The process is basically this. Someone requires a loan. They approach the bank, which asks for a form of security. Let us say they hand over a government bond with a current value of £10 thousand. The bank lends £5 thousand against it. In fact, this is not an exchange as such. Ownership of the £5,000 still belongs to the bank. It is owed to them by the borrower, and is, therefore, an asset. But, this £5 thousand has gone out of the bank's possession, and as money no longer forms a part of its capital. At the same time, the £10 thousand government bond remains in the ownership of the borrower, but is now in the possession of the bank.
Should the borrower default on repaying the loan, the bank will then take ownership of the bond, and recover the debt from the proceeds. If the loan is repaid, the bank takes back possession of the £5 thousand it lent, plus interest. Its capital is increased by this amount. It hands back the government bond to the borrower, and its capital is thereby diminished by this amount.
The clue as to why banks like Northern Rock were prepared to lend up to 125% of the value of the property put up as security can then be seen. In conditions where you believe that the price of property can only ever go up, and is doing so rapidly, a mortgage of £125 thousand against a house worth £100 thousand, quickly becomes a £125 thousand loan against a house worth £200 thousand, which is then held as security by the bank, and thereby forms part of its capital, against which it can make further loans. As its by making loans, i.e. from selling money-capital, as a commodity, that it makes a profit, the more of this commodity it can sell, the more profits it can make.
But, as will be seen, what appears on one half of the balance sheet here is not really capital at all. It is only fictitious capital.
“It is evident at any rate that the actual component parts of the banker's capital (money, bills of exchange, deposit currency) remain unaffected whether the various elements represent the banker's own capital or deposits, i.e., the capital of other people. The same division would remain, whether he were to carry on his business with only his own capital or only with deposited capital.” (p 464)
At an abstract level, this is true, but in practice its not. Banks, under fractional reserve banking, make loans against their assets, and it became the practice to issue loans up to 90% of the value of deposits, because the banks knew that, at any one time, depositors would only require access to 10% of their deposits. But, because such loans themselves create additional deposits, this means that additional loans can be made, so that the amount that can be loaned is then effectively ten times the amount of the original deposits.
In the 19th century, however, a number of banks collapsed, as a result of a run on the bank, as depositors sought to withdraw all of their funds, at the same time, as they worried that the bank might fail. The same thing happened to Northern Rock in 2007. Central banks now stand behind commercial banks, as lender of last resort, so that bank runs can usually be averted by banks obtaining required amounts of liquidity to restore confidence.
But, banks are also now required to hold their assets in minimum levels and proportions, to avoid such problems. This does create a distinction of various classes of assets that the bank must hold in reserve. At the end of the day, as 2008 demonstrated, and as the Eurozone Debt Crisis demonstrated, however, additional liquidity cannot make up for a lack of capital, i.e. additional liquidity cannot resolve a problem of solvency. The importance of that will be demonstrated in the later discussion of fictitious capital.
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