Central banks aren't the only entities that are allowed to create currency out of thin air. Regular banks can do this too. However, they're required to have some capital themselves. In order to print currency, they have to have some fraction of this as deposits from their clients.
The procedure is similar to that of central banks. Currency created has to go into circulation. Currency returned has to be removed. Only the profit can be retained.
The way this is done is through bank loans. If the fractional reserve required by law is at 10%, a bank has to have $10 deposited in order to extend a loan of $100.
The loan of $100 is created out of thin air. The number is typed into the customer's bank account. The $10 in deposits is not directly part of the loan. It serves merely as security.
If the loan is at 3% for a year, the customer has to return $103 after a year. The bank deletes the $100 it created. Only the profit of $3 is kept.
This translates into a profit of $3 on the $10 the bank had as deposits. That's a 30% profit.
Fractional reserve banking has enabled the bank to tenfold its profit from 3% to 30%.
The flipside of this is that banks risk tenfold losses. If a loan of $100, based off of $10 in deposits, is returned only in part, the bank suffers a hit to its reserves, i.e., its deposits. If only $90 of the $100 loan is returned, the bank must still write off $100.
Unlike central banks, regular banks cannot ignore losses. Regular bank losses have to be covered by reserves. This means that fractional reserve banking isn't without risk. However, central banks will step in and help out banks that get into trouble by buying bank assets at inflated prices. A bank in trouble may own some government debt that a central bank can by to recapitalize it.
Returning to our example, we can imagine a bank loan of $100 based off of deposits worth $10. This loan defaults and only $90 is returned. The bank is now without its $10 reserve, held in the form of deposits.
Without reserves, the bank has become insolvent. It can no longer extend credit. However, it may still hold some asset that can be bought at an inflated price. Alternatively, a loan can be extended by the central bank. Cash injection of some kind can be arranged. There are many ways to make the bank solvent again.
The rescue procedure takes the loss off of the bank in trouble. The loss is transferred to the central bank which is allowed to run at a loss without consequence. But, as pointed out in my post about central banking, losses shouldered by central banks correspond to currency without any anchor to anything of value. This diminishes the value of the currency as a whole.
Fractional reserve banking, supported by central banks, is a system that allows banks to make outsize profits on their banking operations with little risk to themselves. When times are good, bankers make money. When things turn sour, the currency takes a hit without any great loss to banks or central banks.
The ultimate bag holder is the average person who sees the value of their salaries and savings evaporate mysteriously as the currency loses its value.
 |
| Federal reserve note |
No comments:
Post a Comment