Previously, in Part One, I looked at where the money comes from for bank loans and mortgages. Here, I describe one of the many restrictions on the amounts that banks can loan: a bank is not just restricted by the amount of deposits it has and the amount it can borrow wholesale. Finally, I’ll comment on the “Fractional Reserve Banking” that gets circulated in YouTube videos and other silliness.

What are the constraints on how much money banks lend out?

Bank loans are not only limited by the money the banks have raised from savers and from the wholesale market. There are additional constraints on how much any bank can lend out: the Basel rules – we’re currently on Basel II, and Basel III is under negotiation right now.

This question brings us to Capital Adequacy Ratios – the belle of the Basle. (Basel is the German version of the name, Basle the French version – and it’s pronounced Barl. Belle of the Basle. Oh, suit yourselves).

Basel rules are dense, tedious, and differ in specific implementation by country, so I’ll use made-up numbers just to illustrate one aspect of what they mean: Capital Adequacy Ratios are just one part of Basel rules; there are also leverage ratios and liquidity rules, but let’s look just at one of the Capital Adequacy Ratios for now.

Right, a quick warning: there’s some unavoidable jargon ahead. I’m going to refer to Tier 1 Capital, and Risk-Weighted Assets. I’ll explain each of those first, then talk about how the Basel rules relate the ratio of them to how much a bank can lend out.

Tier 1 Capital : these are the most robust reserves a bank has – the least touchable part of its reserves. When shares are bought from the bank, then that part of the price that represents the face value of the shares, contributes to Tier 1 capital. When a bank earns profit, but retains some of it to the next year, rather than distributing all of it in dividends, then the retained profit also contributes to Tier 1 capital.

Risk-weighted assets : not all assets are equally risky – some assets are riskier than others. When a bank lends to another bank, that’s less risky (on average) than lending a mortgage to someone. And a mortgage is less risky for the bank than an unsecured loan: the bank can always repossess the mortgaged house, and recover (most of) its loan, whereas recovering unsecured loans tends to be less successful.  “Risk-weighted assets” is a way of adding up all bank’s assets, in a way that reflects  these different levels of risk. Notes and coins are treated as zero-risk assets, so have a risk-weighting of 0. Mortgages are treated as middle-risk, and may have a risk-weighting of 0.5. Unsecured loans may have a risk weighting of 1.

In order to ensure that each bank maintains some level of stability, its Tier 1 capital must be at least 4% of its Risk-weighted assets.

So, for every £4 in Tier 1 Capital, its risk weighted assets can be £100 at most. £100 of risk-weighted assets might consist of:

Asset Amount weight risk-weighted
cash £200 0.0 0
mortgages £100 0.5 £50
unsecured loans £50 1.0 £50
Total £350 £100

In this example, £350 of assets represent £100 of risk-weighted assets.

Hence, the size of a bank’s Tier 1 Capital, and the different proportions of its loan book that go to other banks, to mortgages and to unsecured loans, limits how much a bank can lend out.

So given these constraints, why did things get so bad in 2007?

After 1998, banks were able to stretch the rules, by selling off packages of loans in various types of special-purpose vehicle. Furthermore, investors became quite indiscriminate in their support for banks, even for Northern Rock, which had a basket-case balance sheet long before the meltdown happened.

Markets occasionally do engage in collective madness. We’ve come through this one so far remarkably unscathed, given the scale of the meltdown. Credit where credit’s due: when it went down, Gordon Brown and Shriti Vadera pulled off a magnificent escape act for the world. However, one of the consequences of the meltdown has been a plague of Austrian-School and other fringe (pseudo-)economists banging on about money creation. This too shall pass.

Did you see some animation that claimed to blow the lid on how banks really work?

Fractional Reserve Banking is a messy term used with a whole bunch of different meanings. However, in the youtube videos that get circulated, that particular meaning is a nonsense, and bears very little relation to how banking works.

It confuses the minimum reserve ratio (which applied to deposits, not loans) with ratios on the size of the loan book (which are very complicated, and one aspect of them is illustrated above). It makes a series of predictions that have been shown to be untrue: e.g. that expansions in broad money proceed from expansions in narrow money, whereas in reality, they typically precede them; that the money multiplier is a constant; or that Britain would explode in hyperinflation after quantitative easing.

So because many descriptions of Fractional Reserve Banking use assumptions that are demonstrably wrong, and make wrong predictions, they’re useless descriptions of how banking works.

In conclusion

Sensibly-regulated banks can do a very good job of mediating between short-term savers and long-term borrowers. The world is now moving back to that paradigm of stricter regulation, with tighter controls on lending and better management of bank liquidity. There are some who would go further, and attempt to destroy the entire banking sector, chasing something they call monetary reform but which is an attempt to drag economics back to the Dark Ages: it’s hard to see who’d benefit, other than loan sharks. So, the next time someone starts banging on about monetary reform, just walk away – they’re not worth it.  Well, when they start telling you how the reserve ratio means that banks can create money at will, you could always remind them that the minimum reserve ratio was abolished in Britain in 1981. That usually stops them in their tracks for a minute or two, while they think up some new bluff and bluster.

Banking is complicated. And in 2007, it blew itself up pretty badly, after 20+ years of increasingly light-touch and limited-touch regulation. Throughout that time, Greens were some of the few voices that said that banks needed firm regulation, in the interest of the whole economy. As with environmental protection and human liberties, the other parties have finally come around to agreeing with us. It would have been better for the economy, for people, and for the world, if we’d been proven wrong.