Alla inlägg den 20 januari 2009

Av Sunda Pengar - 20 januari 2009 07:36

Fractional Reserve Banking (Part 2 in English)

This English version is written on request of Ellen Brown.

Capital adequacy ratio (CAR) in Sweden and the Basel II Accord.

Basel II is a private initiative that has originated from the banks themselves through BIS (Bank of International Settlements). The committee is comprised of central banking representatives from 10 different nations, among others Sweden, USA, Japan, Germany and so on. They meet four times a year with the goal of conforming reserve requirements globally and a mutual view on how to judge and handle risk.

It was this type of harmonization preparation that pave way for the Euro area in connection to the Maastricht treaty.

The key point of the Basel II accord is the separation between operational risk and credit risk which was not separated in Sweden under the liquidity requirements.

The directive is comprised of three pillars.

Pillar 1. Deals with capital adequacy ratios based on these three main fields of risk; market risk, operational risk, credit risk.

Pillar 2. Deals with regulation to supervise the points in pillar 1.

Pillar 3. Deals with issues regarding increased transparency in the banks book keeping and information supply. This to instill more market confidence.

The accord is implemented in Sweden and supervised by FI (Swedish Finance Authority) under law:

Lag (2006:1371) om kapitaltäckning och stora exponeringar.

The law states that the capital base has to be a minimum of 8% risk weighted exposure.

With the introduction of Basel II, there are now 15 risk groups judged with different risk weight.

The risk weight mechanism is very simple. Say a company wants a loan for 1000SEK. They are given the risk weight of 10%. Total capital base needed by the bank to cover the loan will then be; (10%*8%) *1000 = 8 SEK

I will list some of the actual risk weights for different loan categories in Sweden.

From 1 Jan 2007 enl. BASEL II
1.    State, centralbank 0%
2.    Municipalities and similiar authorities 0%
3.    Companies 4-12%
4.    Households 6%
5.    Households with security 2.8%-8%
6.    Funds 4%-12%

The capital base needed will then be calculated according to this formula.

The size of the loan * (Capital Adequacy Ratio * Risk weight) = needed capital base.

As you may have noticed, the state has a risk weight of 0 which in practise means that a private bank could issue loans towards the government regardless of capital base towards infinity. The bank is required to have close to no reserves for government lending since a states default is mostly a case of theory since it can monetise its debt to pay it off (paying through inflation).

This is also confirmed by FI. The only thing constraining the banks is the limitation stated under operational risk so the bank can have extremely high leverage towards state lending.

As you might have observed, these rules are considerably different from the liquidity rules popularly quoted online as restriction of government lending. With the application of Basel II regulation, private banks are allowed to create much larger quantaties of credit then possible before in relation to its capital base. How it works in practise can most easily be understood with some simple book keeping examples.

The banks bookkeeping, the liquidity requirement

In this simple example, we assume a liquidity requirement of 10%, which means they can lend 90% of current capital. The bank below has a deposit of 200K SEK and isses a loan for 90% of that deposit.

Nr    Description            Debit       Credit
1    Deposit (Asset)    200,000 kr    
2    IOU (Debt)        200,000 kr
3    Creation of loan (Asset)       180,000 kr    
4    Creation of IOU (Debt)        180,000 kr

The banks balance sheet will now look like this.

Money            200,000 kr    Money                                        200,000 kr
Loan              180,000 kr    Money with no covearage (IOU)    180,000 kr
Sum Assets    380,000 kr    Sum Liabilities                              380,000 kr

Please note that the assets and liabilities incrase in proportion to the loan. The depositors money is never used to create the new loan. It only exists as new bank money (BCM) in the book keeping of the bank.

The difference with Basel II and practical bookkeeping

In practical book keeping, the size of the deposits is not an absolute requirement for how large a credit (loan) a bank can issue. In the liquidity requirement, we saw that a loan could grow with 180K with a deposit of  200K. The limitation in Sweden is as earlier described based on the risk weight.

In this example, we say that a bank is going to issue a loan to a company which has been given the risk weight of 4% in total. The capital base of the bank is still 200K.

The maximum theoretical loan the bank can issue is then:


The balance sheet will then look like this:

                             Assets        Liabilities
Money                200,000 kr    Money                                         200,000 kr
Loan              5,000,000 kr    Money with no coverage (IOU)    5,000,000 kr
Sum Assets    5,2000,000 kr    Sum Liabilities                          5,200,000 kr

Notice the same thing here. Deposited money in the bank is not used to issue new credit. The credit is issued over and above existing money, thus the money supply as a whole has increased in society. This is called the creation of wealth.

The bank has now stretched its capital base to the maximum for loan recipients with this risk weight.

Now the state wishes to take a loan from an additional 5,000,000SEK from the same bank. Since the reserve requirement is 0%, needed additional capital base the bank needs to issue the credit is also 0.

The balance sheet will now look like this:

    Assets        Liabilities
Money             200,000 kr    Money                                           200,000 kr
Loan          10,000,000 kr    Money with no coverage (IOU)    10,000,000 kr
Sum Assets    10,2000,000 kr    Sum Liabilities                      10,200,000 kr

What happens if depositors withdraw money?

The bank has now promised 10MSEK and only has 200K SEK as reserves. What happens if the demand for withdrawals exceeds 200K SEK?

The bank can in the short term borrown on the interbank market. In other words, they can borrow credit from another bank to fill the shortage in their own bank. This only works as long as the bank has trust with the rest of the banking community.

The state or central bank can also intervene and issue loans, usually to a penalty rate to ensure capital adequacy.

It is possible for banks to create this much credit since banks to this in unison. The in flows and out flows in the entire banking network tend to net eachother out and the differences over the medium term is small and easily covered by inter bank lending.

What have we learned?

The restriction is how much money, or credit that can be created in a bank is restricted by the Basel II accord.

A loan is never based on a depositors money, the credit is instead created when you request it.

This means that when you take a loan for your house, you receive a new credit that instantly is balanced by corresponding amounts of new savings.

This means that all savings = loans.

The notion that savings are low is completely impossible. Savings are always the same size as loans within the laws of accounting. The distribution is however not evenly spread out.

A bank note is a proof of debt, not money in the traditional term.

A deposit you have on your bank is not an asset, it is a claim on your bank. The bank never in short term has possibility of paying more than a fraction of its depositors back. This is why bank runs are so feared.

The only way for a depositor to receive full payment on your claim on the bank is to withdraw physical cash.

The fact that money is created when it is borrowed also means that it disappears when it is repayed. This explains the fluctuations in money supply and why the money supply always seems to decrease in a credit crunch and increase in expansionary economy.

A wealthy society is also a highly indebted society.

Key differences for USA and Swedish capital rules

USA is under the Basel accord but has not yet adopted it fully.

There are several things differing in USA banking practise, the key being that capital adequacy ratios are only calculated on deposits. Not loans.

This is also effectively worked around through the practice of Sweep accounts and off balance sheet accounting.

Sources of credit creation

Money Mechanics Federal Reserve

Of course, [banks] do not really pay out loans from the money they

receive as deposits. If they did this, no additional money would be

created. What they do when they make loans is to accept promissory

notes in exchange for credits to the borrowers¡¯ transaction

accounts. Loans (assets) and deposits (liabilities) both rise [by

the same amount

The Chicago Federal Reserve, Modern Money Mechanics (last updated


When a bank makes a loan, it simply adds to the borrower´s

deposit account in the bank by the amount of the loan. The money is

not taken from anyone elses deposit; it was not previously paid in

to the bank by anyone. Its new money, created by the bank for the

use of the borrower.

¨C Robert B. Anderson, Secretary of the Treasury under President


Banks create money. That is what they are for. The manufacturing

process to make money consists of making an entry in a book. That is

all. Each and every time a Bank makes a loan, new Bank credit is

created, ªbrand new money.

C Graham Towers, Governor of the Bank of Canada from 1935 to 1955



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