In this happy little scenario, you will notice there is no speculation. People who knew other people lent them money because they were pretty sure they were going to get it back – yes, with interest, but that interest was modest and everyone ... the bank, the depositors, the borrowers ... all benefitted from the "system". And two immediate questions raise their eerie heads: why is the banking scenario no longer so happy; and just how is it with the bank and its ability to "invest" at all. Let's take a look at how this works, starting with the bank's ability to invest at all.
The astute reader, or anyone who has been following along, will recognize that the bank can only lend money if it has money to lend. In other words, as long as I, and my neighbors and other people in the community, bring our money to the bank, then the bank has money that it can lend to others. That makes perfect sense. We got interest on our savings accounts because we put this money at the bank's disposal, and we expected them to be prudent and reasonable in investing this in such a way that they would get a return and that they would share that return with us. The real question is, just how much money does a bank actually have to have and how much are they able to loan out to others? And this is where things start getting interesting.
Although it goes under different names and at different times was determined by any number of different formulas, for simplicity's sake we'll just call it the bank's capital requirement. Not all capital is cash, and some non-cash capital can be relative risk-free and other may entail a lot of risk. While the requirements have changed, for example from the so-called Basel agreements (we're at Basel III now), at present you only have to have about 8% to 10% capital "in the bank" at any one time. So what does this mean? Well, in simplest terms, you and me and Joe and Joan down the street may have our savings in the bank, and the bank itself may be well-capitalized and be holding at around the 10% level, but all that means is that they have about 10 times more "out and about" (invested, loaned, whatever). A simple example can help make this clear:
Let's say a bank has 1000 units of whatever as their way of meeting the 10% requirement. (You can think of these units, which we'll call ∆ for lack of anything better at the moment, in terms of singles, tens, thousands, millions of whatever; it doesn't really matter.) Mrs Jones needs a small-business loan and the bank lends her ∆500. Mr Smith wants to improve his house and gets a ∆250 loan approved. Acme Products needs to make payroll and wants a short-term cash injection of ∆1000. The bank has invested as well, say, ∆10,000 in various securities (bonds, treasury bills, etc.), and the list goes on and on. Simple arithmetic reveals that the bank has already used more "money" than it actually has (i.e. ∆11,750) but it can continue doing this until it reaches its ceiling of ∆100,000 in total. Of course, everyone (or almost everyone) to whom the bank makes a loan makes periodic payments and the total of those payments will be greater than the sum loaned out because the bank in charging interest on those loans. Not everybody who has money in the bank will want their money all at the same time – generally speaking – and so the bank is safe, so to speak, in lending out more than it actually "has".
Note: This series was originally published in slightly modified form on the Daily Kos.
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