Fractional Reserve Banking

POSTED BY vj-manutdfan ON January 3, 2012 2:52 pm COMMENTS (3)

Hi ,

I saw this documentary Zeitgeist and it was about how world’s banks are duping people with Fractional Reserve Banking(banks lending money which they dont have and charging interest on it).Its like creating money out of thin air.If a bank has 100 rupees deposit they can loan 1000 even if they dont have it.I think it is a fraud.What is your view on this?I was shocked when i learnt about this.I think this system of money lending makes our money to lose value and this creates lot of inflation.This is what created the 2008 Recession in america because the money created out of thin air was backed by real estates,when real estates lost value everyone lost money big time.this system only serves the banks and public lose thier money’s worth.

Thanks,
Vijay

Thanks,

Vijay

3 replies on this article “Fractional Reserve Banking”

  1. Vijay – Fractional-reserve banking is as old as Banking itself. Reserves were made mandatory only at the turn of last century The US Federal Reserve was created as a response to a crisis where large amounts of money had to be withdrawn in 1913.

    Fractional-reserve would not directly amount to fraud because for every time the new money is created there is possibly an asset backing it.

    Assume Cash Reserve Ratio is 8%:

    Step A: I deposit Rs. 100 in the bank. Bank keeps 8 as reserve with RBI and lends out 92.
    Step B: This 92 is given for a home loan. Home buyer takes 92 and gives to home builder. Home builder deposits this 92 in their account. Now Bank has 92 as ‘new’ deposit.
    Step C: Bank will retain 8% of 92 = 7.36 and lend out 84.64, say as a vehicle loan. The Vehicle dealer will get this 84.64 and deposit this in the Bank and so on and so forth – now you get the drift.

    The initial Rs. 92 loan has the backing of the house
    The next loan of 84.64 has the backing of the vehicle etc.

    When government feels there is more money in circulation they will increase the Reserve rate so the amount of money flow decreases. As long as Banks remain solvent, all participants are given the same deal so this does not NECESSARILY lead to Inflation.

    [You may see the initial Rs. 100 baloons to Rs. 1200 loans (fresh money:)) in 55 steps.]

    The main reason why the economic crisis evolved, simply put, is that Banks did not follow the 3C’s of lending – very basic ones. Credit, Capacity, Collateral.

    – They gave loans to people who had bad credit
    – They considered only the current capacity to pay (initial teaser loans at 0% for 2 years, for example)
    – They estimated that the collateral (Real estate prices) would keep rising for ever

    Thus they violated all 3 Cs of lending.

    To add to the problem they sold the future stream of income as well in tranches. Thus an Bank asset created (by giving loans) by violating the 3 Cs, when it should have been considered junk, was divided into tranches — “Very Good, Good, Average, Bad” etc. and people were gung-ho on these Mortgage backed securities (MBS). Some tranches of the bad loans started to have even a AAA rating. All these started in 2005/2006 and in 2 years from then on (2007/2009) people had a situation where they had to start paying the morgages when the first defaults started to appear. The people who created MBS were certain that this would be a passing phenomenon and they will not be impacted.

    The problem is – if I am an honest person and miss an occassional payment – I am trustworthy. But if I default over and over again I am NOT TRUSTWORTHY. Banks lent money to such people.

    SO the defaults went into the rise and even AAA rated securities started to default! This had a dynamo effect because people were left with assets that were now worthless (MBS). Banks received back lesser and lesser payments so there was only lesser to lend out. So all the reserve banks across the world reduced reserve ratios so money supply can increase and they created/pledged funds to ‘bailout’ banks. Citibank is still one of those “too big to fail” banks because a fail of citibank, for example, will have a ripple effect – one reason why US, inspiteof public outcry, bailed out all the banks (So did Europe and most others).

    1. vj-manutdfan says:

      Thanks a lot for the detailed reply,but my understanding is that suppose a bank gets 100 rupees as deposit it uses the full 100 as reserve(assuming 10% reserve) and it lends 900 rupees which it does not physically possess(creating money out of thin air).so having 100 as deposit they loan out 900 which it does not exist and this multiplies to a huge thru a chain of transactions.Since lending within banking can be done at a very low rate it helps this process.this is what i understood from various sources on the net.pls correct me if i am wrong
      Thanks,
      Vijay

      1. Vijay – What the Bank does really is not creating money out of thin air (Creating money would correspond to hard currency). But the money multiplier facotr just gives this effect.

        When every loan is paid off the bank keeps destroying the ‘multiplied’ money but will again lend it again so this is really a perpetual cycle.

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