Updated: Jun 28, 2022
The Magic of Fractional Reserve Banking
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I had a conversation last week with someone who had read my recent pieces about the federal funds rate. It made me think that I should write a post about how banking systems work. If you are already thinking that this is going to be a bit technical you'd be right. I shall however try to make it as accessible as possible.
Let's start with old fashioned IOUs which came before banks and which are key in understanding them.
If today you lend me £10, I will write you an IOU saying I owe you £10. Before the existence of money in any form an IOU might have said "You have given me ten chickens, I will give you ten chickens in return" or "You have done or given something for/to me, I will do for you or give to you something of comparable worth when you present me with this piece of paper" - note that worth does not require money to exist, just some measure of it such as the number of hours of effort put in to produce a good or service.
In other words, IOUs are about reciprocation. Indeed, much of the time, reciprocation does not even require a pen and paper, which would anyway be hard outside of the human species. Chimps, for example, just know that they should scratch each other's backs.
Reciprocation is and has been pivotal in stimulating economic activity. The requirement to exchange goods or services simultaneously might have meant no activity occured at all; scratching each other's backs at the same time is clumsy and thus inefficient, whichever the primate species.
Although they facilitated greater activity, IOUs were non-fungible, meaning that they were specific to two individuals, and thus were inefficient. Enter Mr Bank, who says to the party who wants, say, ten chickens, that he will give - aka lend - him pieces of paper - aka cash - that he can pass to a chicken seller in exchange for chickens.
The chicken buyer provides Mr Bank with reassurances that he will indeed buy ten chickens with the cash and not go and put it all on red. And that he will himself work hard to earn cash plus a bit more - interest - to pass back to Mr Bank on the date agreed.
The chicken seller knows that he can use the cash he receives to buy goods and services from anyone, not just the chicken buyer - i.e., it is fungible - and is reassured by Mr Bank's excellent standing in the community - he does not go around handing out pieces of paper to just anyone, only to those who he believes will repay the loans. Too many bits of paper chasing too few goods and services would mean prices accelerate - rising inflation - so it is a good thing it is in Mr Bank's self interest to control his urges.
Mr Bank's pieces of paper are his product - his currency - and he earns revenue by charging interest. Also, he must balance his books, so he needs whoever is holding the bits of paper at a particular time to pass them back to him for safe keeping - aka deposits - on the basis that they can have them back to use whenever they like - on demand. He pays them interest on these deposits to encourage them to pass back the bits of paper to him. Despite this interest cost, Mr Bank's profit is still positive because his lending rate is higher than his deposit rate.
However, there are soon many other Mr Banks, each with their own currency. Wouldn't it be better if there was only one currency? Enter Mr Central-Bank who says to all the Mr Banks that it will issue by fiat one single currency that they can all use. And that it will hand them some to get them started - central bank money. It also says that it will limit the amount they can lend, thus providing consumer deposit protection, by requiring them to handover for safe keeping a certain proportion - fraction - of the deposits that they themselves are looking after. It calls these the banks' reserves and the proportion/fraction of the deposits to be passed to the central bank for safe keeping the required reserve ratio.
It should be noted that commercial banks do not necessarily require the existence of a central bank. They could all agree on one single shared currency and lend without the constraint of having to deposit reserves with a central bank. Indeed, this was the system in the US until a banking crisis in 1907 led to the creation of The Federal Reserve in 1913.
One widespread misunderstanding about the banking system is that banks lend out deposits, i.e., that the deposits somehow existed "un lent" and the bank then decided to lend them out. This is incorrect.
If a bank lends you, say, £1,000, it places the £1,000 in your bank account. In other words, it creates the loan and the deposit simultaneously. How else can the bank's books always balance? There are no such things as "un lent" deposits. All deposits - other than central bank money deposited with commercial banks - were created when loans were extended.
Having received the deposit in your account, you then spend the money and it ends up as a deposit in someone else's account, who in turn at some point spends it etc. The deposit does not get destroyed. The £1,000 loan stimulates spending/activity that would not otherwise have happened i.e., it contributes to GDP. You just need to make sure you have sufficient funds in your account to pay loan interest and principal on the day or days agreed.
This system that I have described is known as fractional reserve banking, and it is used by most countries. However, how it works it is not well understood, other than by those who need to understand it plus those who want to. By the way, not having ever worked in central or commercial banking, I had to teach myself fractional reserve banking. I found this hard - it involved a lot of head scratching, scribbling and frustration. In other words, don't fret if you also find it hard.
So, how and by how much does the amount lent by commercial banks get constrained by the required reserve ratio? And how does QE lift this constraint?
I think the best way to understand the beauty of fractional banking is if you consider the balance sheets of the three parties involved - the central bank, the commercial banks, and the borrowing public/consumers - and how they interact with each other/change over time.
Three key things to keep in your mind are a) balance sheets must always balance, b) one party's asset is another's liability and, c) liabilities are always intangible/non-physical while assets can either be physical or intangible/non-physical.
Figure 1 below shows highly stylised representations of the balance sheets of the three parties at five different times. Note that:
a) Certain items that exist in the real world are omitted because they are not needed for an understanding of how fractional reserve banking works. For example, you'll notice that the commercial banks have no equity. In practice, banks own physical assets such as buildings and bullion which count towards their equity. And their equity will increase over time as they make profit or - heaven forbid! - issue equity.
b) Consumers might pass their gold for example to a bank for safekeeping and be given a deposit (certificate) in return. This deposit was not produced by a loan. And the original production of the gold may not have required a loan - and thus a deposit - to be created, as the owner of the gold may have panned for it himself without the need for any loan.
c) The figures do not show loans being paid back.
d) The representations do not show central bank money deposited with commercial banks growing, or changes in the RRR, both of which impact loan growth and broad money supply by changing the maximum possible total loans.
e) The size of the boxes does not reflect relative sizes in the real world. The assets of consumers for example are far greater in value in relation to the size of bank balance sheets than the representations in Figure 1 suggest.
To view Figure 1 as a PDF (recommended!) click here.
Figure 1: Highly stylised balance sheets of central bank, commercial banks in aggregate, and consumers in aggregate at five different stages illustrating how items are related and how they change over time.
Source: Chimp Investor
The above figure is a bit intricate but I think it shows everything you need in order to better understand fractional reserve banking (Figures 2 and 3 below should help further).
Figure 2 (below): Broad money supply for an RRR of 20% after each succesive deposit (D0 to D21) is created, showing a maximum broad money supply of 500 units (based on central bank money deposit of 100 units). Note that the horizontal scale is not time but successive deposits. In theory a bank could create the maximum possible value of loans/deposits for a given RRR simultaneously.
Source: Chimp Investor
Figure 3 (below): Broad money supply (actual and maximum) for five given RRRs (1%, 5%, 10%, 20% and 50%) after each successive deposit (D0 to D21) is created.
Source: Chimp Investor
In the US, QE resulted in huge excess reserves that led The Fed to:
i) start paying interest to banks on their required and excess reserves from 6 October 2008 at, respectively, the IORR (interest on required reserves) rate and the IOER (interest on excess reserves) rate;
ii) introduce on 17 September 2014 the overnight reverse repurchase (ON RRP) facility. While the IORR and IOER represented risk-free short-term assets for banks, the ON RRP did the same for non-banks such as pension funds;
iii) set all reserve requirement ratios to 0% on 24 March 2020, eliminating all reserve requirements;
iv) introduce on 29 July 2021 a single rate, the IORB (interest on reserve balances) rate, to be paid to banks on all reserves, thus doing away with the need for separate rates on required and excess reserves.
Prior to October 2008 the Fed would adjust the effective federal funds rate (EFFR) through its ONO (overnight operations), buying or selling short term Treasuries in order to increase or decrease the supply of banks' reserves and thus decrease or increase the interest rate on reserves i.e. the federal funds rate.
After October 2008 this was no longer feasible given the banks' huge QE-related reserves - the Fed would not have been able to sell a sufficient amount of its holdings of financial assets to make an impact on the federal funds rate. So as to be able to stop the federal funds rate falling below 0 and ensure it was able to increase it when the time came, The Fed started in October 2008 paying interest to banks on their reserves and in September 2014 interest to non-banks on their excess cash holdings.
As noted by the New York Fed,
"...the FOMC chooses the target range for the fed funds rate to communicate the stance of monetary policy. The goal of monetary policy implementation is then to make sure that the effective federal funds rate (EFFR) remains in that range.
"In the current framework, the Fed’s main implementation tools are interest on the reserve balances (IORB) that banks hold overnight in their accounts at the Fed, and the rate offered at the ON RRP facility to a broad set counterparties including money market funds and government-sponsored enterprises."
As I noted in this post, I had been wrong in an earlier post not to mention the IORB rate - or indeed the ON RRP rate. However, the point I was trying to make was that currently banks have no need to borrow reserves from each other so the Fed cannot adjust the effective federal funds rate through open market operations. It had to start paying interest on reserves at the IORR and IOER (later merged into one, the IORB) rates and also offer a more attractive risk-free short term rate to non banks. Perhaps it is easier for the financial media to not focus more on the Fed's current "main implementation tools", the IORB and the ON RRP, but I wish it would.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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