Saturday, 9 August 2008

Financial basics - Banking Part 2

Fractional reserve banking (unique item.)

It's an almost cast iron rule in banking that the name of the subject concerned is exactly the opposite to what is occuring, or has nothing whatsoever to do with what's really going on. oh, and I know that people get very worked up about this stuff but don't worry, nowhere actually still uses FRB these days but we'll get to that soon to. Just fyi before we begin. :)

Let's start with our first sort of fractional reserve banking - unique item fractional banking.

If we remember our piano from the previous blog - we left it in the care of the banker and paid him a fee to look after it for us, but then found out that he had loaned it to someone else - a pianist. Now...why could the banker do that?

Well, pianos are kindof hard to move and if we store them it's not all that likely we will be coming to check on them or want them back anytime soon. The banker can therefore be reasonably sure that he can loan our piano to someone, charge them a fee and still give us our piano back when the time comes for us to collect it.

In a fractional reserve system, the banker lends the piano to several other people for a fee. The piano is the reserve and the fraction is the amount of people he can lend it to before some external constraint like being found out by the original owner or running out of people who want to borrow limits the lending. One crucial constraint is the amount of time it takes to move the piano about. The faster that piano moving can occur, the more times the piano can be loaned.

If the banker has 1 piano and lends it to 20 people, the fractional reserve is 5%

Lets say he lends Bob the piano in January and Bob pays him a violin for doing so.
In Febuary, he lends John the piano and John pays the banker a flute for this service.
In March, he lends Linda the piano and Linda hands over a bassoon as payment.
And so on...

We can see that pretty soon the banker has a whole orchestra worth of instruments (but no idea how to play them.) What can he do? All the banker knows is lying, storing and it's pretty easy to imagine that he will try to lend out the other instruments he has gathered if he can - not being able to play them for one and saving on storage for another, plus he can get still more fees from those loans.

In fact, by lending the piano out, he pushes the cost of looking after the piano onto others. Each pianist is paying the banker to do the bankers job for him.

Of course, this isn't quite as simple as I make it appear - the piano can be damaged, it can be stolen, it can go missing. However, it's worth noting that if, say, Linda loses the piano when she is borrowing it, it's up to Linda to replace it. If she can't, the banker can take her to court and make a very good show of having lost "his" piano. All the paperwork will certainly show that and Linda herself will almost certainly think that this is what has occured. Linda will be paying for a replacement piano, have to find the instrument as fee and will probably be paying the bankers court costs as well.

A fractional reserve system as regards a unique item, therefore, is a recording of who has been loaned what, where and when from the bankers perspective but without the global perspective that will reveal him as a fraudster.

The banker has 1 piano but receives a whole orchestra on the back of apparently carefully looking after it for someone else. As long as the banker selects his pianists reasonably carefully, he has absolutely zero risk. All he need do is loan the piano to people who already have more in assets than the piano is worth and he can never, ever lose.. Worst case is he has to write off the piano because someone has damaged it, pay the original borrower back (in fiddles?) while apologising and keep all the instruments he has gathered in the meantime. Win/win/win for the banker.

Now we can see why a banker is a man who lends umbrellas when it's sunny and wants them back when it is raining.....

The next question to answer is what happens when there are two bankers......which I will cover tomorrow.

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