Understanding Fractional Banking and the Financial CrisisDecember 31st, 2012 by Aaron Koo
Most people I know of are at least vaguely familiar with the catch phrases and cliches of the current financial crisis. I remember I was at a party the other week and a buddy of mine was passionately telling the group that the central banks give money out at interest. We all instinctively feel that it sounds like a bad thing. I asked him, “What specifically does that mean?”
Despite his fervor, he, in fact, hadn’t a clue. We’re all experts as long as there no one in the room knows more than us. I remember another conversation where someone complained about the bailouts and that the money should have been given to the people instead of to the corporations, again quite passionately. I asked them, “How specifically would things be different if people had the money in their pocket instead of the corporations?”
Again, it just sounds like a bad thing. I’m not saying whether it is or isn’t, but I do want to take away the confusion so that everyone can have a firm grasp on a situation. The “can screw me over” to “how much I care about it” ratio is the most distressing of any in the world.
What’s The ACTUAL Problem?
Is it the corporations? Is it the government? Is it out-of-control consumer debt? In a nutshell, there just isn’t enough money in the world.
Before World War II, banks were small independent business owned and operated like the way any other small business was run. When it came to lending, the owners of the bank would put up the money themselves. In fact, it was the law that they had to. So, if I went for a loan to start a business, the owners of the bank would sit down with me and chat. Since it was their own money, they wanted to make sure it was going to be in good hands.
The Fractional Banking System
Fast forward to the days of the Reagan administration. Banks became deregulated and that rule of the bank having to fork over the money first no longer applied. They could use the money they had on hand from their clients, which is what is referred to as the fractional banking system. And since it wasn’t there’s, they felt free to be a lot more reckless with it.
So, I’m “Bank A” and I have $1 billion in my care. It’s not my money, but I’ll lend it out at interest in the way of mortgages, loans, credit and the like. A borrower comes through my doors looking for a $2 million loan. No problem. I don’t even have to give you paper money. I can give it to you electronically. And it’s still my money, since you have to pay it back to me at interest.
The borrower takes that money and puts it into another account at “Bank B.” Bank B can now show on their books that I have given them $2 million. Meanwhile, Bank A still has that $2 million on their books too. As an aggregate, we somehow now have $4 million on the books, even though there really is only $2 million in existence. And then, at the same time, Bank B does the old “rinse and repeat,” further loaning that money to someone else and the cycle escalates.
When the person at the end of the line can’t repay their loan to Bank Y, this creates a domino effect. On the books, all the banks combined need hundreds of millions of dollars. What they actually have to work with is only $2 million. See the problem?
What a Tangled Web We Weave
This phenomenon was most prevalent and popular in the form of a Collateralized Debt Obligation (or CDO). CDOs were an initial debt that was passed around. Imagine at school that you borrowed $5 from a buddy at a 10% interest rate. If your buddy told another buddy that you would owe him the money instead at the same interest rate, he could sell that like a CDO for $6. And because it was all amongst friends, we knew that the debt was secure and had a high likelihood of being paid back.
The difference with the current banking system was that, in the case of the $5, I in fact lent it to one of my least trustworthy friends and simply told you that I really trusted him. CDOs were debts held by the riskiest of people: people who wanted to buy a home and yet made no money (known as a sub-prime mortgage) or people with lines of credit who couldn’t control their spending. And the credit rating companies were telling people that bought CDOs that they were good for it and that they were financially strong people.
Remember that fractional banking system? These CDOs were bought and sold like we buy our morning coffee and newspaper. And, as the initial debt collapses and people can’t pay their mortgages, you run into that problem of having hundreds of millions of dollars being owed, and not nearly enough money to pay it back.
Can It Get Even Worse?
This may seem like a post about the recent financial crisis we had. However, it is more accurately a look at where we’re headed, the how and the why this happened. The CDOs were only a part of the whole story. The most important part I believe is how this affects you. I’ve said earlier that finance unfortunately has the lowest “can screw me over” to “how much I care about it” ratio. The freaky part is that because of this inflating economy, we have the illusion of everything being okay. That just facilitates this carefree attitude.
But how long can it last and what will happen when it’s all said and done?