How the (Fractional) Banking System Works

We are witnessing what some journalists call “the disintegration of the financial system.” How did we get here? How did some bad subprime mortgages lead to what is beginning to look like the collapse of capitalism? [Note: For a fuller explanation of subprime mortgages and what went wrong in the housing market, see "The Mortgage Mess and Financial Meltdown" in END 94.]

This is the great unanswered question in the midst of this extraordinary crisis, as banks implode one after the other across the world. We hear a lot of financial jargon. But underneath all the jargon is a fundamental truth about banking: that it is based on a kind of confidence trick.

It’s called “fractional reserve banking.” Alone among commercial institutions, banks are allowed to create value out of nothing—in other words, they are allowed to lend money they don’t have.

To explain more fully: At any one time a bank may have, say, $1 billion in assets, but it will have loaned out at least $10 billion. That $10 billion will yield interest, earning money for the bank—but it’s interest on money the bank doesn’t actually own. Magic. Money for nothing.

But this magic only works if the debtors the bank has loaned to don’t default on their loans, and if the savers who have placed deposits in the bank do not try to take them out all at once. If they did, then the bank would rapidly become insolvent, because of the $9 billion (or more) it has loaned out that it never had in the first place. That’s what started to happen recently: The confidence trick began to fail.

Banking practice dates from medieval times when kings and aristocrats deposited their gold with goldsmiths for safekeeping. The goldsmiths noted that the owners didn’t all ask for all the precious metals back at the same time, so they started to lend it out. This is why, until recently, bank notes “promised to pay the bearer on demand” a sum of gold or silver. It was all based on precious metals.—But not any more.

Most currencies ceased to be linked to precious metals during the 20th century when countries abandoned the gold standard. In the aftermath of WW2, with much of Europe and Asia bankrupt, the U.S. dollar became a universal medium of exchange, and with a deal that all oil must be purchased in dollars, it secured its place as the primary currency that countries hold their reserves in. America said that the world should regard their dollar as being “as good as gold.”

This is called “fiat” money, paper money decreed as being valuable by government, and some economists believe that it is the root of all evil. Because it has no intrinsic value, governments cannot resist printing more and more of it, thus devaluing their currency.

Central banks try to control the value of their currency by manipulating interest rates, the rate they charge institutions, businesses, and people who borrow money from them. High interest rates make it more expensive to borrow money, so less money is borrowed, and that acts as brake on the nation’s economy, deflating it. Low interest rates make it less expensive to borrow, so more money is borrowed and circulates in the economy, stimulating it. If interest rates are low, this not only stimulates the economy, it also leads to inflation, so banks generally alternate between raising and lowering interest rates so that they can try to keep the economy in balance.

For the past 20 years, however, central banks have constantly cut interest rates. After economic downturns in 1987, in the late 1990s, and in 2001, the U.S. Federal Reserve—followed by central banks in other countries—cut interest rates dramatically and kept them low, in an attempt to boost the economy and avoid more downturns. People could borrow money easily, so they did—and often invested it unwisely. They often invested in housing and properties, bidding its value way up, far beyond what it was actually worth.

At the same time, the bankers made saving money a losing proposition. Interest rates were held below the rate of inflation, so anyone who saved actually lost money. Therefore, few people saved. Those who had little money to begin with borrowed money fairly easily, often going into debt. Those with more money invested it to try to make even more money, assuming that the things they invested in would just keep going up, as they generally had for the last 20 years or so.

The bankers knew what they were doing. Some even admitted that the housing boom was “unsustainable,” but they kept lowering interest rates, pumping more and more cash into the economy to prevent a recession. Unfortunately, it got out of hand.

Banks invested heavily in property, making housing loans even to those with poor credit, since both banks and their customers believed that house prices would keep going up. Both lenders and customers figured that even if housing prices fell, their central bank would slash interest rates again (making mortgages cheaper), and house prices would rise again.

This confidence that central banks would ride to the rescue led banks to take bigger and bigger risks. Thinking the market would keep going up, banks bet more and more of their money on it doing so, because the potential profits were so great. For example, they might make a $10 million investment by putting down $1 million of their own funds, or funds they’d borrowed from other banks or institutions, and make millions. This is called leveraging, and it became all the rage.

Instead of lending ten times the value of their underlying assets, investment banks started lending out 30 times their asset value. After all, by leveraging their money and using all that they had or could borrow, they gambled that they could make much more money. This allowed the hedge funds (high-risk investment companies) and private groups financed by investment banks to go on buying sprees across the corporate world. They were getting colossal quantities of almost free money.

“Leveraged buy-outs” (LBOs) became the name of the corporate game. Groups of investors would get together, target a company, borrow to buy it, sell it at a profit, and move on. Hedge funds flipped multi-billion-dollar companies the way amateur property speculators in California flipped houses.

But it was all based on credit, and the dark side of credit is debt. All of this leveraging works only as long as the underlying assets, the collateral for the loan, retain their value. Using leverage seemed like free money. But when assets decline in value, the ugly side of debt appears in the form of “deleveraging.”

If a big bank has loaned out 30 times its assets, for example, it may have loaned out $3 trillion on the basis of only $100 billion in reserves. If those assets lose half their value and the bank suddenly has to come up with the cash it owes, it then finds itself in the hole to the tune of $1.5 trillion or more. It was able to leverage its funds to make huge investments, but the downside was the possibility of huge debts, as well as bankruptcy.

Greatly simplified, this is what has happened in the last year. A class of complex paper assets called “securities,” which are based on the value of residential mortgages, started to lose their value as U.S. house prices started to slide. The banks suddenly stopped trading these mortgage-backed securities because they were afraid of the potential losses that might show up if they did.

These assets included the now-infamous subprime loans—money loaned to people who couldn’t possibly pay, or who couldn’t repay as much as they had borrowed—which were packaged up into what was called “collateralized debt obligations” and sold to other banks and governments around the world who didn’t really know what they were buying.

About a year ago, housing prices started dropping, and smaller banks that had engaged in the riskiest lending and purchased some of the shakiest securities started failing. Then huge Wall Street investment banks such as Bear Stearns started to discover that their assets were declining even more rapidly than expected. (Since these assets were based on house values that were plummeting, the assets were plummeting as well.) Sensing this, investors started withdrawing their funds from them, causing a kind of bank run.

To prevent widespread defaults, the U.S. government stepped in and forced another bank, JP Morgan, to buy Bear Stearns at a fraction of its value. But this didn’t stop the collapses. Within the space of six months, all the big investment banks on Wall Street had collapsed, merged with other institutions, or been converted to commercial banks, in one of the greatest banking crashes of all time.

Then the big mortgage banks, the last stop in guaranteeing mortgages, started to go under. The two huge state-supported U.S. mortgage banks, Freddie Mac and Fannie Mae—responsible for more than $5 trillion in mortgages—had to be nationalized, along with the world’s largest insurance company, AIG.

Banks which had previously handled trillions in investments were finding that they were becoming insolvent almost overnight. Because of the global reach of these companies, this became a crash even more severe than the series of banking failures that led to the Great Depression in the 1930s.

This financial crisis has spread through the entire banking structure of the West. It has moved from a crisis of insolvency to a crisis of confidence in the banking system—everyone wants their money out because no one trusts their banks. The essential trust that allowed the goldsmiths to lend on the basis of their borrowed gold has begun to evaporate.

The International Monetary Fund warned that the world financial system stood on the “brink of systemic meltdown” after stock markets plummeted around the world, with an estimated $4.6 trillion in losses. The financial crisis, which began in the U.S., has poisoned global finance, disrupting markets that trade everything from stocks to sugar. Russian financial markets have closed two or three times as stocks have plummeted. Banks failed or were nationalized in Europe, and the economic turmoil has taken a toll on governments as well, with Iceland desperately seeking a bail-out, Ukraine seeking IMF aid, Pakistan edging toward default on its debts, and a number of other countries in Asia, Africa, and Latin America dealing with the plummeting value of their currencies.

Recently the U.S. and Europe agreed on a financial plan that has stabilized the financial markets to some degree. Major European powers unveiled a $2 trillion plan to prevent further bank failures, the U.S. government announced plans to invest up to $250 billion in the nation’s banks in a move that will amount to a partial nationalization of banks, and Australia and New Zealand guaranteed bank deposits. It remains to be seen whether this will turn the economic crisis around or whether it only amounts to a pause in the downward financial spiral.