<p>Canada abolished bank reserves in 1992. Canada has had very similar inflation rates as the United States since then.</p>

<p>Increases in house prices do not improve bank equity. Banks make a profit based on being paid a rate of interest above their cost of funds. Increasing house prices just reduce losses in the case of default. Threfore, the relatively steady profits that come from interest rate spreads slowly builds up equity, with the result that bank balance sheets only exhibit moderate growth rates (similar to nominal GDP growth rates).</p>

CC BY-SA 3.0
2018-01-19T06:16:31.507Z
But don't most banks coordinate with realtors and invest heavily in real estate?  If someone defaults on their payments the bank has lien on their property through their mortgage.  I was under the impression that most banks were held in trust by property groups that act as holding companies.  Don't you think this is a conflict of interest?
KevinBattleson
CC BY-SA 3.0
2018-01-19T12:26:29.203Z
Banks lend against real estate, they are barred by regulations (and common sense) from owning real estate (other than when they are stuck with it after a repossession). Banks make money by borrowing at low rates, and lending them at a higher rate - to entities that pay them back.
Brian Romanchuk
CC BY-SA 3.0
2018-01-19T12:29:46.870Z
(A bank might have a non-bank subsidiary that is in real estate. That business is supposed to be isolated from the bank parent, even if they have a similar name.)
Brian Romanchuk
CC BY-SA 3.0
2018-01-23T15:58:37.647Z
So in cases where a bank acquires a property through foreclosure, does the equity of that home count for its debt to equity ratio?  If all a bank has to do is make loans in bad faith and sit on its foreclosures to develop equity, it would seem to prove my point.
KevinBattleson
CC BY-SA 3.0
2018-01-25T01:39:19.977Z
Banks are only entitled to the amount of the loan. They normally try to sell the property in an auction, and anything above the loan value is supposed to be returned to the borrower. If they end up with a large number of properties, that means the recovery value is far below the loan amount, and the banks lost a ton of money. Such a property portfolio is going to be insignificant, or the bank will have failed.
Brian Romanchuk
CC BY-SA 3.0
2018-01-25T03:18:20.700Z
So the bank can't simply sit on the estate and use its equity to establish more credit?  The bank can't have the property assessed after it has gone up in value and use the equity in the house to improve its debt to equity ratio?
KevinBattleson
CC BY-SA 3.0
2018-01-26T12:31:50.320Z
Not in practice. If the bank owns a property, that means it has lost money on the loan. However, it will probably hold the property on its books at higher price than market. It will get out once market prices have recovered, and just avoid a loss. Also, they would only be able to book profits after a sale; real estate is not marked to market.  In any event, this is rare, and regulators keep banks out of the owning property business. Feel free to read earnings reports by banks; they will not break out gains from property value increases - since they are negligible, at best.
Brian Romanchuk
CC BY-SA 3.0
2018-01-26T14:14:44.417Z
To cut this comment thread off: you are also not taking into account how bank capital rules work. A risky aset like real estate typically requires 100% capital backing (depends on the regulatory regime for the bank). Any increase in real estate value will also raise the required capital that must be held against them, which means that this does not increase lending capacity.
Brian Romanchuk
CC BY-SA 4.0
2018-06-13T22:35:21.550Z
I asked some other people if banks were able to own real estate and they said they were unaware of any regulations prohibiting banks from owning real estate outside of a foreclosure.  Do you have a source or citation?  I am also curious as to what policy or legislation requires banks to have 100% capital backing for real estate investments, and if that capital requirement must be actual currency held in reserve.  Brian seems like the person to ask.
KevinBattleson
CC BY-SA 4.0
2018-06-14T10:44:48.837Z
@KevinBattleson - “capital” is not “currency held in reserves”, as that would be an asset (on the wrong side of the balance sheet); it refers to equity or equity-like instruments. There is no prohibition against holding real estate, rather it has a high risk weighting. I found this on Basel risk weightings, where commercial real estate has a weighting of 100%: https://en.m.wikipedia.org/wiki/Standardized_approach_(credit_risk)
Brian Romanchuk
CC BY-SA 4.0
2018-06-17T03:33:23.800Z
right, so you use your equity to make more loans which drives up prices which leads to foreclosure which increases your equity and allows you to make more loans, yes?
KevinBattleson
CC BY-SA 4.0
2018-06-17T23:34:10.317Z
Banks typically lose money on foreclosures; they are not getting paid back, and they need to handle the costs of salvaging the value of the property.
Brian Romanchuk
CC BY-SA 4.0
2018-06-21T06:10:09.627Z
But the whole idea behind fractional reserve was that bank loans aren't 'money' (in the sense that they aren't backed by the federal reserve), they are private accounts held by banks.  Whoever holds those accounts, (most likely another bank) can extend as much credit as they like, so long as they receive their interest payments.  Whats to prevent a bank issuing another bank a 5 million  loan on a 500,000 dollar home, so long as the interest is low enough that they never have to pay back the principle?
KevinBattleson
CC BY-SA 4.0
2018-06-21T06:25:33.763Z
For that matter, what even happens to a bank who defaults on a loan payment to another bank?  Don't they just get a ding on their credit, close their accounts and move on?
KevinBattleson
CC BY-SA 4.0
2018-06-21T12:23:08.787Z
@KevinBattleson - The format of this website is that comments are not supposed to be used for conversations. There is a way to send messages privately, or you could ask another question on how fractional reserve banking actually works, moderators may just delete this entire comment thread. This existing question is not useful as it makes incorrect assertions about banking, which makes it impossible to answer.
Brian Romanchuk
CC BY-SA 3.0
2018-01-11T23:23:19.223Z
2018-01-11T23:23:19.223Z
Brian Romanchuk
<p>It is my understanding that countries without fractional reserve requirements still have capital requirements, but what I do not understand is how equity can be used to satisfy these requirements without causing large amounts of inflation in the housing market.</p>

<p>If banks are not required to have currency reserves, then what is to prevent them from extending themselves effectively unlimited credit based on their equity?  In the short term, they may be limited by debt to equity ratios, but in the long term, wouldn't this lead to a consistent rate of near constant inflation?  </p>

<p>Every time a bank issues credit to buy a house, (in aggregate, of course) the price of housing increases, which increases equity, which allows them to issue more credit..</p>

<p>Does anyone else not see a problem with this?</p>

CC BY-SA 3.0
2018-01-10T01:38:54.027Z
I had always had the assumption that Fractional Reserve Requirements applied to Loans, not just Bank Deposits.  I have recently learned that this is not so.  Has this always been the case in the US?  What about outside the US?
KevinBattleson
CC BY-SA 4.0
2020-05-29T09:39:25.980Z
The price of housing does not increase banks' equity
Henry
<inflation><monetary-policy><finance><money-supply>
Does Not Having a Fractional Reserve System Cause More Inflation?
KevinBattleson
# Does Not Having a Fractional Reserve System Cause More Inflation?

(Asked by: username_0 on 2018-01-10)

It is my understanding that countries without fractional reserve requirements still have capital requirements, but what I do not understand is how equity can be used to satisfy these requirements without causing large amounts of inflation in the housing market.

If banks are not required to have currency reserves, then what is to prevent them from extending themselves effectively unlimited credit based on their equity? In the short term, they may be limited by debt to equity ratios, but in the long term, wouldn't this lead to a consistent rate of near constant inflation?

Every time a bank issues credit to buy a house, (in aggregate, of course) the price of housing increases, which increases equity, which allows them to issue more credit..

Does anyone else not see a problem with this?

**Tags:** inflation, monetary-policy, finance, money-supply
> **Comments:**
> **username_0**: I had always had the assumption that Fractional Reserve Requirements applied to Loans, not just Bank Deposits.  I have recently learned that this is not so.  Has this always been the case in the US?  What about outside the US?  
> **username_1**: The price of housing does not increase banks' equity  

---

## 1 answers

### Answer by username_2 on 2018-01-11. Score: 1

Canada abolished bank reserves in 1992. Canada has had very similar inflation rates as the United States since then.

Increases in house prices do not improve bank equity. Banks make a profit based on being paid a rate of interest above their cost of funds. Increasing house prices just reduce losses in the case of default. Threfore, the relatively steady profits that come from interest rate spreads slowly builds up equity, with the result that bank balance sheets only exhibit moderate growth rates (similar to nominal GDP growth rates).

> **Comments:**
> **username_0**: But don't most banks coordinate with realtors and invest heavily in real estate?  If someone defaults on their payments the bank has lien on their property through their mortgage.  I was under the impression that most banks were held in trust by property groups that act as holding companies.  Don't you think this is a conflict of interest?  
> **username_2**: Banks lend against real estate, they are barred by regulations (and common sense) from owning real estate (other than when they are stuck with it after a repossession). Banks make money by borrowing at low rates, and lending them at a higher rate - to entities that pay them back.  
> **username_2**: (A bank might have a non-bank subsidiary that is in real estate. That business is supposed to be isolated from the bank parent, even if they have a similar name.)  
> **username_0**: So in cases where a bank acquires a property through foreclosure, does the equity of that home count for its debt to equity ratio?  If all a bank has to do is make loans in bad faith and sit on its foreclosures to develop equity, it would seem to prove my point.  
> **username_2**: Banks are only entitled to the amount of the loan. They normally try to sell the property in an auction, and anything above the loan value is supposed to be returned to the borrower. If they end up with a large number of properties, that means the recovery value is far below the loan amount, and the banks lost a ton of money. Such a property portfolio is going to be insignificant, or the bank will have failed.  
> **username_0**: So the bank can't simply sit on the estate and use its equity to establish more credit?  The bank can't have the property assessed after it has gone up in value and use the equity in the house to improve its debt to equity ratio?  
> **username_2**: Not in practice. If the bank owns a property, that means it has lost money on the loan. However, it will probably hold the property on its books at higher price than market. It will get out once market prices have recovered, and just avoid a loss. Also, they would only be able to book profits after a sale; real estate is not marked to market.  In any event, this is rare, and regulators keep banks out of the owning property business. Feel free to read earnings reports by banks; they will not break out gains from property value increases - since they are negligible, at best.  
> **username_2**: To cut this comment thread off: you are also not taking into account how bank capital rules work. A risky aset like real estate typically requires 100% capital backing (depends on the regulatory regime for the bank). Any increase in real estate value will also raise the required capital that must be held against them, which means that this does not increase lending capacity.  
> **username_0**: I asked some other people if banks were able to own real estate and they said they were unaware of any regulations prohibiting banks from owning real estate outside of a foreclosure.  Do you have a source or citation?  I am also curious as to what policy or legislation requires banks to have 100% capital backing for real estate investments, and if that capital requirement must be actual currency held in reserve.  Brian seems like the person to ask.  
> **username_2**: @KevinBattleson - “capital” is not “currency held in reserves”, as that would be an asset (on the wrong side of the balance sheet); it refers to equity or equity-like instruments. There is no prohibition against holding real estate, rather it has a high risk weighting. I found this on Basel risk weightings, where commercial real estate has a weighting of 100%: https://en.m.wikipedia.org/wiki/Standardized_approach_(credit_risk)  
> **username_0**: right, so you use your equity to make more loans which drives up prices which leads to foreclosure which increases your equity and allows you to make more loans, yes?  
> **username_2**: Banks typically lose money on foreclosures; they are not getting paid back, and they need to handle the costs of salvaging the value of the property.  
> **username_0**: But the whole idea behind fractional reserve was that bank loans aren't 'money' (in the sense that they aren't backed by the federal reserve), they are private accounts held by banks.  Whoever holds those accounts, (most likely another bank) can extend as much credit as they like, so long as they receive their interest payments.  Whats to prevent a bank issuing another bank a 5 million  loan on a 500,000 dollar home, so long as the interest is low enough that they never have to pay back the principle?  
> **username_0**: For that matter, what even happens to a bank who defaults on a loan payment to another bank?  Don't they just get a ding on their credit, close their accounts and move on?  
> **username_2**: @KevinBattleson - The format of this website is that comments are not supposed to be used for conversations. There is a way to send messages privately, or you could ask another question on how fractional reserve banking actually works, moderators may just delete this entire comment thread. This existing question is not useful as it makes incorrect assertions about banking, which makes it impossible to answer.  

---

