How banks work

How banks work -Fractional reserve system

(an article by norbert, published on his website

(updated 04.May.2016)

Excel files for the topic

How fractional reserve works

How bank create money through charging interest3

The fractional reserve system and the interests

The bank works according to the “fractional reserve lending” system. I will demonstrate their operation through some simple examples later, but before that we have to understand what this system means.
To explain what the fractional reserve system really means I will use a simple example for demonstration purposes: So e.g.: if we deposit $1 billion in a bank the bank is allowed according to the law to lend out $900 million, and they should keep a small 10% fraction from the total amount they receive – for $1 billion it’s $100 million. Now since they allowed to charge interest on everything they lend out this whole system means that they can create money out of nothing simply by getting those interests on those monies (in the example on that $900 million). But this would not be the problem since there is a risk that some people cannot pay back what they borrowed, and they also have to pay for their people (including managers, clerks, maintenance team…). The real problem is that everything they lend out will usually land directly or indirectly on an other bank account and that transferred money to an other bank account looks like an other deposit -thus in the example above if the $900 million lands in an other bank account they have 1.9 billion deposited in the banking system from which $900 million is not real money. From that $900 million they should again keep that 10% and are allowed to lend out an additional $810 million.

Naturally that $900 million eventually can land by an other bank through different purchases, but the point is that it will remain in the banking system. So e.g.: if you asked for that $900 million loan and if your employee has an account by an other bank you will transfer from that 900 million loan his salary to his account thus the other bank has the ability to lend out more, and your bank has to reduce their lending reserves. If the whole 900 million will be transferred to an other bank your bank can actually ask for loan from an other bank in order to avoid bankruptcy and other administration issues (but this is seldom the case because of the lots of deposits).

The bank’s profit is the interest the company pays for that $900 million dollar minus what interest they pay for the deposits and additional expenses (like e.g.: the expensive cars and super high salaries for the CEO-s and the managers… amongst paying the minimum for the employees and maintaining the buildings and advertisements campaigns…) So the company (or an individual) pays the interests which will be deposited in the bank’s own account and also pays to reduce the loan through those monthly installments. If the company pays back that $900 million debt, the loan disappears, but the bank created some money because of the interests. (And if they charged the people 20% interest (considering the whole period) there can be $200 million more money in the system owned by the bank (even if that $200 million has less value because of the inflation.)

In theory the banking system can lend out $8.5-9 billion out of that $1 billion -please see the examples below and also download the excel file from my webpage.

(The interesting thing is that if people would lend out money privately without the bank, there would be no money creation since people cannot deposit the loan (and actually this is how it should be, because this is normal). People could still give interest on those borrowed monies by simply giving items or services for the lender (e.g.: you can give 10 kg apple for their help…) If people could create money the way banks create money, the monetary system could not exist and collapse because of the lack of control. -The reason that we need to have our own bank is to be able to finance our endeavors that are beneficial for the humanity.)

Example 1 -How banks works

Example 1 deals with a situation where a person wants to buy a car.

So let’s say that you have 10.000 deposited in the bank. With your deposition by law they should reserve 1.000 and they can loan 9.000 to someone who want to buy a car

The borrower pays for the car selling company 9.000 and that sum can eventually land in the bank if the dealer has an account by the bank or indirectly if the dealer will give cash to their employees who will buy their product in the supermarket which has its account in the bank.

So the bank has an other 9.000 -and they have someone who owns them 9.000 + interests. This 9.000 is not a real deposit, but it allows the bank to lend out more money and get profit on interest which they can deposit in their accounts.

With your 10.000 deposition the bank can loan out theoretically 90.000. (That is to say: If everyone has a bank account and they lend out every cent they can) -please see the Excel file on my website.

If people cannot pay back their loan, the bank can sell their properties at auction and they will receive the selling price which will reduce the borrower’s loan. They will deposit every interest they received so it can be that the borrower remains in negative figure and because of the interest there’s no change how much the bank can lend out.

If you as the original depositor want your money they would be in big trouble, unless they have an other people who put 10.000 in the bank.

Example 2 -Family buying a car

Example 2 deals with a situation where a family buys a car for credit but unable to pay back the loan -and how the bank gets an asset without paying a single dime for it.

Let’s say we have a family of four who wants to buy a car for 27100 dollar. Both of the family member works and they have good credit ratings from the bank.

The father has 10000 dollar which he deposited to the bank, which means that the bank can give away 9000 dollar to other people.

Let’s say that same person’s wife asks for 9000 dollar credit. She gets the credit, but she puts the money back to the bank for a month. Now the family has 19000 dollar in deposit and 9000 dollar credit. But because of that 9000 deposit the bank can lend out 8100.

Let’s say their son asks for 8100 dollar which he also deposits and because the car is not in the saloon.

(with that 8100 deposit the bank can lend out 7290 to someone else)

How bank works -1

1. Table: Fractional reserve lending example

Now our people has 27100 dollar. 27100 dollar was created because they deposited that 10000 dollar.

If the family buys the car for 27.100 dollar that amount will be removed from the family’s account, but if the car and motor company has an account at the bank they deposited that 27100 dollar -so all is well as far as the bank is concerned (they can still lend out 7290 dollar (the last line in the table above).

Now the family has 17.100 dollar in debt. If they are unable to pay back the loan the bank can take the car and sell it on auction. If the family was able to pay back some interest it will be the bank’s profit.

The problem with bank loans is that usually people pay back just enough to cover the interest on the loan and a bit more to reduce the loan.

Thus if you pay 20% interest on the loan -you have to pay around 3.420 dollar interest on that 17.100 debt, but that won’t reduce the amount of the credit you took. For that you have to pay more.

E.g.: the 10 year long loan is calibrated that your debt will be reduced 10% (for the family 1.710 dollar) a year and you will pay interest on the remaining loan. So on a monthly basis the family have to pay in the first year 3.420+1.710=5.130 -Throughout the 10 year they paid 18.810 as interest. (Naturally there was also some inflation, but if that was around 2-4% it is negligible.)

Over the 10 years:

How bank works -2

2. Table: How a family pays for an interest over 10 years because buying a car

If the family was able to pay the debt for 5 years they will be around 8.550 in debt and they also paid 13.680 interest.

If they cannot continue the bank can sell their car. If they get 8.550 for the car they will have no debt, and they will have no deposit + no car. (Naturally they can sell the car for more, and they will have some money on their account.)

On the other hand during those 5 years the bank earned 13.680 on interest -so they could actually buy the car -And they didn’t really risked anything since they are paying with others deposit. (They also paid some interest on the deposits, so that 13.680 is not their actual profit, but they charge for various services and there are additional fees, to compensate the loss.)

An other interesting thing is that the bank hardly ever pays more interest on the deposits than the actual inflation is -So even if you receive 5% interest on your 10.000 deposit which is around 500 dollar -the purchasing power of that 10.500 dollar is equal or less than the original 10.000. So if you could buy 10000 lollipop in the first year probably because of a price increase you will be able to buy 10.000 lollipop for that 10.500 dollar -on the other hand if the lollipop’s price increased to 2 dollar from 1 dollar you could only buy 5.250 from your 10.500 dollar…

The problem’s about how bank deals with the money is that they will have additional deposits, and thus they can create 50-90.000 out of 10.000, and they can charge interest on that created money, and because of that interest they actually can buy up the different assets. And if they cannot pay, well they lost their initial investment, and other’s money. On the other hand their initial founding money returned to them many times.

Every money created will remain in the banking system, so if not with the same bank with the other, and additionally banks can borrow from each other, if otherwise they could close their business. And top of all of that if everything goes wrong the government bail them out from our taxes, just to avoid the situation where people cannot use money because the whole system collapsed in which case there will be lots of unemployed, and probably the food ticket system.

So is it acceptable that the bank can take its hand on assets without risking anything? That asset belongs to the commune, and the commune can decide what to do with it. They could give it back to the family if they bought the car because they needed for their business, or it can rent out the car for the family or someone else. Thus making profit on an asset which they could invest buying green energy devices. Additionally with this commune system the family would not be in debt.

Example 3 -How banks build their colossal buildings for free

Have you ever wondered about the sizes of the different bank buildings? Aren’t they the biggest in the town? And these buildings cost nothing to the bank, since banks have the right to create money, and they can do so by lending out to companies and individuals and receiving interests.

Now if they lend to their construction partner they will have their house created for free.

E.g.: if they have 10 million from the different deposits they can lend out 9 million to the construction company. If that company has their account by the bank, the bank will receive an additional 9 million deposit, from which they can lend out 8.1 million which they can give to the subcontractor, thus having additional the ability to lend out additional 7.29 million or they can keep it for security reason.

In reality they don’t have more than that 10 million, but with 3 lending out layer they have 34.39 million deposited. From that 9 million the construction company can create a 9 or more million dollar worth building, from that 8.1 million an other one building.

If they lend out that 9 million for 5 years on 20% interest they will receive 5.4 million dollar on interest and top of all of that they can lend out from these incomes every year to other individuals and they can charge additional interest from them.

If they lend out that additional 8.1 million with the same condition they will receive 4.86 million dollar on interest.

In sum they will receive from this 2 loans 5.4+4.86=10.26 million. They might paid for the deposits and for operational costs, but let’s say they earned 9 million (which they can lend out.)

How bank works -3

3. Table: How much a banks gain by lending out 9 million to a company for 5 years

How bank works -4

4. Table: How much a banks gain by lending out 8.1 million to a company for 5 years

The buildings value will be more than 9 million on the market since the company has to cover the interests and they also want to make a profit. The value of the building is not just the material but also the salaries the company had to pay for its workers. So if the company is bankrupted in the 6th year and the house will be sold for 9 million on auction and will be purchased by the bank or its affiliates as an investment.

Since the company paid back its credit the 9 million deposits disappeared from the initial lending, but since the bank made actually 10.26 million there was no disturbance in their operation.


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