Our banks - at least the ones who took all our tax money last fall - are members of the Federal Reserve system. It's called Federal because its territory is the entire country. It's called Reserve because it is a banking system based on reserves.
Reserves is the word used to describe the money that a bank is required to keep on hand to cover the deposits made by their customers. The idea behind a reserve is that if you deposit $100 in the bank, you might want to withdraw that $100 later. If you show up at the bank wanting to withdraw your money, the bank better have money to give you. It may surprise you to know that the banks are not required to keep a dollar on hand for every dollar that is on deposit. They are required to keep some fraction of that money on hand. That is why our banking system is called "fractional reserve banking".
In the Federal Reserve system, that fraction ranges between 3% and 14%. In other words, for every $100 deposited with the bank, the bank is required to keep between $3 and $14 on hand.
(By the way, I am simplifying quite a bit here. If you are really interested in the arcana of reserve requirements, there are some interesting links here and here. And God bless you if you are.)
So what happens to all the rest of the money? The bank loans it out. This is where the alchemy of fractional reserve banking occurs. Watch carefully now - nothing up my sleeves.
Assume we have two people, you and me. I buy things and take out loans, and you sell things and make deposits. And finally assume we have a bank, Bank A, that will take your deposits, will make loans to me and has a reserve requirement of 8%.You deposit $100 with the Bank. Bank A keeps $8 on reserve, and loans me the balance, $92.
I buy $92 worth of goods from you with that money and you deposit that $92 in Bank A. Bank A keeps 8% of that money on deposit and loans me 92% of it, about $85. I buy $85 worth of goods from you with that money I borrowed. You take that money and deposit it in Bank A.
Bank A takes your $85, keeps 8% of it, and loans me the remaining 92% of it, about $78. I buy $78 of stuff from you with the money I borrowed. You deposit that $78 in the Bank. They keep 8% of it and loan me the remaining $72. I buy $72 worth of stuff from you, and the game goes on and on and on...
So from a single $100 deposit, Bank A can make over $1000 in loans. If I repay those loans, then the bank has magically created profits of over $1000 on a mere $100 worth of deposits.
Pretty sweet little business, huh?
But what happens if I don't pay those loans?
Ah, here's where the magic goes all wanky. Instead of creating $1000 in profit out of thin air, the banks have created $1000 in debt out of thin air.
Most banks require that you put up some collateral before they give you a loan. If they loan you money to buy a car, they keep title to the car until you pay off the loan. If you don’t pay the loan, they take your car and sell it to satisfy the loan. Sometimes the car fetches enough to pay off the loan, sometimes it doesn’t.
You pays yer money and you takes yer chances.
This is where the Big Banks got caught. They loaned money to people who couldn’t repay it so that they could buy houses that were overpriced in the first place. Who would have ever imagined they'd have problems?
So why did they make such stupid loans?
Greed, plain and simple. They were lusting after the profits they could create out of thin air and were ignoring the risks that they were creating debts out of thin air instead.
Of course, it wasn’t $1000. It was more like $4 trillion.
According to Federal Reserve rules, if the amount of money a bank actually has on reserve falls below the minimum required amount to cover deposits, then that bank is - by definition - insolvent and must be shut down. There is more to it than that, but that is the important part.
Last fall, the Big Banks were insolvent. But since they are big, and since they own most of Congress, most of the executive branch, and probably several judges, they maneuvered their way out of that tight spot. They arranged it so that you and I – people who had nothing to do with the loans – would bear the losses.
Like I said, it’s a pretty sweet business.
News of the Week coming up tomorrow...
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