The basic concept of debt is fully understood by only a fraction of the population. You’d be correct to find this strange, seeing how dealing with debt on a daily basis has become a present-day norm. In this article, we will let you in on a little secret about debt. A secret that even many financial experts and scholars don’t include in their investment decision making – either from a lack of understanding or, by consciously disregarding it.
In this article, we will expose how the money in your wallet is essentially a debt coupon. This coupon relies on your faith in the government and in society to give it worth.
Starting to Feel Confused?
Did you know that debt pre-dates money? Debt can be traced back to Babylonian accounting tablets. The promise of reimbursement is actually one of the first recorded financial transactions.
Fractional reserve banking is an even trickier subject. Most people either verge away from or don’t understand it. While there’s tons of information on the topic, hardly any of it relates to Asia. For that reason, we’ve composed a simple way of understanding it, highlighting different examples across the region.
Understanding Fractional Reserve Banking in Asia
However, this system is a little different in Asia. In Asia, the reserve requirements are devised by both the government and the central bank. Together they set the reserve requirements, by a percentage of the deposit. Just like in the west, if a customer deposits $100, then the bank cannot use all of the $100 to loan out.
For instance, a typical reserve requirement in China is 16%. Therefore, if $100 was deposited, the bank keeps $16 (in reserve), while the left-over $84 can be used for loans and credit products. The reserve requirement is used to regulate monetary policy. China’s central bank, called the People’s Bank of China, is responsible for setting reserve requirements. If the PBOC wants to lower the amount of money in China’s financial system, then it can raise its reserve requirement. An increase to the reserve would also boost the money supply.
As the factional reserve system only demands a small portion of its deposits to be available for immediate withdrawal, the credit amount in the system can quickly multiply.
The graph below shows us how China’s reserve requirement is in a constant flux – because it is a tool used by the government to control monetary policy.
What are the Benefits of Fractional Reserve / Debt Based Banking?
It may look like commercial banks are receiving the best perks from the fractional reserve system. But, in reality, they are actually just pooling society’s wealth. This increase allows them to multiply funds and transfer cash to businesses and entrepreneurs. This process generates GDP growth, and is especially helpful in emerging markets – where credit demand is high and GDP growth rates are strong and steady.
The biggest debt misconception comes from assuming that when someone borrows money through a banking institution’s credit facility, that the bank is the owner of those funds on loan. In actuality, that person is really borrowing from a shared collection of that bank’s depositors.
This financial process allows multiple depositors to merge their assets together. This minimizes overall risks and also generates interest on deposits. And the more people the bank lends to, the higher the overall interest level the depositors receive in return.
The below graph illustrates how bank reserve percentages differ across Asia. As you can see, the Philippines and China have high reserve requirements. This lets them have more influence over the liquidity in their financial systems. Because even tiny alterations to the reserve requirement can cause great waves of change for commercial bank lending levels and the total money supply.
Of course, the fractional reserve model comes with a certain hazard. The danger is that the money created to spark the economy is made from debt. When nations stopped requiring their currencies to be backed by physical assets (like gold or silver), the central bank’s ability to manipulate the money supply of an economy sky-rocketed.
With the central bank’s new-found power to create money, essentially out of nowhere (by printing or electronic transfer), the larger amount of debt or broad money that can be generated using the fractional reserve banking method.