Sunday, 13 April 2008

Fractional reserve banking for beginners (2)

Maybe it's easier to explain this with balance sheets.

On Day 1, I set up Wadsworth Bank Limited with £50 of my own money, which I stick into the cash-box in coins and notes. On Day 2, WBL lends the money to Mr A who toddles off and buys a house worth rather more than £50 (that house being WBL's security).
By Day 3, I notice that other banks are taking deposits, which enables them to lend out far more than WBL can. I assume that a Tier One Capital Ratio of one-eighth is a sensible figure, and can thus lend Mr B £400 to buy Mr A's house. WBL's balance sheet duly records an asset of £400 (what Mr B has to pay back to WBL), and a liability of £350 (money that Mr A can withdraw at any time, being his sale proceeds of £400 less the £50 that he owed WBL from Day 2).
This is all rather splendid, as Mr B is paying WBL 7% interest (£28 per annum) and WBL is only paying Mr A 6% interest (£21 per annum) so WBL is making a handsome gross profit of £7, or 14% return on the £50 I originally invested.

On Day 4, I take most of the afternoon off to enjoy a splendid lunch at my Club. On my return I am horrified to see that my fresh-faced young mortgage salesman has been rather too enthusiastic in granting new loans. He has financed the sale of Mr D's house to Mr C for £400. WBL's balance sheet looks like this:
"But look, Sir" he enthuses "We can earn £56 a year interest on our loans to Messrs B and C, but we only have to pay £45 interest to Messrs A and D, so our gross profit will rocket to £11 a year, a 22% return on capital!".  I explain the Basel capital requirements to the young fellow and he is briefly crestfallen. "Ah, but Sir" he suggests after a few minutes head-scratching "We could lend the bank's good name to a completely independent company incorporated in the Channel Islands, transfer Mr C's loan to it and invite Mr D to withdraw his deposit and use it instead to finance that company. We could even offer him a slightly higher interest rate of 6.5% to compensate him for the higher risk".

After discussing the matter, Mr D agrees and by Day 5, WBL's balance sheet is again showing a healthy Tier One Capital ratio of one-eighth.
Wadsworth Bank (Jersey) Limited is not licensed as a deposit taker in the UK, and so has no need to comply with such petty requirements.
As WBJL is a totally independent company, WBL is not required to include its figures in its own balance sheet, and because Mr C is paying 7% interest and WBJL is only paying 6.5% interest to Mr D, WBJL is generating a further £2 gross profit each year out of thin air, which my mortgage salesman and I share as an annual bonus. Splendid!

Unfortunately, Mr D's solicitors insisted that under the terms of his loan to WBJL, WBL (as sponsor) have to guarantee any shortfall should Mr C be unable to meet his commitments, or should Mr C's house turn out to be worth less than the £400 purchase price ...


Anonymous said...

Very interesting. However, I'm probably being dense but why does a drop in the value of Mr C's house impact upon the bank? Certainly it affects what the loan is secured against and what value can be swiftly reclaimed in the event of non-payment but negative equity, as long as affordable, is surely Mr C's problem?

Also can WBL Jersey be guaranteed by WBL and not come under the tier one capital ratio rule? I know it is offshore but surely such guarantees count as liabilities of WBL, which is bound by that rule. please.

Thirdly, what is it you do for a living, Mark? You obviously know lots about finance, you live in London and I remember you said you earned "loadsamoney" so I'm assuming something City-esque.

Mark Wadsworth said...

If Mr C can't pay his mortgage (and this is what always triggers the crash in the end), then WBJL (under pressure from Mr D) call in the guarantee from WBL, and WBL then have to force the sale of Mr C's house to get as much as it can and minimise its losses.

WBL's solicitors and accountants have assured me, after poring through hundreds of pages of regulations, that provided the guarantee is worded in a certain way, there is no need for WBL to disclose the latent liability to WBJL - a bit like Northern Rock/Granite, or Enron and its myriad SPV's or indeed the taxpayer and Northern Rock/PFI/Railtrack (cont. page 94).

PS I am a humble accountant, nothing to do with 'The City'.

knirirr said...

But, I expect that this sort of thing does look very confusing indeed to a lot of people, which might explain why they could be swayed by the sort of argument here:
N.B. I have nothing to do with this, but know people who do, and thus get to hear about it from time to time.

Anonymous said...

Interesting but you don't explain how FRB increases the money supply.

Mark Wadsworth said...

William, that depends on how you define 'money'. If you only look at one side of the equation, then you can argue that it does.

If you look at both sides, and net off assets and liabilities, then none of the transactions I have mentioned make the slightest difference. The net value of all money in the world minus the corresponding liability is by definition nil, nothing, zero zilch, nada.

Taking the extreme view, I could agree to sell you a pencil for £1 trillion. Has this transaction affected the money supply? Has it affected total wealth in the economy? Nope.

If we were to find a bank dumb enough to give you a £1 trillion mortgage secured on the pencil, then that is of course reckless lending, that is a different topic - that is looking at the asset price bubble side of things, not the credit bubble.

Anonymous said...

There are two meaningful definitions of money in the UK. The first is narrow money (created by the bank of England) the second is broad money which is the sum of narrow money plus bank credit (created by commercial banks). The difference between full-reserve banking and fractional-reserve banking is that only the latter has the ability to create bank credit. Can you explain why (even though they loan money) full-reserve banks cannot increase the money supply and yet fractional-reserve banks can do so?

Mark Wadsworth said...

The Bank of England does not create money, and never has done. It prints bank notes, which say "I promise to pay the bearer on demand the sum of £...".

In other words, for every £5 note in your pocket, the taxpayer has a corresponding liability of £5. Given that people with fivers in their pockets and taxpayers are largely synonymous, that asset/liability nets off to nil. So much to narrow money!

In my examples, what do you define as 'bank credit'? Take the extreme case, WBJL's opening balance sheet on Day 5 - Mr C owes WBJL £400 and WBJL owes Mr D £400. Which half is credit that has been created? What if Messrs C & D enter into a civil partnership, pool all assets and liabilities and waive mutual entitlements? What has happened to total wealth? Nothing whatsoever. Ergo, there is no such thing as bank credit (once you minus off bank liabilites) either.

So this whole 'broad money' and 'narrow money' is a smokescreen used by dumb people trying to pretend they are clever. As long as the borrower can afford to repay what he owes, the whole banking system is A Very Good Thing that oils the wheels of the economy.

The problems only arise when banks lend money on the basis of over-inflated and unsustainable asset values -that's when the trouble starts!

Hence my enthusiasm for a 'Property Bubble Tax' and so on... (cont. page 94)

Anonymous said...

Just because we use double-entry bookkeeping doesn't mean it isn't possible to increase the money supply. Does this answer your question?

Mark Wadsworth said...

"money supply" is a totally artificial definition.

Now you answer my question, if you agree to buy a pencil from me for £1 trillion, have we increased the money supply?

Anonymous said...

"money supply" is a totally artificial definition.
Because we use double-entry bookkeeping?

Now you answer my question, if you agree to buy a pencil from me for £1 trillion, have we increased the money supply?
Not unless I have borrowed the money from a fractional-reserve bank.

How about you answer a question of mine (form earlier) "Can you explain why (even though they loan money) full-reserve banks cannot increase the money supply and yet fractional-reserve banks can do so?"

Mark Wadsworth said...


With Full reserve banking WBL is restricted to lending out thee £50 in coins and notes that it started off with (Day 1 and Day 2). It cannot take deposits and lend them out again. It cannot make loans over and above its own capital and reserves.

If we define 'money supply' as 'coins and notes' plus 'total deposits at banks', the money supply is £50. It cannot increase beyond that.

Once WBL stumbles across this idea of fractional reserve banking, 'money supply' (as defined) goes up to £400 (£50 coins and notes that are still sloshing around, plus the £350 that Mr A has at the bank on Day 3).

And once WBL throws the idea of prudent lending out the window, money supply goes up to £800 on Day 4 and 5.

Anonymous said...

So my understanding is that there is a trade-off between stability and flexibility. Full-reserve banking, whilst stable, is totally inflexible, and suggests sluggish growth, if not stagnation, whilst fractional reserve banking requires a bit of a balancing act so as to be more like WBL and less like WBJL.

If the credits and liabilities of fractional reserve banking net off to zero, then does that mean fractional reserve banking doesn't influence inflation?

Mark Wadsworth said...

PT, it's not fractional reserve banking that's the problem (provided they stick to a sensible Tier One Ratio like one-eighth) it's reckless lending and borrowing on the basis of inflated asset values and wild guesses of future income that causes the problems, including inflation.

Anonymous said...

The money reformers frequently cite the Channel Islands as an example of non-debt money. It is claimed the govt. issues notes directly instead of borrowing money and then issuing notes. My research indicates this practice ceased in 1836. Since you are from England, do you know this history?