Tuesday, 16 March 2010

Quantitative Easing, Fractional Reserve & Bankers' Bonuses

Can somebody put me right? I have been trying to work this out, but as I have very little knowledge of how these things work, I really don't know if my thinking is correct or not.

First of all - Bankers Bonuses. There has been a lot of criticism of banking bonuses recently, but these have been defended on the grounds that these are such clever fellows and deserve the bonuses for making so much money.

Next, Fractional Reserve Banking System. From what I can gather from reading Wikipedia, as banks only need to keep 10% of their deposits in liquid form, it basically means they can loan out 9 times the amount they have on deposit.

Finally, Quantitative Easing - from what I understand, the government borrows money from the Bank of England (at interest), and deposits it in high street banks.

So, if I have this right, if the government borrows £1 billion and then places it on deposit in, say, Barclays Bank, then all this costs the government is the interest on this billion (1% pa? - £10,000,000).

Barclays can now 'create' £9 billion worth of loans. Assuming for the moment that everyone they loan money to leaves the money in a Barclays account for today, they now have an additional £10 billion on deposit (£9bn + Govt £1bn) for which they are keeping 10% in liquid form (Govt.'s original Bank of England cash).

Barclays have just made £9bn clear profit (doesn't seem particularly clever to me!)

Now in order to hide some of this easy money (they have to make it look difficult), they must pay their senior people vast sums of money, which, hopefully these bankers will pay some tax on (windfall tax 50%?). So the Govt has spent £10mn and gets back, say £3 or £4 billion, which seems good to me.

Now if the bankers held that £9bn in reserve and didn't spend it on inflated bonuses, they could lend the money to anyone, and every repayment made would be profit, wouldn't it? Especially as there is interest as well. And if a few people defaulted, would it really matter? Profits would be lower than expected, but so what. £9bn profit in a day is pretty good going.

But if they pay huge bonuses based on the £10bn deposits and then the borrowers default, then it will look like they have made a loss - but they didn't really, they just paid themselves too much money.

I understand that there is much more to it than this, but can someone tell me where my thinking is wrong, please?

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