How banks really work

Published on Tuesday 13 January 2009 19:08

Alistair McConnachie's eloquent description of how the banking system operates (Letters, 12 January) contrasts with the more widely held misunderstanding of how the system works, exemplified by Alan Black's letter (same day).

Mr Black, like most people, believes the money banks lend comes from our deposits and the bank's capital. In fact, these two elements are a small proportion of what they lend. The banks operate under the fractional reserve system, which allows them to lend a multiple of their reserves (ie, capital and deposits). This multiple differs from time to time and from country to country, but is now between 5 per cent and 7 per cent.

On a reserve ratio of 5 per cent, for every 20,000 of deposits, only 1,000 need be deposited with the Bank of England and the bank can lend up to 19,000. This 19,000 will probably be spent by the borrower (eg, to buy a car) and the seller of the car will, in turn, deposit the 19,000 with his bank, which can put 950 in reserves and lend a further 18,050. Once this is repeated by the magic multiplier roundabout enough times, the original 20,000 deposit is transformed into loans of 380,000 and reserves of 20,000.

The 380,000 is created out of thin air by banks getting borrowers to sign loan agreements and then creating electronic credits in the borrowers' accounts. The debt money has cost the bank nothing to create, and if it lends it at just 5 per cent, by the end of year one, the income on the loan, if added to its reserves, will almost take the bank back to where it started. Money is debt, created by the banking system, uncontrolled by government.

DEREK BROCK

Corstorphine Road

Edinburgh