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Market lenders aren't banks. They cannot use fractional reserve banking. If they take in $100 they loan out $100. A bank takes in $100 having loaned out $10K to

• pbhjpbhj 12y ago
  Don't we already have a collapse in the money supply? I wonder if the huge number of people/organisations that can loan money but not set up a fractional reserve system (eg because of regulations) amounts to a smaller amount of money available. People making smaller loans may be less risk-averse too?
• jackgavigan 12y ago
  If the bank's reserve requirement is 10%, wouldn't it only be able to lend out $90 of the $100 it had taken in deposits?
  • radmuzom 12y ago
    Yes. But typically banks can leverage - for example, the bank which employs me typically lends out around $125-$135 for every $100 dollars in deposits. I guess the OP was trying to explain the money multiplier but got the example wrong. (Money multiplier is the inverse of the reserve requirement)
    • arjunnarayan 12y ago
      No. Deposits are what are used to "lever" up in the first place. If a bank lends out $125 for every $100 that it gets in deposits, where is the other $25 coming from? The answer is that it comes from equity. Banks have two sets of inputs: (1) Equity (i.e. the owners of the bank put up capital. This is great because it requires them to have 'skin in the game') (2) Incoming debt (i.e. depositors give them money.). They have two outputs: (3) Outgoing debt (i.e. the loans the bank makes out to people, in the form of mortgages, small business loans, lines of credit, etc.) (4) Reserves (money they have to keep on hand) Notice that as an accounting identity, we must have that (1) + (2) = (3) + (4). Leverage limits essentially limit the ratio (2):(1). For example, a leverage limit of 9:1 means that a bank lends out $100 has to source at least $10 of that from equity, and at most $90 of that from incoming debt. Fractional reserve limits essentially limit the ratio (3):(4). As "user downandout shows in a sister thread to this one, this can be used to determine a "multiplier" for the economy as a whole, since for a nonzero limit, there is a closed form fixed point solution maximum multiplier ratio in the economy as a whole. (Although in practice the "true" multiplier can be lower since people might stuff their mattresses with money, or have lots of loose change lying around, etc.). Note that the fractional reserve limits are something that is enforced on banks by the government to limit the multiplier. This restriction doesn't exist on P2P lenders (as of yet), and so if any thing, it means that P2P lenders are even freer to do bad things (such as have no reserves on hand at all).
      • userbmf 12y ago
        surely p2peer is just that. If I have $100 and you want to borrow $100 I lend to you. I get a rate of return on this and the p2peer company take a cut on that rate for being the middle-man. They don't act as guarantor, if you fail to repay the $100 I loose out (and they loose their cut of the interest). When you "lend on" money you yourself borrowed in peer2peer lending at this point you cede access to that money. Unlike when you save with a bank where your money is lent out (except the 10% reserve) yet you have a demand deposit for the full amount. Hence the multiplier effect. I think your description above is totally wrong. Banks in the UK had leverage at over 20 times assets to capital. It was precisely this high level of gearing which meant that our banks collapsed very quickly when there was a shift in the economy. Banks lend most of the money out back out based on the probability that most loans won't default. Your 1+2 isn't correct.
      • nhaehnle 12y ago
        > Deposits are what are used to "lever" up in the first place. If a bank lends out $125 for every $100 that it gets in deposits, where is the other $25 coming from? The answer is that it comes from equity. That's not entirely correct. Those $25 mostly comes from other banks with other business models, e.g. banks holding treasury bonds instead of loans. That said, I really like how radmuzoom's comment contained the kernel of real-life data that should help people realize that the typical money multiplier explanation is just wrong: if you actually look at the sum of deposits and the sum of loans that banks have, you'll see that they are more or less equal. Yet, if you believed the typical money multiplier story, the amount of loans would have to be at least 10x higher than the amount of deposits (even infinitely larger in countries where no reserve requirement exists!).
  • downandout 12y ago
    Kind of, sort of, but not really. The $90 that was lent, at some point, winds up back in a bank, where that loan is now a new deposit. Then 90% of the $90 can once again be lent out. Now that original $100 deposit = $171 in loans. And on it goes, until that $100 deposit is roughly $1000 floating around in the economy. This is called the "money multiplier". Here's a chart that shows the expansion potential of money at various reserve requiements: http://en.wikipedia.org/wiki/Fractional_reserve_banking#mediaviewer/File:Fractional-reserve_banking_with_varying_reserve_requirements.gif http://en.wikipedia.org/wiki/Fractional_reserve_banking#medi... This also shows how banks make so much money, and why there are both laws and services designed to encourage people to keep their money in banks. A $100 deposit generates slightly less than $1K in loans. At only 5% interest, the banks will realize $50 in interest per year on the ~$1K in loans enabled by that single $100 deposit.
    • jackgavigan 12y ago
      And can't the person who borrowed $100 using a p2p loans marketplace also loan it out again?
      • arjunnarayan 12y ago
        You are correct, and downandout is wrong. The same fixed point calculation that he/she makes with fractional reserve banking is true of the p2p loans marketplace as well. Your original calculation (reserve requirement of 10% -> $100 of deposits becomes $90 of loans) is correct. Edit: Downandout isn't wrong, it's the GP userbmf that is, since he/she said that market lenders aren't banks and "cannot use fractional reserve banking", which is a ill-defined statement. I erroneously assumed that the two users were the same. My apologies.
        • downandout 12y ago
          > downandout is wrong. Did I say that it didn't apply to p2p loans? It, of course, applies to any money that can be a new deposit. And how exactly am I wrong? The concept of the money multiplier is pretty well documented. There's even a chart that I linked to.
  • userbmf 12y ago
    oops missed a zero, but you get the point, there is an order of magnitude between FRB and peer-to-peer like lending.
  • nhaehnle 12y ago
    No. This is probably the most widely spread misunderstanding about banking. A reserve requirement says the following: Sum up the amount of deposits of a bank (on the passive, debt side of the balance sheet), call that A. Then look at what the bank has in its account(s) at the central bank, call that B. Banks must ensure that on average, B must be greater than x% of A. So, let's look at a simple example of a bank B that fulfills its reserve requirements exactly at the beginning of this story. Let's say some client, C, receives an electronic transfer from somebody at a different bank to the amount of 100#. The bank updates their database to increase the number that C sees on their bank statement. Around the same time, the sending bank S also makes an electronic transfer of central bank money of 100#. This typically goes indirectly via a clearing system, but in practice we can pretend that both banks have an account at the central bank, and central bank money is transferred between those accounts by the central bank updating its database. [0] At the end of the transaction, bank B's liabilities have increased by 100# (more deposits), and so have its assets (more money in its central bank account). Moreover, while B has gained 100# in central bank money, its reserve requirement has only grown by 1#, assuming a 1% reserve requirement. This means that according to the reserve requirement, bank B is allowed to have an additional 9900# in deposits. One way that the bank can leverage this is to hand out a 9900# loan. Let us assume that it does so. That is, it gives some client a deposit of 9900#. Now the reserve requirement is fulfilled precisely again. You will now probably think, well, the client is going to do something with those 9900#. True, and it becomes relevant if the client transfers this money to somebody whose account is with another bank (otherwise, everything happens locally to one bank and the reserve requirement does not matter). In that base, bank B will have to send 9900# of central bank money to the receiving bank. However, it's reserve requirement is reduced only by 99#, so it will be 9801# short. Oops. Did the bank break the law? No, because they are only required to fulfil the reserve requirement within a specified amount of time! During this time, the bank's interbank market traders will simply borrow the required amount of central bank money from another bank, using the bank's assets as security. Most of the times even this is unnecessary [1], because other banks also make loans, and electronic transfers between banks cancel out. Initially, this may now look as if the banking system as a whole could just create loans absolutely at will - and that is actually largely true. However, there are some limitations. However, reserve requirements are not a limitation. If you think the above through, you might come to the conclusion that the banking system as a whole might at some point not have enough central bank money to satisfy the reserve requirements. However, this can never happen because of the central bank's mandate for interest rate stability. What happens when the banking system as a whole creates a huge number of loans is that bidding in the interbank market would drive up the interest rate for short term central bank money. However, the central bank has a fixed target for this interest rate and will therefore lend out central bank money to the banks (thereby increasing the monetary base) to calm the bidding. [2] The true limitation of bank lending comes from capital requirements, and for good reasons. When a loan defaults, this hits the banks profits, and when a bank makes losses, they hit the bank's capital - which is morally and capitalistically okay. Loss of capital is exactly what should happen when a bank makes bad lending decisions. So society requires a buffer of capital that is large enough relative to the amount of loans (not deposits!) that a bank has made. Naturally, the size of this buffer is a hotly debated topic, because the larger the buffer, the better for stability, but the smaller the buffer, the better for the bankers. [0] This is simply a description of how inter-bank money transfers work, and really should be part of every school curriculum. I bet a clear majority of people has never even thought about how any of this works, even though it is a foundational fact about how our society functions. [1] Actually, it is still necessary due to fluctuations, but the flows involved are much smaller. [2] This is describing the "normal" situation outside of the liquidity trap scenario we are currently living in. It is important to note that in what I described, the expansion of the monetary base is not a decision of the central bank. It is endogenously driven by the commercial banks' lending decisions.
• grayclhn 12y ago
  No, you would need a larger monetary base to support the same size economy. But printing more money is easy.