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What industry secret are you aware of that most people aren't?
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this post was submitted on 24 Jun 2024
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Fractional-reserve banking. Most people have no idea what it is, probably a good thing. You could argue that it's not a "secret", but most people aren't aware of it regardless. I don't think most people would be fond of grinding for $15 an hour if they knew banks could just lend money they don't actually have. https://en.wikipedia.org/wiki/Fractional-reserve_banking
I didn't know what it was called, but I think it's common knowledge at this point that banks don't actually have all our money. Pretty sure we (Americans at least) found that out during the great depression when everyone was trying to withdraw their money at the same time.
And to be fair, there's stuff in place to stop bank runs now. If a bank goes under, the government takes over until it can find a buyer, so your money stays safe.
That has already become outdated, at least according to some economists.
Banks can just create loans out of thin air without having to check their own reserves first.
https://en.wikipedia.org/wiki/Money_creation#Credit_theory_of_money
So if I understand correctly, the reason it's outdated is not because we don't need those pesky banking regulations any more, but that it has been found that banks will just take out their own loans to cover the reserves they need from the central bank, so they can just lend as much as they want, no seatbelts. And the central bank will never run out of loans to give, since they have insane reserves, in their own currency it is technically unlimited.
So money is not really the thing we think it is. If banks overextend themselves and fuck up, the only thing we'll see instead of failing banks is runaway inflation in the consumer and asset (housing) markets. Wonder where I've seen that.
I'm always surprised how few people know about this. The banks are literally gaining interest on money they never had. It should be illegal.
It's a little more complicated than that. Without fractional reserve banking, the economy would be more difficult to control. I would recommend a quick macroecon video or something.
I myself took quite a while to really understand why this was legal even during my macroecon credit. It actually makes sense when you think about it.
I've been thinking about it and it still doesn't make sense. I'm a scientist, not an economist, so it's wildly out of my wheelhouse. Would you mind pointing me in the right direction?
Here's where I'm hung up. Let's assume a 10% fractional reserve and, for the sake of simplicity, just one bank and a dramatically simplified deposit/loan scenario, just to minimize the number of hypothetical people and transactions.
Person A deposits $1000. Bank lends $900 to person A which is sent to Person B.
Person B deposits $900. Bank lends $810 to person B which is sent to Person C.
Person C deposits $810. Bank lends $729 to person C which is sent to Person D.
Person D deposits $729. Bank lends $656 to person D which is sent to Person E.
Let's stop there. So we have one initial deposit of $1000, which has resulted in an additional $2,493 in deposits ($3,493 in total) and $3,095 in loans. The bank is now receiving payments, plus interest, on over 3x the amount of actual money it was actually given. To me, it seems like the bank is figuratively "printing money" and gaining interest on it. Nothing I've read on fractional reserve lending has suggested this is incorrect.
Halp!
I'm neither lmao. We just had a macroecon credit in my degree program, which is where I learnt about this.
Now onto this... You're kinda right but kinda wrong in that fractional reserve banking "creates money". Here's a way to think about putting your money in a bank. By opening a bank account, you are not putting your money in a vault. You are loaning it to the bank. The bank then loans it out to another person, who then "loans" it to another bank. Hence, fractional reserve banking is a natural side effect of this logic. What would happen if we had a 100% fractional reserve? Well, the bank wouldn't be able to loan your money to anyone then. It would essentially become a vault.
Therefore, fractional reserve banking is necessary to make loaning money possible. Loaning money is necessary for obvious reasons.
Now to the "creating money" part. Sure, at the macro scale, you get a lot of virtual money in the economy. At the micro level though, individual banks aren't creating money. They still have to get the money that they've lent out back. If they fail to do so, they're going to go bankrupt. Banks would never go bankrupt if they could print money on a micro scale, right?
Okay, so now let's zoom out back at the macro scale. Now, you can accelerate or decelerate the economy by controlling the ratio of money that is in circulation vs money that is out of circulation. It's simple- more money in economy = more demand = more profits = more investments in increasing supply to be competitive = more work done. If this demand however drops, profits drop, and increase in supply drops. This is very bad as no work will be done. However, if demand increases too much for essential goods (like food, housing, etc.), it is bad as it can cause problems for people till the supply can catch up. The economy is going too fast in such cases.
Now, you can slow the economy down by many ways- by increasing interest rates, increases the fractional reserve and so on. This way, less people are going to borrow (you just reduced demand by this simple technique). You now reduced demand in your economy and slowed it down. The opposite can be done to speed the economy up.
Holy shit. I get it! That's a great explanation and I really appreciate your taking the time to type it all out. I'm glad we don't have Lemmy medallions to award but, if we did, I'd give you one. I now see how a 100% reserve requirement, i.e., all deposits completely backed in cash, would entirely change banking.
The only thing that feels weird to me is the virtual money the bank creates doesn't seem go away once it's paid back. For example, if a mini bank only had $1000 and lent $900 with a 10% reserve, they'd end up with $1900 once the loan is repaid (ignoring interest). Or does the $900 they lent create a -$900 for the bank that is cancelled through repayment?
While the loan is outstanding the bank would only have $100 ($1000 - $900 loaned out), so when it is repaid they go back to $1000.
Correct (effectively). Remember how you are "loaning" money to the bank by depositing money in ur bank account? Think about it - if someone loaned you money, and you spent it somewhere, would you have 0 money or would you have negative money (in terms of cash)?
Interestingly, this is why Nordic countries technically have one of the highest wealth inequalities in the world. It's because they easily get home loans as the government acts as their guarantors. Here's a vid to explain this.
Awwww thankssss
Well, they have it in the sense that somebody deposited it with them, and they have some fraction of it held ~~in reserve~~ to cover withdrawals.
Edit: Well, in the form of capital, so that's actually the wrong terminology.
Yes, they still have it. It's just not in cash.
Fractional reserve banking works because most people don't need all their money as soon as they get paid. Most businesses keep some money in the bank too. Banks have a required percent of deposits that they must keep on hand to allow these withdrawals. And if they run low on cash, they just borrow money for a day from other banks (literally just one day). The US government can adjust the percent of required reserves or the overnight lending rate to keep banks from lending too much money out.
Banks use this money to loan to businesses or people buying houses. It works well because whenever the money is loaned out it is used for a purchase and just redeposited in another bank. A percentage of that money is retained by the bank and the rest is loaned out again. And again and again. This way money is "created" when people buy things in the economy.
This seems like an already failed banking model which places lenders at the front of the pack and will lead to only larger asset bubbles. Japan's Kiretsu system of banking led to banks taking out loans to cover up their own investment losses as they had put their money into an asset bubble which collapsed. Banks then committed wholesale fraud by disguising such losses on their books. The Japanese government then used quantitative easing. They create money ex nihilo, swap the money for a t bill, then they bought the toxic assets by giving t bills to the bank. The bank doesn't sell the t bill, they merely collect interest on it.
The main effect is a system in which bubbles are never popped and consumers suffer a declining standard of living in order to keep asset prices high.
I mean, there's all kinds of math that goes into making modern fractional reserve banking a self-correcting system with a reasonable theoretical basis, but I'm guessing you've made up your mind already.
Sorry I appreciate your comment. So I read (erroneously?) that central bankers had done away with the reserve ratio in the fractional reserve banking article. And that just seems like a reckless thing to do given how prone to bubbles our economy is.
One of the main points in "this time is different" is that despite the math, we are experiencing greater and greater asset bubbles and at no point in world history were things actually different.
In a lot of jurisdictions there's no minimum reserve requirement anymore, in cash. It's not really a problem, because at the big bank level money on paper is barely real. If they need more, they can almost just ask. They do have to have a certain minimum amount of capital, though, which can take a number of forms.
I mixed up my exact terms a bit earlier, sorry about that. I'm not a professional macroeconomist, I only know enough to know they're not completely full of shit.
I'm not sure what you mean by this. If things aren't any different from before, how can we have bigger and bigger asset bubbles? I don't know that we do, really. The niche for bear investors is very full, if something's overvalued by the whole market you and me won't know either.
Everything you wrote lined up with the article on wikipedia so if you got something wrong I didn't see it.
I'm referring to the book "This Time Is Different: Eight Centuries of Financial Folly" the title of which mocks the oft repeated defense of bubble investors:
https://www.nber.org/system/files/working_papers/w13882/w13882.pdf
But their point is that every single asset bubble ended up popping, despite the protections instituted by banks and governments. They also point out that the bubbles have been getting bigger and bigger
It's not a "failed model". Japan has issues because banks committed fraud and disguised non-performing loans. There are strict rules in the US about when assets must be "marked to market". Plus the US has a growing population because we let in immigrants, which supports a growing economy. We are not close to having problems like Japan.
There are also many levers the Federal Reserve can pull to keep banks in check. As I said, they can raise and lower the reserve requirement and raise and lower the overnight lending rate. This can prevent banks from going nuts with lending, but obviously can't prevent all asset bubbles. Sometimes people are just irrational.
Frankly you seem to be using a bunch of big words and implying that they make a point. Using "ex nihilo" instead of "from nowhere" clinched it for me. Also, you spelled "keiretsu" wrong.
Thanks for the reply. I hope you don't let my spelling or use of ex nihilo (this is the exact language used by the fed and economists, I didn't just make it up) turn you off, because at a policy level they are pursuing policies that keep real estate prices high.
You think that high interest rates keep real estate prices high? That's the opposite of what happens with high interest rates. People can't afford to pay as much when interest rates are high (like they are now).
I'm judging solely based on your comments. You are using big words incorrectly. You clearly don't understand what you're talking about if you think high interest rates keep real estate prices high. Also, your description of Japan's economic problems are disjointed and confused, not correct.
I'm not sure what you mean, but no, I don't think that and I didn't write that but i can understand the confusion because it's not well known how QE works. Some forms of QE prevent crashes. The Fed can achieve this by taking the bank's failing debt instrument off the books, and swapping it for a t bill.
Wait till you hear about how your bank account gains interest, hooo boy
I'm horrified to ask, but what do you mean?
Probably something about how your bank account only earns interest because banks can lend out a fraction of that to make money. Otherwise they would just be like a vault service who you have to pay to keep your money safe (basically negative interest).
Not true any more. Banks don't have to hold cash.
I don't think you understand how fractional reserve banking works. The first paragraph of that Wikipedia page already clearly contradicts you. The banks can still only lend money they have (otherwise how would they lend it? Where would it come from? Only the central bank can print currency). What fractional reserve banking is saying is that banks can invest some portion of the customer deposits that they hold into non-liquid assets, often in the form of loans to other customers, but it could also be invested in other things eg government bonds. The interest banks earn by doing that helps pay for the interest they pay to customers on their saving. They also have to carefully manage their liquidity: maximising returns while still holding enough liquid assets to cover any potential spikes in withdrawals.
Even when investing customer funds, banks still have to meet captial requirements set by the regulators which basically say that their risk-adjusted assets have to cover the liabilities of customer deposits, so that for example they can't just invest all the deposits in Bitcoin as that would pose too high a risk of insolvency. The reason SVB went insolvent recently was that they successfully lobbied the Trump administration to relax capital requirements for banks of their size, then made risky investments that lost money and they suddenly had less money than they owed their customers.