Thanks Sydneyite. I feel I'm getting closer to understanding the system.
However I'm still a little stuck on the depositors funds. I understand what you're saying about the capital requirements being in place to cover deposits. However why do they even need or want deposits? If I'm getting it when they lend money for a house they simple create the money through an accounting entry i.e. DR Accounts Receivable CR Accounts Payable (they then make their money through the difference in interest between the receivable and payable). The accounts payable side of the entry I still have some questions on, I believe they borrow that money from another bank? Anyway back to point why do they need or want the deposits? Do they actually lend out deposits? Perhaps the amount of funds on deposit affects the rate they can borrow at? But why would it if there is no requirement for deposits?
Once again apologies for the mountain of questions.
Yep I think you are close!
Firstly, a part of having a banking license requires you to be a deposit taker. Ie, to be licensed to make loans, participate in the inter-bank lending and payment transfer system, and to have an ES account at the RBA, you need to actually be a licensed bank, which means you take deposits. Fundamentally, to operate as a bank, you need funds, ie reserves / deposits etc. And if you want to be able to issue loans, you need to be a bank.
So at the end of the day, loans and deposits have a symbiotic relationship, even though the "modern" view is that deposits are NOT required first to make a loan etc. But, you won't make any money issuing loans without also being able to take deposits (in terms of the system). To operate, you need funds, and deposits is where they come from. That's fundamentally why banks take deposits.
Firstly, a part of having a banking license requires you to be a deposit taker. Ie, to be licensed to make loans, participate in the inter-bank lending and payment transfer system, and to have an ES account at the RBA, you need to actually be a licensed bank, which means you take deposits. Fundamentally, to operate as a bank, you need funds, ie reserves / deposits etc. And if you want to be able to issue loans, you need to be a bank.
So at the end of the day, loans and deposits have a symbiotic relationship, even though the "modern" view is that deposits are NOT required first to make a loan etc. But, you won't make any money issuing loans without also being able to take deposits (in terms of the system). To operate, you need funds, and deposits is where they come from. That's fundamentally why banks take deposits.
One step closer again I feel
Ok so a banking licence requires the bank to be a deposit taker. From that perspective I can understand why banks would take deposits if they are required to under their licence. However where I start to come unstuck again is that banks seem to really want deposits i.e. introductory rates etc, they battle it out for market share of deposits. I know you said that to operate you need funds, and deposits is where they come from. That was always my understanding that the amount of deposits affects how much you can lend (although you can lend many times more than your deposit base). However, that seems to be contradictory to where we're saying that Australian banks no longer have a deposit reserve requirement? Why are banks so thirsty for deposit monies?
If there is no minimum deposit requirement wouldn't the most profitable model simply be to take minimum deposits, lend as much as possible (with as much security as possible), of course staying within the capital requirement regulations. I would have thought with lower amounts of deposits that would reduce the risk of a bank run affecting the bank.
I feel there is something missing here, that in real life deposits play a more central role in the banking system. What I don't understand is that if there is no minimum deposit requirement for banks, why are deposits so important? I know they are important because the government guaranteed deposits during the GFC. If banks don't need deposits they wouldn't have done this. The only logical answer I can come up with is that banks actually lend out deposit monies i.e. they are a source of loan funding, and a cheaper one. This would explain why they want deposits, and also why deposits are at risk.
Ok let me know where I've gone wrong, although I feel once again a step closer.
Two more lines of questioning to go (ha you thought I was done :)). The actual process of banks creating loan monies. I know there must be two sides to the entry. One side is obviously going to be DR accounts receivable (i.e. the money loaned to the home purchaser), the other side I'm fairly sure is going to be CR Cash/Accounts Payable. What I'm wondering though is where is that money coming from? If the money is sourced from existing deposits the credit entry will simply be to cash. But clearly not all of lending is sourced from deposits, so it would normally be CR Accounts Payable. Do the funds come from huge interbank loans? Or does it initially come from overnight RBA loans and then settled through another bank after all the paperwork is sorted? I know our banks source a lot of their funds from overseas banks. I guess what I'm asking is are all these loans funded separately, or are there huge interbank loans already in place from which they get the funds? If they did it that way they would need to have excess loan funds on hand constantly in anticipation of new business.
Second additional question. What is the part of the RMBS I keep hearing about in the banking system?
That was always my understanding that the amount of deposits affects how much you can lend (although you can lend many times more than your deposit base).
You are getting operations mixed up with lending. Forget about loans when you think about a banks day-to-day operations. Operations needs funds for example to able to pay another bank the funds for a cheque one of your depositers has given them. Remember there are literally billions of $$$ worth of transactions every day that flow through our banking system. If a bank does not have enough reserve to settle the net result of all inter-bank transactions in a given day, then they need to borrow on the inter-bank lending market to make up the difference - which has costs. All the workings can be quite complicated, but at the end of a day no bank wants to be the guy that has to borrow everything on the inter-bank market to settle all their transactions - that presents a large liquidity risk for your operations. In fact it is probably more profitable for you to have excess funds each day which you then get to lend out on the inter-bank cash market. So banks compete for funds (deposits) to maintain their operations and maximise their over-all profitability.
Bottom line, the amount of deposits that are held in reserve has no impact on how much a bank can lend - that is constrained by capital plus the ability to find credit worthy customers.
Ok so a banking licence requires the bank to be a deposit taker. From that perspective I can understand why banks would take deposits if they are required to under their licence. However where I start to come unstuck again is that banks seem to really want deposits i.e. introductory rates etc, they battle it out for market share of deposits. I know you said that to operate you need funds, and deposits is where they come from. That was always my understanding that the amount of deposits affects how much you can lend (although you can lend many times more than your deposit base). However, that seems to be contradictory to where we're saying that Australian banks no longer have a deposit reserve requirement? Why are banks so thirsty for deposit monies?
If there is no minimum deposit requirement wouldn't the most profitable model simply be to take minimum deposits, lend as much as possible (with as much security as possible), of course staying within the capital requirement regulations. I would have thought with lower amounts of deposits that would reduce the risk of a bank run affecting the bank.
I feel there is something missing here, that in real life deposits play a more central role in the banking system. What I don't understand is that if there is no minimum deposit requirement for banks, why are deposits so important? I know they are important because the government guaranteed deposits during the GFC. If banks don't need deposits they wouldn't have done this. The only logical answer I can come up with is that banks actually lend out deposit monies i.e. they are a source of loan funding, and a cheaper one. This would explain why they want deposits, and also why deposits are at risk.
Ok let me know where I've gone wrong, although I feel once again a step closer.
You need to understand that there is a difference between operational requirements and regulatory requirements. Under a fiat system a bank does not need to hold deposits, they are a cost, but the regulators REQUIRE banks to hold deposits, and so they do.
Quote:
Two more lines of questioning to go (ha you thought I was done :)). The actual process of banks creating loan monies. I know there must be two sides to the entry. One side is obviously going to be DR accounts receivable (i.e. the money loaned to the home purchaser), the other side I'm fairly sure is going to be CR Cash/Accounts Payable. What I'm wondering though is where is that money coming from? If the money is sourced from existing deposits the credit entry will simply be to cash. But clearly not all of lending is sourced from deposits, so it would normally be CR Accounts Payable. Do the funds come from huge interbank loans? Or does it initially come from overnight RBA loans and then settled through another bank after all the paperwork is sorted? I know our banks source a lot of their funds from overseas banks. I guess what I'm asking is are all these loans funded separately, or are there huge interbank loans already in place from which they get the funds? If they did it that way they would need to have excess loan funds on hand constantly in anticipation of new business.
Second additional question. What is the part of the RMBS I keep hearing about in the banking system?
The money doesn't come from anywhere, they create it. Really they are just giving the borrower a bank credit which is acceptable within the community because we all believe that the bank can make good on every dollar that they lend. If we stop believing that then that bank has a serious problem. The MMT'ers call money created by banks "outside money" and money created by the government "inside money" - or maybe I have that the wrong way around.
Please read that Cullen Roche booklet as it explains this in a way that is fairly easy to read.
RMBS is "registered mortgage backed securities" which is just a tranche of home loans sold off into the market to investors, the process is often called securitisation. It means that the bank can make those loans and then sell them and thus get them off their balance sheet and still collect a margin on the loans in the tranche without the hassles of having deposits to cover them. You may have noticed that once Australian banks found it difficult to sell these investments into the market, they suddenly got cuddly with depositors as they realised how much they needed them under the new normal.
You are getting operations mixed up with lending. Forget about loans when you think about a banks day-to-day operations. Operations needs funds for example to able to pay another bank the funds for a cheque one of your depositers has given them. Remember there are literally billions of $$$ worth of transactions every day that flow through our banking system. If a bank does not have enough reserve to settle the net result of all inter-bank transactions in a given day, then they need to borrow on the inter-bank lending market to make up the difference - which has costs. All the workings can be quite complicated, but at the end of a day no bank wants to be the guy that has to borrow everything on the inter-bank market to settle all their transactions - that presents a large liquidity risk for your operations. In fact it is probably more profitable for you to have excess funds each day which you then get to lend out on the inter-bank cash market. So banks compete for funds (deposits) to maintain their operations and maximise their over-all profitability.
Bottom line, the amount of deposits that are held in reserve has no impact on how much a bank can lend - that is constrained by capital plus the ability to find credit worthy customers.
Yes, it's useful to separate the lending from the operations.
The lending is simply the entering of the credit for the borrower in one account and the entering of a debit for the borrower in another account. At that point no money is moved anywhere.
However, the creation of the loan leads to obligations on the bank which created the loan. The borrower can be expected to spend the credit money. If the borrower uses the loan to buy a car and the car seller banks with the same bank then the bank still has no need to obtain or move any money. The bank in that case simply debits the borrowers credit account and credits the car sellers deposit account.
But usually the borrower will purchase something from someone who uses a different bank. If the borrower buys a car from someone who uses a different bank, the borrowers bank will be required to transfer money to the other bank. They don't do this for each transaction. They total the transactions for the whole day and then make the necessary transfer to cover the whole day's net transactions between the two banks. They probably do this via their ESAs at the RBA.
So the banks need to meet their obligations arising from the issue of loans. They can do this mostly by using money as it is coming in.With large banks, incoming and outgoing money will not be hugely different. But it is something they have to manage and more deposits help rather than borrowing elsewhere.
It's worth appreciating that a deposit account is just a liability of a bank and it contains no money. The bank owes that money. When the deposit is first made the actual money the depositor gave to the bank immediately becomes the property and asset of the bank and ceases to be the property of the depositor (though he is entitled to recover it according to the agreement). The bank is then entitled to use the deposited money as its own for its own purposes, which usually means using it to meet the obligations arising from the loans it has issued, as above.
Just read this, pretty much answers my question. So is the only difference for Australian banks that they have no restriction on the amount that they can lend compared to banks that a have a reserve requirement? Wouldn't this make them more risky? I've read somewhere recently that this places an added reliance on the central bank to bail them out when there is a shortage of funds to pay out deposits?
Not quite. Setting a reserve fraction is a blunt instrument that is no longer used in the more advanced economies. Even in the US, where (I believe - someone correct me if I am wrong) there is still a reserve requirement as a fraction of deposits, the banks are not reserve constrained because regulation has moved onto the BASEL model, where banks are constrained by:
a) Tier I capital as a percentage of risk-weighted assets (note assets, not liabilities as in the case of the fractional system) b) Tier I + Tier II capital as a percentage of of risk-weighted assets c) (Basel III) Liquidity requirement as a percentage of deposits (liabilities come back into the equation)
and of course there are local non-Basel requirements such as APRA requiring the banks to have a certain term of of funding, and on top of that the requirement from their shareholders that they be profitable.
All of these constraints constrain the amount of lending a bank can do.
This is why people tend to hit the skip key when someone throws in "fractional reserve" as if it is a meaningful thing. The author is either centuries behind the times or they are decades behind the time or (far more likely) they are just throwing in random epithets to confuse and scare the punters. In any case there is no need to read on. Nothing to see here.
propertymogul
19 Jul 2013, 03:27 PM
At first glance it still sounds like a fractional reserve banking system though, just that the way loans are created is different now. That is where loans used to be funded from deposits (reserves) multiple times, now the banks simply create the loans independent of deposits, but under both systems the total loans banks can lend is restricted by deposits held (the fraction). Obviously for Australia though the reserve backing requirement was abolished. This might have been what you were trying to say, but anyway I'll have a read through all those links maybe I'm still not understanding it.
Once again, not quite. Under Basel the amount a bank can lend is constrained by deposits (liquidity requirement - but note that if the bank had no deposits there would be no liquidity constraint!) but much more importantly by their Tier I Capital (essentially equity plus preferred shares) as a percentage of their risk-weighted assets (essentially the amount of their loan book which would be at risk in a bad crisis).
It really is a different way of looking at things from the old reserve-constrained model, but actually also more onerous unless the reserve fraction was very high (as it is in China, for example.)
propertymogul
19 Jul 2013, 04:14 PM
However I'm still a little stuck on the depositors funds. I understand what you're saying about the capital requirements being in place to cover deposits. However why do they even need or want deposits?
Bloody good question which I have never seen a good answer to. Hopefully somebody can enlighten us both on this one. There are of course lenders who are not deposit-taking institutions.
While the rest of you have been debating house prices, gold has been slowly creeping back up. Today it is $1430 aussie, only $370 shy of it's all time peak here at $1800. Paper manipulation of the gold price has a dramatic effect on the public mind and I am sure it has scared a lot of the paper investors out. But for us holding onto the yellow metal itself, these little pullbacks are irrelevant in the context of a long term bull market.
Shadow was hopelessly wrong about the Gold Bull Market. What else is he wrong about?
Not quite. Setting a reserve fraction is a blunt instrument that is no longer used in the more advanced economies. Even in the US, where (I believe - someone correct me if I am wrong) there is still a reserve requirement as a fraction of deposits, the banks are not reserve constrained because regulation has moved onto the BASEL model, where banks are constrained by:
In recent times the US banks are required to use 10% of the reserves behind the "checking accounts" alone to purchase government bills. This doesn't apply to all the other savings accounts in American banks, no fractional reserve is required for these. I think there's about 1.5 trillion in the US checking accounts, so that requires a fractional reserve of 150 billion worth of government bills.
Down the bottom of this page you see stats that show an actual fractional reserve deposit system in operation in 1901. As you can see only 10 million of the 32 million in currency was still outside the banks. 22 million was locked as fractional reserves inside the banks and could not be used to create new loans.
The next trick of our glorious banks will be to charge us a fee for using net bank!!! You are no longer customer, you are property!!!
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