Originally Posted by chadta
so 12 - 1 is good ?
Am I the only one who thinks banks should only be able to lend what they have ? If any other kind of company kept records like banks it would be fraud, but not in the banking world, its business as usual.
Fractional Reserve Banking is what enables banks to loan money based on deposits. Without fractional reserve banking, a bank would have to keep 100% of deposits as cash on hand -- meaning it couldn't lend that money out.
A leveraging ratio describes how much cash on hand the bank has to cover deposits (and other liabilities). For example, if a bank has 10 customers all with $10 deposited, a 10:1 leveraging ratio would mean that the bank was loaning out $90 and keeping $10 in cash (i.e. $100 in liabilities : $10 in assets). If the ratio was 1:1 (no fractional reserve), the bank would have to keep all $100 in cash and be unable to actually loan any money out.
It's a bit more complicated, because leveraging ratios are inclusive of all bank liabilities (customer deposits, outstanding loans, etc.). But that's the gist.
Previously the legal limit of FRB was 4:1. Under that limit, the solvency of the bank was only threatened if more than 25% of its total liabilities were called in (withdrawals, defaults on loans, etc.)
A little over a decade ago, that limit was completely abolished, which is pretty much the root cause of the 2008 financial crisis where many institutions were leveraged far, far beyond that original 4:1 limit (most at 50:1 or more, some even as high as 500:1).
At 50:1, only 2% of liabilities being called in would cause the bank to be insolvent. At 500:1, only 0.2% would cause insolvency.
Of course, any effort to get back to a sane compromise such as 4:1 limits is consistently met with ZOMG BIG GOVERNMENT!