Author Topic: Fractional Reserve Banking - How It Works!!  (Read 1926 times)

mikkilaw

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Fractional Reserve Banking - How It Works!!
« on: Sep 20, 2012, 01:01:51 PM »
It occurred to me recently that many people who are struggling with debt may not be aware of the Fractional Reserve Banking system, and how banks generate huge amounts of revenue by effectively lending out money which doesn't exist. The practice is legal, licensed and mainstream. Having worked as an analyst in financial services for the last ten years, it is something that I have been aware of for a long time, but recently I have been surprised at how few people properly understand this practice. If anyone would like any further information about this, please let me know as there are a number of informative resources available on the internet that give an overview of how FRB works!

James Falla

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Re: Fractional Reserve Banking - How It Works!!
« Reply #1 on: Sep 21, 2012, 05:46:30 PM »
Hi Mikkilaw
How would an understanding of this help people who are struggling with debt that they cannot pay?
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mikkilaw

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Re: Fractional Reserve Banking - How It Works!!
« Reply #2 on: Sep 21, 2012, 06:20:14 PM »
Whilst having an insight into the mechanics of how the economy works will not necessarily give anyone any practical help with managing their debts, I am a great believer in the maxim "knowledge is power". Perhaps if people are suffering with stress and feelings of guilt and inadequacy etc. as a result of having unmanageable debts, understanding the wholly unethical and corrupt principles that allowed them to get into this situation will give them some hope and strength to help them to find a solution, and (hopefully) sufficient resolve to find a means of legally avoiding paying back the full amount they owe?


If not, then surely there is no harm in my offering my knowledge and expertise. After all, it's not like I'm going to be using my skills and experience in the workplace any time soon! :-) Unlike yourself, I am not qualified to advise people with regard to finding debt solutions, but I am more than qualified to explain fundamental economic principles!

James Falla

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Re: Fractional Reserve Banking - How It Works!!
« Reply #3 on: Sep 24, 2012, 09:32:42 AM »
Sounds good to me mikkilaw
Can you give us any kind of an overview here on the forum?
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mikkilaw

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Re: Fractional Reserve Banking - How It Works!!
« Reply #4 on: Sep 24, 2012, 11:29:11 PM »

Ok, to give a very simplified overview, let's imagine that there are two fundamental lending models which banks employ:


1) Satisfying unpredictable credit requirements: An example would be a person with a £2,000 credit card limit and a balance of £500 going out and spending £1400 on a single purchase, thus suddenly increasing their balance to near its limit. The minimum monthly repayment required will be a function of the APR and the balance (as long as the resulting amount meets any minimum requirements), and will also be subject to adjustment should the balance or APR change.


2) Satisfying predictable credit requirements: Someone goes into their bank and arranges a loan (secured or otherwise) over a set period at set interest and with set monthly repayments.


Let's explore the first lending model to begin with: The required liquidity for this type of lending is predominantly generated through inter-bank depositing - Money Market deals, as they are known. Local authorities, large corporations and even private investors can also deal on this market. I worked for several years as the Sterling position keeper in the Group Treasury at Alliance and Leicester Bank (now part of Santander). My remit was essentially to ensure that the Sterling desk (ie. the ledger balance of all Money Market deals made in Sterling during the day) was as close to "square" as possible. This meant that the amount of money held by the bank was as close to the minimum allowed under the required regulations as feasibly possible at the end of every working day. Money that is not being lent out is effectively "dead money", it's earning you no revenue (when it could be put on deposit earning interest), whereas money borrowed from another bank (or other lender) is costing you interest. So the trick was, when trading closed, to have as little money left in the electronic vault as possible, but without being in debt too much either! (The requisite amount of currency to be held at the Bank of England - more about that later - was excluded from the balance sheet at this level). To close the day within a million pounds of square was generally a reasonable achievement, and it was the Money Market dealers' job to ensure that all deals were electronically signed off in time for the SWIFT (formerly CHAPS) transactions to be made before the final closing position was called (either "long" or "short" depending on the amount on deposit versus the liabilities). An interesting element of this type of lending is that deposits can be as short as overnight, ie. literally <24 hours. The interest is payable daily, and does not compound, hence many astute Money Market dealers would ask for repayment of P and I (principal and interest) regularly, then immediately reinvest. To give a basic idea of how the markets ran at the time, the overnight interest on a million pounds Sterling was approximately £167. For longer term commitments, a better rate might be offered but risk was always mitigated with regard to potential future undulations in the marketplace! My final job of the day, after all trading closed, was to submit Balance Set Entries (journal entries) to the accounting team.

That's probably enough for now, sorry if I've sent you to sleep!  :(  Let me know if you want me to continue with an explanation of the second type of lending (which is actually far more interesting and controversial), if not no worries!