The Mechanics of the Banking System

The Mechanics of the Banking System

Today marks a turning point in UK banking, with the long awaited report from Independent Commission on Banking, chaired by Sir John Vickers.
[http://bankingcommission.independent.gov.uk/]

Effectively this is recommending that the retail banking business is ring fenced from the risking investment banking arm, to avoid a banking collapse, and protect the UK taxpayer from a bailout.
The banking system on the high street works on a process called The Fractional Reserve Banking. This refers to a banking system which requires the high street banks to keep only portion (a fraction) of the money deposited with them as reserves. The bank pays interest on all deposits made by its customers and uses the deposited money to make new loans. In order to understand how fractional reserve banking works, in this blog let’s look at the following example.
[I read a book on finance by Liaquat Ahamed that gives a worked example]
Somebody (not Asad Karim, he’s not that flush…) deposits £10,000 with HSBC. HSBC is obligated by law to keep 10% of the deposited money as a reserve, that’s why the bank keeps £1000 and lends out £9000. Somewhere down the road the £9000 loan is deposited in another bank account (RBS for example, or it could be with the same bank HSBC but let’s keep things simple). Now RBS (our second bank 83% owned by us, the UK Taxpayer…) also wants to make money by giving out loans, that’s why it keeps the required £900 and lends £8100. Fast forward to a deposit with a LloydsTSB (fourth bank, 41% owned by us, the UK Taxpayer…) and you’ll get the following:
Bank             Deposit           Reserve           Loan
HSBC             £10000            £1000                £9000
RBS                £9000             £900                  £8100
Barclays         £8100             £810                  £7290
LloydsTSB     £7290              £7290                £0
Total              £34390            £10000              £24390
As you can see from the table above, the banks created £24,390 in loans based on the first £10,000 deposited. Yes, you guessed it a licence to print money. This is sometimes known as the ‘Money Multiplier’ where money gets re-lent out, some commentators call the banking system a hugh Ponzi Scheme. The fractional reserve banking works for now, because the total amount of withdrawals is offset by deposits made at the same time. While the depositors are confident at the fractional-reserve banking system, a very small part of all deposits is withdrawn at the same time allowing the banks to handle the withdrawals through their minuscule reserves. However when people’s confidence in the banks is shaken, bank runs are possible, (2007 UK Northern Rock) and the entire banking and financial system can collapse.
However, what I don’t understand from the Sir John Vickers report, is that even if the report is put into law, and retail deposits are secured, that would not saved HBOS, Northern Rock, Bradford and Bingley, London Scottish Bank, all of which, were Retail banks, with NO risking investment arms, and were brought to their knees, by simply lending too much (from retail deposits) to the property (real estate sector) !!
In otherwords, poor credit management was to blame.

Leave a Reply

Your email address will not be published. Required fields are marked *