When the financial crisis erupted full force in the second half of last year, there was panic all round. This and the next posting will focus on the banks' contributing role in the crisis. Before going into details, one has to understand the basic principles on which the banking system operates.
Students at the A-level are taught about "multiple deposit creation," It is the most rudimentary money creation mechanism for banks, which if administered properly serves the economy and public at-large very well. In the deposit creation process a bank accepts deposits and lends them out. But almost every lending returns soon to the bank as a deposit and is lent again. In essence, when people borrow money they do not keep it at home as cash, but spend it, so this money finds its way back to a bank quite quickly. It is not necessarily the same bank, but as the number of banks is limited (indeed very small) and there is—or was—a very active interbank lending. In terms of deposit creation the system works like one large bank.
Therefore, the same money is re-lent over and over again. If all depositors of all banks turned up at the same time there would not be enough cash to pay them out. However, such a situation is highly unlikely. Every borrower repays his loan and pays interest on it. In principle, the difference between a loan and a deposit interest rate is a source of the banks' profit. Naturally, banks have to account for some creditors that will default and reflect it in the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it, the banks possess their own capital to provide security.
Fundamental to this deposit creation principle is the percentage of deposits that a bank lends out. The description above used a 100% loan-deposit ratio, meaning that all deposits are lent out. In traditional banking this ratio was always below 100%. For example, a conservative bank, lets called it Safe Bank, intended to lend out 86.5% of every deposit. For every $100 deposited, the bank lent out $86.5, while the remaining $13.50 was retained in the banks reserve with a small portion of it kept in the Central Bank.
Therefore, the same money is re-lent over and over again. If all depositors of all banks turned up at the same time there would not be enough cash to pay them out. However, such a situation is highly unlikely. Every borrower repays his loan and pays interest on it. In principle, the difference between a loan and a deposit interest rate is a source of the banks' profit. Naturally, banks have to account for some creditors that will default and reflect it in the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it, the banks possess their own capital to provide security.
Fundamental to this deposit creation principle is the percentage of deposits that a bank lends out. The description above used a 100% loan-deposit ratio, meaning that all deposits are lent out. In traditional banking this ratio was always below 100%. For example, a conservative bank, lets called it Safe Bank, intended to lend out 86.5% of every deposit. For every $100 deposited, the bank lent out $86.5, while the remaining $13.50 was retained in the banks reserve with a small portion of it kept in the Central Bank.
In practice, this ratio was the bank's control tool on deposit creation process, ensuring that the amount of money supplied to the market was limited. According to this principle, for every $1 deposited, a bank lends out $0.865. After only five cycles the amount is reduced to below $0.50 and after 32 cycles it is below 1 cent. If this process continued forever the total amount of money lent out of a dollar would be less than $6.41. With every cycle of deposit creation, a bank built up its reserves, ultimately collecting almost entire $1 for every $1 initial deposit. Added to capital repayments, interest payments on loans and the bank's own capital base this system ensured that that there was always enough money in the bank for every depositor.
For years banks worked as a confidence trick—the notional value of deposits and liabilities to be paid by the bank exceeded the value of money on the market. Since only a very small number of depositors demand cash withdrawals at the same time and almost all these paid-out deposits are deposited in a bank again quickly the banks ensured that every depositor got his money while circulating money in the economy and stimulating growth. The loan-deposit ratio was a self-regulating tool. As with every cycle it multiplies, the reduction of amounts created decreases exponentially and quickly. The faster the deposit creation cycles occur the faster the reduction progresses, thus accelerating with every cycle. The total "created" from the original $1 deposited in a bank is a finite, not more than $6.41 at the 86.5% loan-deposit ratio, backed by nearly $1 reserve. It is an inverted pyramid scheme starting from a fixed initial deposit base and quickly reducing through deposit creation cycle to zero.
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