Fletch wrote:That happens when banks have gambled too much and then lost. Creating money as loans is a bet. They are not lending someone else's money, the money never existed before the loan was made. The gamble is that the loan is repaid and then the created money can be deleted from the books and it's all back to normal. If the loan is not repaid, or in the case of a mortgage, the loan sliced and diced with others loans then sold on as financial investments, then there is a problem if the loan 'stops performing'. (goes in to default) The bank has to make up that loss.
What you have to remember is that all money is createdout of thin airon a computer as debt. ie a loan.
Regulation of banking means sticking to a leverage of around 35 times. The idea of capital reserves is that not all of the deposits can be used to create money, hence limiting banks to around the 35 times mentioned.
When a loan doesn't perform (defaults) it causes a liquidity problem. Suddenly banks are outside the lending ratios and have less ability to carry out day to day functions due to that imbalance. The solution in the 2008 crash was to inject capital so the lending ratios were back within limits and enable liquidity to be available for day to day business.It was in effect a paperwork exercise with the money to bail them out also being created on a computer with the government signing up to the debt. They took shares in the banks in return for the capital but those were also created at the time by the banks.
How loans become deposits:
Person A borrows 1000 from bank 1.
Bank 1 created the money when the loan was agreed
Person A buys a car from person B. He pays person B 1000 for car.
Person B pays the 1000 in to his bank, Bank 2.
Bank 2 now has 1000 deposit which can be leveraged to loan out 35,000.
Money is created as debt but has to be laundered through a third party. Banks can't create debt for themselves, only the BoE can do that. The central bank has no limit on how much it can create, commercial banks do.
Your illustration is wrong
The bank cannot lend £1000 to person B
The bank is required to hold back a FRACTION in RESERVE
That's why it's called Fractional Reserve Banking
Under Basel II the absolute minimum reserve for Capital Adequacy is 8% which means that they can loan up to £920 to person B
Then only £846 to person C etc diminishing with each loan
So the total amount of funds leveraged from the original £1000 of deposited funds is not £35,000, it's only £11,825
Which brings us back in a full circle to the calculation that banks must use for their risk-weighted capital adequacy reserve
And back to your exam question which you have avoided from the very start
Now it's time to respond.