Readers Question: I have a question on the credit crunch – if banks are operating fractional reserve banking then why would they cut back on lending to businesses as every loan increases their money reserves? Surely they would only suffer a shortage of credit if they reduced their lending so they are in effect cutting their own throats. Please explain?
An increase in bank loans will reduce the money reserves that a bank keeps. More bank loans will increase their assets on their balance sheets.
In fractional banking, banks lend out a high % of their liabilities (Bank deposits)
For example, a bank has £1 billion of deposits. It may make bank loans of £900 million. In this case the bank is keeping a reserve of only £100m or 10% of liabilities.
If banks increase their lending, then their bank reserves falls, e.g. if it increases bank loans to £950 million, then its cash reserves will fall to £50m or 5% of its liabilities.
If the bank makes a loan, then this is counted as an asset. This is because in theory, the borrower will repay the bank. However, if a bank increases the amount of loans, then the reserve ratio will fall.
Reducing reserve ratio
If a bank reduces its reserve ratio, then it can enable more lending and spending in the economy. Reducing the reserve ratio can lead to a substantial increase in economic activity because of the money multiplier effect.
What happened in the credit crunch to bank lending?
In the run up to the credit crunch.
- Banks reduced their reserve ratios. They lent a higher % of their liabilities and their reserve ratio fell.
- In many cases banks were borrowing money on short-term money markets to lend mortgages and other loans.
after the credit crunch
- When the credit crunch occurred, banks found it hard to remain liquid. They had relied on borrowing money to finance long-term loans. But, after the credit crunch it became very difficult to borrow on short-term money markets. Banks didn’t have suitable reserves so they had to cut back on their lending. Essentially, they could no longer maintain their same level of loans because they could no longer access sufficient finance. Banks couldn’t lend because they didn’t have sufficient reserves.
- Also, because of the recession banks became more nervous about making bank loans. They felt there was a greater risk firms would go bankrupt and not be able to repay banks.
- To make matters worse, the credit crunch and recession caused some loans (assets) to reduce in value. People could not pay back some mortgages so they defaulted on their loans. Therefore, their balance sheet deteriorated because the bank’s assets fell in value.