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Why do banks even need deposits?

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October 25, 2010 – Comments (13)

I heard a stat that the amount of leverage is 14:1 (thought it was 10% reserve so it should be 10:1, but whatever).  So why do banks even need money in the first place?  If they can create 10x more credit than money, why do they even need that little bit of money in the first place?  Its not like its a secret that they create all of this leverage out of nothing, so they dont need to do it to disguise how they work.  So why not just make a bunch of credit out of nothing?

13 Comments – Post Your Own

#1) On October 25, 2010 at 11:11 PM, ikkyu2 (99.23) wrote:

..crickets..

 

You ask all the right questions, Valyooo.  I have been enjoying your questions a lot over the last couple weeks - wish my post on your 'green' topic hadn't gotten eaten, it was a goodie.

I think the short answer to your question is, that's how the Fed works.  The Fed, bear in mind, is a consortium of 12 regional Federal Reserve banks.  The shareholders in those regional FRBs are large and small banks nationwide.  The Fed is empowered to make money out of nothing, and it is governed by representatives beholden to its community-bank and supermarket-bank shareholders.  So the answer is, "they do."  And when you want to talk about TARP or TALF or HAMP or QE, the answer is, "Oh, how they do and do and do and do!" 

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#2) On October 25, 2010 at 11:28 PM, Valyooo (99.39) wrote:

Thanks for reassuring me I am asking the right questiions.  There are so many things like this that boggle my mind and whenever I ask them nobody has an answer, so I start to think maybe I am just crazy.  I am very glad that you help me with these questions, and I enjoy conversing with you through these blogs.

 My main problem is when I dont get something like this, instead of just being confused, I think about it all day and it bothers the hell out of me, too.

So, are you saying that the banks dont even need to hold that little bit of money, but they just do because the Fed tells them to?

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#3) On October 25, 2010 at 11:29 PM, Valyooo (99.39) wrote:

Oh and by the way, if you have the time, check out my last 2 blogs.  I made the mistake of posting them after midnight, so nobody really saw them to respond.

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#4) On October 25, 2010 at 11:48 PM, starbucks4ever (96.30) wrote:

If a bank can make any amount of money out of $0, then how is JP Morgan/Chase going to be richer than "Horns and Hoofs S&L" from Salem, OR? 

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#5) On October 26, 2010 at 12:34 AM, Valyooo (99.39) wrote:

JPM is more globalized and better at getting people to repay, and better at covering up scandals, with better customer service?

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#6) On October 26, 2010 at 2:37 AM, ikkyu2 (99.23) wrote:

So, are you saying that the banks dont even need to hold that little bit of money, but they just do because the Fed tells them to? 

They do because regulators say that they have to.  They hold on to, not just cash, but "assets."  Assets can be cash money, but they can also be other things.  For example, BancoMerica lends Valyu $100 to purchase a ValuHouse.  Val buys his house and writes a note:  "Dear Bancer: I. O. U. (I owe you) one hundred dollars in principal, and every year I ain't pay you off, I also will pay you 5% of the unpaid principle balance."

That's an asset.  Reserve requirements can include that kind of asset instead of straight cash; how they're valued depends on your accounting method, and that kind of thing is why Joe Schmo can't just go open a bank; it's complicated.

Now here's the fun part: Val loses his job and can't make his loan payment.  So he quits doing it.  Plus, the housing market tanks and the house that Val wrote that note about is only worth $50.  Or maybe there are no buyers for it at any price, so it's worth $0 on the open market.  Woops, Mr Bancer has to "write down" or "mark down" his assets.  Now he's got less assets than he thought he did yesterday.

Never fear, Quantitative Easing to the rescue.  Because BancoMerica is part of the Exclusive Club of Member Banks of the Federal Reserve Club, the Fed suddenly manufactures dollars out of nothing and buys Val's note from BancoMerica at its full face value, $100.  Suddenly BancoMerica has assets again!  The Federal Reserve Bank now has created $100, "injected" it into the bank and thence into the economy, and owns a worthless piece of paper.   

Yay.  

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#7) On October 26, 2010 at 2:39 AM, ikkyu2 (99.23) wrote:

Oh, by the way, here's a hint: you're not crazy.  You are refreshingly sane.

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#8) On October 26, 2010 at 7:50 AM, dbjella (< 20) wrote:

I enjoy your questions as well.

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#9) On October 26, 2010 at 10:05 AM, chk999 (99.97) wrote:

There is a book called Lombard Street by Walter Bagehot that you need to read. It explains the origin of the fractional reserve banking. It is the best book on money and banking I have ever read. Get it at the library and much will be explained.

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#10) On October 26, 2010 at 11:20 AM, rofgile (99.44) wrote:

You can download Lombard street from books.google.com ifyou can't find it at a library.

 I've been meaning to read this, among like 50 other books lately..

----

 As to why even have a 10% fraction.. the fraction part of the lending limits the total leverage and total currency in circulation.  Not requiring any deposits, would be the same as moving towards a limit of infinite leverage.  At that point there would be unlimited money in circulation and money would be entirely worthless.  

 Having 100% deposits required would = no lending.   Having 0% deposits required would break lending.  10% is just the current happy level between these two extremes, that results in a functioning lending system. 

 -Rof 

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#11) On October 26, 2010 at 12:05 PM, MegaEurope (< 20) wrote:

Have you ever seen It's a Wonderful Life?  If people suspect the bank doesn't have enough excess reserves, there will be a run on the bank which will bankrupt them. Bank runs were quite common over the last few centuries, but FDIC regulations have reassured retail customers so that this is now rare.

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#12) On October 26, 2010 at 1:15 PM, Griffin416 (99.97) wrote:

Was in the middle of writing almost exactly what megaeurope did, oh well. 10% is around the margin of safety banks need against depositer asking for their money back on a regular basis.

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#13) On October 26, 2010 at 5:11 PM, Valyooo (99.39) wrote:

Don't people already know that theres so much leverage?  So why run on the banks?

 

CHK- thanks.  I have like 200 books to read but I will definitely read that one.

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