The Infinite Loan Machine. An examination of the effect of loan securitization on the fractional reserve banking system

Loan securitization has become a widely used method for consolidating collections of loans into financial instruments with sufficiently stable statistical properties that they can be freely traded. In recent years the concept has been generally extended, creating a class of asset backed securities, financial instruments which are created from a wide variety of loan sources, including credit card, commercial real estate and even financial investment (hedge fund) lending. In this paper the money and loan supply implications of these instruments within a fractional reserve banking system are examined. It appears that the interaction of these instruments create an infinite loop within the monetary system, which removes the limit on loan creation that should be imposed by the bank’s reserve requirement. This has effectively disabled the ability of the central bank’s reserve requirements to limit the expansion of credit by commercial banks, leading directly to the current credit crisis. The evidence suggests that loan securitization and the sale of commercial bank loans outside the regulated banking industry are incompatible with the stable operation of a fractional reserve banking system.