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What do banks do with my money ? That's how the fractional reserve ~ Manage Your Loan

Wednesday, September 25, 2013

What do banks do with my money ? That's how the fractional reserve

 The causes of the crisis in Spain is no longer a secret to anyone . The housing bubble , fueled by bank loans about low interest rates , caused the property prices rising beyond their market value and at one point the situation became so untenable that the bursting of the bubble with dire consequences were a fact .

But why credit bubbles occur , and therefore cycles? And if they have such dire consequences for the economy , why not stop in time? Many of these issues are explained by fractional reserve banking .
How does fractional reserve ?

Imagine that we have a free garage left a friend in need , and it begins to rent the moments others do not use it. We would not like it? Well that's what banks do with the money we put into it, because of the privileges that the state grants .

In reality , banks only have to keep a small part of the amount of money they have in deposits , called reserve ratio of 2%. That is, if we attend to the bank to deposit leave as 100 euros , the bank is only required to keep two . The rest of the money it can lend to others who , in turn , can admit you to a different bank , having to save the second only 2% of that amount , giving the rest to a different person and so on.

For example, when a person opens a deposit in a bank , call it Bank A, with 10,000 euros , the bank can pay 9,800 to another individual so that, for example, you can buy a car. At that time, the car salesman enter the money in another bank as deposit in bank B , which must observe only 2% of 9,800 euros , ie 9,640 euros. This process could continue and be repeated up to 50 times , having generated an amount of money of 500,000 euros with an effective base of only 10,000. This is what is known as banking multiplier .

But what if I go to withdraw all my money from the bank? actually be a single person withdrawing money the bank has no effect , because the reserve ratio of 2% is applied to the total deposits , so that, in principle , the money a customer will withdraw at any given time is available . The problem is when many customers flock en masse to withdraw their money , since in this case the bank would not have enough money to supply them all . This is precisely what happens in the movie Mary Poppins and her famous bank run .

However, banks have other tools to avoid this problem . The banks ( and I would highlight only the banks) may access financing from other banks , which is called interbank market or ultimately to the central bank. It is for this reason that the Central Bank is sometimes called lender of last resort , because they cover banks in case you do not have the enough money to have to refund to its customers.

But then, if the bank lends that money is because they do not have ? Not exactly . While it is true that the bank no longer has the physical money that his client deposited , the bank still has the money . The only thing the bank has done is make a note on their balance sheets accounting creating therefore virtual money. It is for this reason that only 10% or less of the cash available in notes and coins , and so the money is not gone , but it never really existed .

The fractional reserve credit bubbles generating

In a financial system in which savings are channeled into investment , customers would open deposits would yield them a certain interest for a while , giving up that money for a while that the bank used to pay investors who needed financing for their productive investments. Your profit would come from the difference between the interest that would be payable to the individual and the interests of your loan.

However, fractional reserve banking this link is broken completely . The ability to create money , and that , should you come wrongly made , will be an interbank market and ultimately a central bank that will cover the liquidity risks to which they have to face , make the bank managers do not have to worry about the solvency of their investments , paying virtually no risk. In these cases, when generating the credit bubble that we all be familiar .

The problem is when something is wrong and investments and loans made ​​more political than business criteria , begin to stop paid. The interbank market funding denied the bank ( the other banks stop offering liquidity for credit risk) , and the Central Bank , looking overwhelmed by what could be a chain demand all banks, forcing them to recapitalize and on occasion the nationalization . All serve to avoid a greater evil : the banking panic .

Therefore, fractional reserve banking is the main cause of the phenomenon known as cycle of boom and depression. When they discover the errors and excesses , it is fair when it happens the reverse of multiplication. Liquidation of investments and repayment of loans , increased delinquencies and loan losses , greater prudence of banks and the withdrawal of funds from depositors , reinvesting the previous expansion and causing the dreaded deflation.

Ultimately, the fractional reserve is the main cause of all these problems. I encourage readers to see the documentary fraud: the reason for the Great Recession , as well as one of the lectures of Professor Jesús Huerta de Soto about the financial crisis, or read his book Money, Bank Credit and Economic Cycles .

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