Turner Turns (10) Banks

Banks create credit. However, the structure of a bank balance sheets means that it is not so constrained as other businesses.

Due to fractional reserve banking laws, only a small part of the bank’s assets are needed for the support of its ongoing business. They do not need to use their currency to make a loan. Reserves at the central bank cannot be lent to private individuals.

When making a loan, the bank simply records a deposit in it’s clients bank account. They record this deposit as a liability on the bank’s balance sheet. The mortgage is recorded on the other side of the balance sheet as an asset.

Banks are not constrained like other businesses. Only a small part of their assets, are needed to support their ongoing business. All they have to do is keep enough reserves of currency or at the central bank to cover potential withdraws of call deposits. Deposit insurance means that their reserves can be kept quite small.

Banks are different from businesses. They do have to give up anything when giving credit to a borrower. Banking laws give them the right to give borrowers something they do not own.

Understanding this is easier, if we think about the situation when banks began as goldsmiths storing gold. People deposited their gold with the goldsmith for safekeeping. Rather than withdrawing gold when they needed to make a payment, they would exchange the goldsmith’s receipts. These receipts acted as money. The goldsmiths realise that only a fraction of the gold was withdrawn at any one time, so they began lending some of it out in return for an interest payment.

All the gold belonged to the people who deposited the gold. The goldsmith bank did not own any the gold (although it would record on its balance sheet). When it loaned gold, it was lending gold did not own. It was cheating because it was lending something that did not belong to it.

Now that we have switched to fiat money, the same situation applies. Banks can lend out money that they do not own, just as a goldsmith bank lent out gold it did not own. The law allows banks to operate in this way. No other person or business has this right. Fractional reserve laws give banks a huge capacity to expand credit. This has been a major cause of instability in economies everywhere.