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What determines how much a given bank can lend to its borrower / customers?
I would appreciate comments on this article. Is my logic faulty in any way?
Also see "Who runs the banking system in the U.S.A.?" at D - 6 and G - 32.
I have always thought that the maximum amount of loans by a bank were determined by a required reserve to loan ratio wherein the bank must have a certain percentage (let's assume 10%) on hand in cash or its equivalent as a reserve to support its loans.
Recently however, a Mr. Hummel at << http://wfhummel.net/>> told me (a) I was laboring under a common misunderstanding and (b) the only thing that limits the amount of bank lending is the capital / asset ratio requirement.
He sent me the URL on his website that deals with that subject and I spent about 8 hours trying to figure out what the simple words at that URL meant.
The following is my take on the information on that page. Despite the fact that I have an engineering degree and have kept full sets of books for a couple of companies, I am not at all sure I understand what was written there. What I have written below may be way off base.
Bank Capital Requirements -- see << http://wfhummel.net/capitalrequirements.html >>
1) Banks have certain capital requirements they must meet under international agreements. The requirement is usually expressed as a capital / asset ratio.
2) According to a sample chart at <<http://wfhummel.net/capitalrequirements.html>> a bank with $800m in assets (add all the asset amounts on the second chart) would have to have a total "capital" (as capital is defined under this system) of $40m (given in red -- under the chart).
3) Therefor -- Based on this chart, which Mr. Hummel assured me is "typical of a small bank" (paraphrased), a typical bank can lend out 20 times more than its total "capital" (as capital is defined under their system).
4) Please note that the capital in the above sentence #2 is not what is normally called capital in a business. Capital is usually defined as One's own or borrowed money invested in a business to generate income. (from "businessdirectory.com)
5) The capital in # 2 has been calculated through a long series of complex, almost inscrutable mathematical manipulations based on assets of the bank and not capital as the word capital is usually used.
6) First, each of all the assets are risk-weighted from 0 to 1. Cash has a zero risk weight and ordinary loans have a risk weight of 1.
7) This means that each asset can either be counted as 0 or 1: the actual amount of the asset. So the total assets can be anywhere from zero to the actual total of the assets.
8) The asset "mortgage loans" have a risk weight of .5. If we are dealing with a mortgage bank, we can reasonably assume that the assets in #2 are reported at 50% of their actual dollar value.
9) Banks must have a certain minimum amount of capital (as defined by international banking agreements). In general that required capital must be at least 4 to 8% of those risk-weighted assets.
10) Further, the 4 to 8% is dependent on whether the capital is Tier 1 capital or Tier 2 capital (each have different definitions). Let's assume a case that would require the highest dollar amount of capital: that worst case would require capital (as in #2) of 8% of all risk-weighted assets be maintained.
11) So when all the calculations are done -- it turns out that a bank must maintain 8% of all risk-weighted assets and those risk-weighted assets in a mortgage bank are 50% of the actual value of the mortgage loans. So the bank must maintain 4% of its mortgage loans (as defined in #4 above).
12) Note that the capital requirement are not capital at all -- they are a calculated % of assets
13) In other words -- If a bank has $40 million in mortgage loans, it must maintain $1.6 million (4%) to support the loans it wants to make.
14) Stating that another way -- $1.6 million of reserves would support $40 million dollars of loans. Note that 40 is 25 times 1.6. So in normal circumstances a bank can lend out 25 times its actual capital.
15) This sounds alarming at first glance because it suggests that it is an impossible situation. How could a bank possibly lend out 25 as much money as it has?
16) But we must not forget (a) that the bank is not guaranteeing those loans and (b) the bank is not lending its money -- it actually creates the money when it makes the loan.
17) It is the borrower that is guaranteeing those loans through their contract to repay the loan.
18) I hesitate to question the motives of the international bankers that set up these capital requirements of banks. I hesitate because you can never be sure of someone's motives.
19) Mr. Hummel has this on his website "In 1989 the U.S. adopted the capital requirements established by the Bank for International Settlements (BIS) in Basel, Switzerland. "
20) In my opinion, the system of calculating the "requirements" are a diabolical sham created by the international bankers that have the result of making the rules virtually beyond the comprehension of almost everyone.
21) In general, I think there are a bunch of people who have a vested interest in keeping this subject much more complicated than it is. It is not only the international bankers. I personally think many of the money reformers are in that category.
22) So, in conclusion, it is ridiculous to take the capital / asset ratio seriously in any way.
Marty Carbone / 10/23/08
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