Thursday, November 29, 2012

Banking reality check

 By Helge Nome

There appear to be many misconceptions about banking out there. A gross one is that a 10% reserve requirement means that a bank can lend out ten times more money than it has on deposit from customers. The idea of a 10% reserve is that the bank is required to have that amount of money on hand to satisfy any depositors that might want to withdraw their deposits at any given time. That, in theory, should mean that the bank is authorized to lend out an amount equal to 90% of its deposits, withholding 10% to cover statistically predictable depositor demands with a safe margin in most circumstances, (except for a bank run).

 That's the theory, and that's where it gets sneaky: A bank's consolidated balance sheet will show, as an example (for ATB Financial here in Alberta in 2008) outstanding loans as assets of $19,443,917 thousand ($19 billion) as against deposits (liabilities) of $21,175,716 thousand ($21 billion). This gives one the impression that from $21 billion in deposits an amount of $19 billion has been re-lent to borrowers. However, and this is important, double entry accounting used by the bank to generate its balance sheet records each loan made as both an asset and liability (i.e. deposit).

 So, an average Joe, like me, looking at the balance sheet believes that a bunch of people dropped off $21 billion of their money in the bank so as to earn some interest, and that the bank re-lent $19 billion of those deposits to borrowers at a somewhat higher rate of interest, thus covering its costs and hopefully some profit for the shareholders on top of that. But as we can see, that's all smoke and mirrors.

 In reality, the bank needs to have money-numbers recorded at the central bank to cover any transactions it makes with its customers because virtually all those transactions involve other banks. In reality, also, the "fractional reserve" idea only exists in textbooks and has never really been practiced. Rather, central banks have made money available to the banking system dependent upon demands from that system at any given time.

 So, in times of economic slowdown, one would expect a bank to make less money than during boom times? Right?

 Wrong!! These are today's numbers from the Royal Bank of Canada as per an article from CityNews in Toronto recorded here:

 "The Royal Bank says it had a record annual profit in 2012, including $1.9 billion of net earnings in the fourth quarter. The quarterly profit amounted to $1.25 per share of net earnings, or $1.27 per share of adjusted diluted earnings. For the full-year ended Oct. 31, RBC had $7.5 billion of net earnings. That's up 17 per cent from 2011 and equal to $4.96 per share of net earnings or $5 per share on an adjusted basis." 

 What is going on here? The economy is stagnant and the bank is making a pile of money! The only explanation I can see is that the money is being made in the "paper" (financial) sector and is not generating any real wealth other than numbers in computers.

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