trader2012,

You wrote, The spread is huge, because they aren’t borrowing at 3% and re-lending those same dollars back out again at sub-2%. They are lending out at least 8x the amount they borrowed. In other words, due to the magic of fractional reserve banking, they are borrowing at 3% and lending it back out at something closer to 16%. That's a fat spread.

As I'm sure you're aware, fractional reserve banking isn't magic. It always amazes me that anyone might think it is. Fractional Reserve Banking is simply a reference to a bank's use of leverage. (Of course in a very real sense, all any bank holds is an IOU from someone else.) Sometimes the central banks also use it to explain the multiplier effect on money; but it all boils down to a bank's use of leverage.

And as far as I can see, no amount of leverage can make borrowing at 3% to lend at sub-2% profitable. That takes other tricks. Like securitization. Even so, I doubt anyone could turn that into a 16% rate of return - at least not without taking huge risks ... or using the money for something other than lending at sub-2%.

If you remove fractional reserve banking (to a system known as Full Reserve Banking), you remove the ability to treat a deposit as a loan from you to the bank. Then the bank would not be in a position to offer you banking services for free, much less pay you anything in interest. They also would probably not be in a position to lend people money because they would have very little money they could actually lend. Full reserve banking requires the bank to NOT lend out deposits. That's the only way to avoid a Fractional Reserve System. While Full Reserve Banking has been used in the past as I understand it, it's been about 200 years since any bank has done so.

Also, Sometime, when you’re truly bored, track down the series of videos on Money as Debt that will put into perspective why banks are the enemy of financial prudence. Reportedly, US banks, on average, are leveraged 20:1, and Europe’s run closer to 30:1. That makes for fat profits when all goes well. But not a one of them could survive very many lending mistakes, much less a bank run, which is why central bankers bail them out.

I've seen parts of those videos. They're quite like urban legends. They seem to be full of half truths and blatant mistakes (or lies). For instance, they seem to think that going to Fractional Reserve Banking is one step beyond loaning out a depositor's money. In fact, that is the definition of Fractional Reserve Banking - you get to loan out all but a small fraction of your deposits. The idea is something akin to holding an e-fund in reserve. If there is ever a run on the bank and the reserves are insufficient and you've otherwise following guidelines, the Reserve Bank will come bail you out with an overnight loan of cash at very favorable rates.

Also, I've never heard of Europe or any other regulated bank running a capital ratio of 30:1. They've come close. But I'm fairly sure it would have violated one of the Basel accords of which the US and EU are parties. On the other hand, 20:1 might have been possible at times in the past. Not now of course. They're targeting a 10:1 or 9:1 ratio as ideal now ... which is kind of reverting back to old standards.

- Joel