Tuesday, December 30, 2008

Credit Expansion

Talifaitasi W. Satele


Some say that credit through fractional reserve banking is a result of “greed”. Many liken anything to do with making money to that ugly term; I just commend it as a good idea. But lending out depositors’ savings while only keeping a fraction of deposits in reserves is not done out of philanthropy. It is to make money or profit, and lending credit is not only beneficial for the banker but the depositor and borrower as well.

If banks didn’t make money through lending, they would have to charge their depositors additional fees. Banks do have to pay for the overhead it takes to secure their depositors’ money. But instead of having their customers pay more in fees for the privilege of having their money in a secure vault (instead of under one's mattress), the bank makes your money work to pay its rent.

And let’s hope banks are profitable while they lend! Profit attracts new entrepreneurs into the market (which means more banks to choose from) and determines whether someone stays in business or not. Economists call profit an opportunity cost, which is the value of the best alternative use of a resource. For example, if you profit only $20,000 from your business, but can make a salary of $25,000 working for the government, would you stay in the market or go to work for the ASG?

For borrowers, getting a loan often means having the funds necessary to seize upon an opportunity that they just didn’t have money at the time to pursue. You take out a loan at the prevailing market rate betting that you’ll make more than principal plus the interest later on. From big and small businesses to homeowners, they are all betting on future success.

Banks, on the other hand, set the interest rates by the level of risk, competition, and the amount of profit they’re seeking. They measure risk by level of income, payment history (credit score), and length of employment of new applicants. Banks too are betting on their borrowers’ future success, and they lend accordingly.

Credit, made possible through fractional reserve banking, allows banks to make a profit, pays to secure depositors’ savings, and provides funds for the economy to expand.

It’s a system that serves the purposes of the banker, the depositor, and the borrower, and it is beneficial to all as long as the bets made are good ones.

Otherwise, like a bubble, it pops.

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