Easily one of the questions I've been getting most over the last year has to do with business news reports discussing the importance of why banks may not be lending to one another on occasion. Specifically, why would they lend to each other in the first place and why is that important to Main Street?
The fractional reserve banking system
To begin to answer that question we need to understand the fractional reserve banking system. As you may know, one of the ways a bank makes money is through the spread between interest charged for lending money to borrowers versus the interest paid on deposits. In theory, if you found one person who had $100,000 to deposit for safe-keeping and on that same day you had one person coming to you to borrow $100,000 you could make money by charging 5 per cent interest to the borrower and paying 2 per cent interest to the depositor. You're now making $3,000 per year before expenses. But it's not quite as simple as that in the real world.
Reserve ratio requirements
Fractional reserve system banks have what is called a reserve ratio, which is currently about 10 per cent in the U.S., that dictates what portion of physical deposits must be kept in reserve versus the total amount of money lent out. In this case, if you deposited $1-million physical dollars to your bank, they would keep $100,000 in reserve and be able to issue loans of $900,000. That $900,000 gets spent by the borrower and the recipients may place their $900,000 back into the bank. The bank could then again keep $90,000 (10 per cent) on reserve and re-lend $810,000 to yet another borrower.
The original depositor has $1-million dollars that they have access to at any time, but at the same time we see that $900,000 and $810,000 has been lent out to two different borrowers. Assuming both borrowers spent their loans and the recipients of those payments deposited their money back into a bank, $1-million has been increased to $2,710,000. This re-lending can continue until the original $1-million has spawned another $9-million in money created by the bank. So long as the bank keeps 10 per cent reserves on hand, they should be able to meet the day-to-day cash withdrawal requirements of the depositors.
Naturally, a bank would want to loan out as much money as they can because the more money on which a spread is earned means more money in revenues.
How it works in the real world
Now expand this system by millions of users and many billions of dollars and multiple banks. On a particular day, perhaps one bank sees a moderately higher request for cash withdrawals and this causes their reserve ratio to drop to 9 per cent. They are required to have a ratio of 10 per cent. They have two ways to fix this. They could call in loans – but that would upset customers. Instead, they will borrow reserves from other banks. Perhaps another bank had more deposits than usual and this pushed their reserve ratio to 11 per cent. To them, that means some money is sitting idle, not generating interest for them. They want to lend it. So the one bank lends to the other. The borrowing bank now satisfies the reserve requirement and the lending bank is making interest on otherwise idle money.
What happens when the lending slows
When banks don't want to lend to each other, it means they perceive the risk of lending is too great. So then, the interest rate they charge one another will go up until the lending bank feels adequately compensated for the risk it feels is present. This increased interest rate trickles down to affect the consumer by reducing the access to money. Higher interest rates means it's more expensive to access money, which in turn deters people from borrowing and results in less spending. If a certain bank is deemed too risky to lend to at all, this could lead to insolvency of the bank or a bank run by depositors all wanting their cash out at the same time for fear that they won't be able to get their money back.
Interbank lending is pivotal to a smoothly functioning fractional reserve banking system. Changes in the willingness of banks to lend to one another indicates a lack of confidence in financial intermediaries, which can affect stock market confidence as well as decreasing consumer spending.
Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee