Posted on August 28, 2009 - by Level13

Dummies guide to crisis 2007-09 (Part 1 of 4)

Photo from Level13 Financial Ramblings

When the financial crisis erupted full force in the second half of last year, there was panic all round. This and the next posting will focus on the banks’ contributing role in the crisis. Before going into details, one has to understand the basic principles on which the banking system operates.

Students at the A-level are taught about “multiple deposit creation,” It is the most rudimentary money creation mechanism for banks, which if administered properly serves the economy and public at-large very well. In the deposit creation process a bank accepts deposits and lends them out. But almost every lending returns soon to the bank as a deposit and is lent again. In essence, when people borrow money they do not keep it at home as cash, but spend it, so this money finds its way back to a bank quite quickly. It is not necessarily the same bank, but as the number of banks is limited (indeed very small) and there is—or was—a very active interbank lending. In terms of deposit creation the system works like one large bank.

Therefore, the same money is re-lent over and over again. If all depositors of all banks turned up at the same time there would not be enough cash to pay them out. However, such a situation is highly unlikely. Every borrower repays his loan and pays interest on it. In principle, the difference between a loan and a deposit interest rate is a source of the banks’ profit. Naturally, banks have to account for some creditors that will default and reflect it in the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it, the banks possess their own capital to provide security. Read more…

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