, for whatever reason, the receiver of the funds then deposits it back into the banking system in the form of additional deposits and the whole process starts over again. By this means the original depositor dollar is "multiplied" several times (creating money) depending on the reserve requirement the Fed has in place at the moment.
What bank have you ever seen do that? Every bank I've ever dealt with issues checks when they make loans; and they usually only make loans to people who have accounts with them so they know the check will be deposited with them. When Jack pays Jill the two banks will simply adjust their ledgers but no cash will ever change hands. The only thing that happens at a bank when loan is made is they change some numbers in their records. Of course the banks are creating new money when they do this. The ability to create new money on demand is the whole point behind fiat currency. There is no other reason to have fiat money.
Google "Fractional Reserve Banking". The banks lend many times the amount of reserves they actually posses. Prior to the current crises they could lend ten times their actual reserves. Now it's higher. Where does that other 90% come from? They create it out of thin air.
Actually, that's not true - banks have either there own funds (capital) or customer funds (deposits) to lend to borrowers - it's not money that never existed. Plus, on the banks books, the loan is an asset with deposits being liabilities - almost the opposite of regular accounting.
The problem surfaces when customer funds are used (to lend) on a leverage basis that far exceed capital (the banks on funds) - when those loans are not paid back, the bank must use its own funds to offset losses - not customer funds, of course.
This article is therefore, nonsense.
correct. The article is misleading (wrong)
Exactly. The false premise is that the house magically appeared without cost AND that the previous owner does not get paid.
They actually have introductory college courses in this sort of thing, that freshman and sophomore economics majors take.
“Robert is a late-blooming anarchist” - Oh, The Man is holding him down. Whenever someone writes about labor as capital, I remember our good old friend Karl Marx. This is just another marxist wearing a Ron Paul button.
I was unclear. Bank lends Jack $100k and demands $110k in return (interest due to inflation, risk). They temper their risk by demanding an asset in return (the house that the mortgage is on).
Bank either sits on that (olden days of savings and loans where banks sat on mortgages) OR they sell that note to person B for LESS than $110k to someone else. They get less than the initial $110k they demanded but also reduce greatly the amount of time they are exposed to the risk.
Person B now has the same option as the bank: sit on the note and collect or pass it on to person C. As long as the note circulates, it acts like cash. That was my only point.
“Robert is a late-blooming anarchist” - Oh, The Man is holding him down. Whenever someone writes about labor as capital, I remember our good old friend Karl Marx. This is just another marxist wearing a Ron Paul button.
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