Yesterday, I wrote a post about fractional banking. Fractional banking is based on reserves. I recommend that you read that post (or even re-read it!) before coming to this one.

To summarise the fractional banking process:

1. Let’s say that the Central Bank has printed $100 worth of notes, for usage by the general public.
2. The Central Bank buys a government bond worth $100 (ie. the Central Bank lends that $100 to the government).
3. The government then uses that money to pay for things.
4. The contractors that received the money from the government deposit their $100 into the commercial banks.
5. The Central Bank says to the retail/commercial banks “You have to keep 10% of any deposits that you receive – in cash – in case any one of your depositors needs some cash.”
6. The commercial banks then say to themselves “Ooh – $100! Well, we obviously need to keep $10 in cash. But let’s lend the $90 out to earn interest!”
7. At this point, the banks have $10 in cash and $90 in loans outstanding – all financed by that first $100 in deposits received.
8. The borrowers go and spend their $90.
9. The people that just got paid go and deposit their $90 in the bank.
10. The commercial banks then say to themselves “Ooh – $90! Well, we obviously need to keep $9 in cash. But let’s lend the $81 out to earn even more interest!”
11. In total, the banks now have $19 in cash and $171 in loans outstanding – financed by $190 in deposits received.
12. You’ll notice that the fractional banking system just “created” a further $90 of money.
13. But this process continues, because that $81 in new loans will be come back as deposits, 90% of which can be used to give out more new loans, which will also come back as deposits, and so on…
14. …until the banks have to keep all $100 in cash to make up that 10% reserve requirement.
15. By then, the banks have $100 in cash and $900 in loans outstanding (assets) – all financed by $1,000 in gross deposits received (liabilities).
16. The fractional banking system created $900 of new money out of the original $100 printed by the Central Bank.
17. And you may see that this is a function of the liquidity reserve requirement?
18. Total Money Created = Money Created by Central Bank ÷ Reserve Percentage

Some important things to point out:

1. This money creation, in itself, is not really a problem.
2. Fractional banking is built on the back of transactions between people. That is: there is a real economy in which services and goods are traded, and money is just an overlay to that real exchange of goods and services.
3. Many of those people might be good at their jobs, but terrible at managing their money. Any bank is still going to have concerns about just lending out cash willy-nilly.
4. I suspect this is partly why the full extent of “fractional banking” is rarely reached.

But what I want to do is focus on what hypothetically would happen when the reserve ratio changes. In the example above, it’s fairly easy to see what happens when the reserve ratio drops to 5%:

1. The banking sector now has excess reserves.
2. It only needs $50 in cash to cover the $1,000 worth of deposits that it has on its books.
3. So it can lend out the other $50.
4. The process repeats itself.
5. And you end up with $100 in total reserves, covering $2,000 of total deposits and $1,900 of loans.

There is a dramatic and sudden increase in the money supply. In theory. As I said earlier, the banking sector is still going to have concerns about the credit quality of their borrowers. And the banks will either:

1. Hold excess reserves, until they find projects of sufficient credit quality to finance; or
2. Get reckless with the mortgages and start a housing bubble.

The second option is the more concerning one. It’s where Austrian Economists get excited about credit bubbles and malinvestments – and clearly, there’s a fair amount of empirical evidence to support that.

But I’m equally as concerned about what happens when the reserve ratio is raised. Let’s say that the reserve ratio is doubled to 20%.

The banking sector suddenly finds itself going: “Sherbet, we need to have $200 in cash reserves in order to cover this $1,000 in deposits!”

Some of you might be thinking “How awkward, only $100 of cash exists.”

Well exactly.

The individual banks though will react to this new reserve requirement by trying to collect the cash anyway (at least, that’s my suspicion). They’ll put a hard stop to any bank lending, and start trying to collect on those outstanding loans.

But looking at the banking sector as a whole, one man’s loan can only be repaid by transferring money from a deposit elsewhere.

So what will actually happen:

1. $500 of loans will be collected.
2. But these $500 worth of loans will be repaid out of deposits.
3. So total deposits will drop to $500.
4. Total loans will drop to $400.
5. And total cash reserves will still be $100.

Which is fractional banking in reverse. A doubling of the reserve requirement = a halving of the money supply.

Also, a credit crunch.

Which brings us to the heart of why the monetary system is so vital. There may well have been a time when we all operated on IOUs and had personal relationships that allowed us to maintain separate lines of credit with our grocer, our baker, our butcher, our doctor, our dressmaker, and anyone that you’d transact with, really.

Today, you only have credit with your bank, and they vouchsafe your transactions with everyone else.

If that bank stops extending general credit for any reason, then the “real economy” of goods and services freezes up because those individual credit-lines no longer exist in quite the same way.

Which brings me to Basel III.

#tobecontinued

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.