understanding the crisis - questions from new member

Economics Economics Questions
1

I’ve gotten turn on to Mises and have ordered books to read over the holidays. I also have an office full of people who I’ve turned onto the basic nature of fractional reserve banking.

Question: I understand that banks can create credit out of thin air and this in turn makes up a huge part of the money out there. My question is why aren’t banks loaning money to people then? A simplistic view is that if they can create credit out of thin air, why is there any real loss to them if it were not paid back? Is this due to reserve requirements being an issue? What drives them now to not make the loans to new homeowners, businesses, ect…? Thanks for the help as I try to learn about our economic system.

2

Banks’ issuance of loans is limited by the amount of reserves they have, the amount of liabilities they already have, and the reserve requirements. In general, banks operate with very little excess reserves. Should they operate with less, they are subject to being legally prevented from doing business. The federal reserve would assume control of the bank and its assets. Thus, banks with excess reserves can loan them to banks with lower reserves than requirements. When the federal reserve increases total bank reserves (or lower reserve requirements), it allows all banks to uniformly expand credit.

If a bank makes a loan, it increases its liabilities in relation to its reserves. The loan is simply an increase to the borrower’s deposit account, a bank liability. Let’s say the borrower spends all the money buying some capital goods from another client of the bank. The bank has the same liabilities. The deposit account of the borrower is completely transferred to the other client’s account. Now the borrower defaults, the bank auctions the debtor’s goods if it can, and sees a huge loss on the loan. Let’s assume that all of the recovered money simply affords the bank’s expenses required to conduct the loan, which it already paid out. The bank cannot add to its reserves. If the original loan put the bank up to its reserve requirement, the bank cannot make further loans, without waiting for other loans to be repaid, or borrowing money from some other party.

Finally, adding to the money supply will cause price inflation, which means nominal interest rates and real interest rates diverge. In other words, let’s say a bank creates $100 and loans it to a risky borrower and recovers $0. Ignoring the impact this will have upon its liabilities:reserves ratio and its ability to make future loans, the bank still takes a loss, as the banks’ reserves, outstanding loans, and other dollar-denominated assets will now have less purchasing power than they would have if that $100 was not created and the loan was never made.

3

I’m maybe not on solid ground here, since I’m not an accountant and the last time I studied Accounting I was 15 (I didn’t find it particularly interesting at the time).

Still, when the bank makes a loan it effectively takes some reserves and gives them to the borrower (by way of putting them in the borrower’s account) which decreases the banks assets (those reserves were an asset). However the bank considers the loan that they just made to be an asset of equivallent value… so their net position remains exactly the same. The loan that they extend does NOT (as far as I’m aware) increase their liabilities in any way since otherwise, from an accountant’s point of view, they’d be decreasing their assets (their reserves) and increasing their liabilities… which just doesn’t make sense to a bean counter.

So the way I think it works is actually this:

Bank starts with $100 is deposits and thus $100 in assets (the deposits) plus $100 in liabilities (the money they owe the depositor that gave them the $100). They can, on the basis of a reserve requirement of 10%, lend $90 out and then they still have $100 in assets, only these consist of $10 in reserves and $90 in loans. So far so good.

If the $90 they leant gets deposited at another bank and that other bank then lends out $81 that gets paid back to a customer of our original bank then they can expand their balance sheet somewhat. They now have $181 in liabilities (depositors) and $91 in reserves and $90 in loans - so also $181 in assets… the bean counters are happy. They can then proceed to lend a further $72.50 and so on and so forth.

At the end of the day, let’s say all the banks lend to the very legal limits of their capacity to do so while remaining within the reserve requirements. Quite regardless of how much profit they’ve all made etc. there will be almost $1000 in the economy, $100 of which will take the form of reserves and $900 of which will be in the form of credit. As the banks may have made some profits by way of interest, transaction fees etc., they might actually have a chunk of that $900 on their books as assets as well, but for the moment let’s imagine that the banks spent EXACTLY what they earnt in profits on wages, maintenance etc. As such, every one is square and the banks are right on the margin of what is legally and technically possible for them.

Scenario One

Now let’s imagine that one of the bank’s loans goes bad because Joe Shmoe get’s fired and isn’t able to make his repayments. The bank sells Joe’s car (which is what the loan was made for) but can only recover $10 even though Joe still owed another $20 on that car. Now the banks balance sheet has changed because a $10 “Asset” in their books has just gone up in smoke. The bank effectively traded $10 in reserves (which it leant to Joe) for nothing at all.

The banking system as a whole, after that loss has been realized, now only has $990 in assets but $1000 in liabilities and is, therefore, insolvent. In particular, the bank that had to realise the $10 is insolvent. If that’s the only loss that is made then all the other banks are still fine.

Scenario Two

Instead of a loss, imagine the following. Bank B which participates in this system has $200 in deposits and has loaned out $180 of that. As such, they still have $20 in reserves for liabilities (i.e. total deposits) of $200, which is fine. They currently meet their 10% reserve requirement. Now imagine that one of the depositors comes in and asks to close their account and withdraw the $10 that they had on deposit. The bank then finds themself in the situation that they only have $10 in reserves but they have $180 extended in loans - so they only have 5% reserves and fall short of their reserve requirement by $10.

Scenario 2a.

What’s more, at the current stage in our story the customer hasn’t deposited the money they took out when they closed their account at any of the other banks. Imagine the customer does actually go accross the road to Bank A and desposits the $10 there instead. Bank A would then be in a position to “loan” those reserves to Bank B (so that Bank B could meet their reserve requirements). But Bank B would want to be pretty sure that they’d have $10 plus whatever they have to bank Bank A in interest coming in as revenue at some stage in the near future in order to pay Bank A back. Indeed, Bank A would want to be pretty sure of this as well (and in particular Bank A). If Bank A wasn’t sure of this, it would be no deal… which is pretty much what we have happening at the moment (banks not willing to lend to one another).

Scenario 2b.

Let’s imagine instead that the customer didn’t deposit the money at another bank. Instead, they decide to keep the cash under their pillow because they don’t trust any of the banks (good for them). Now the banking system as a whole has insufficient reserves to sustain the total quantity of loans that they have extended. Bank B won’t be able to borrow the money they need to meet their reserve requirements from any of the other banks and must turn to lender of last resort in order to borrow the reserves that they require… and by the lender of last resort I am, of course, refering to the central bank which can print of a fresh batch of reserves willy nilly as they please.

To prevent banks from simply borrowing infinite quantities of cash that they never intend to pay back from the central bank, there are capital requirements and all sorts of other regulations, but I think the above covers the general principles - unless I’ve misunderstood something (which is possible - as I say I’m not an accountant and I’m not really a specialist in reserve banking either).

4

Banks can only create credit if they can supply enough cash to cover withdrawals. If it can’t, it will be bankrupt. In order to really profit from credit creation, all the banks have to move together. If one decides to call in deposits, it will bust the other banks. That is why a central bank was created, but it cannot work if banks doubt each other’s solvency.

5

The banks are unwilling to loan money at rates that consumers are willing to pay. Even with the source, the Federal Reserve, giving money away at near zero percent, banks are wanting to part with this money at prices consumers are unwilling to pay. So banks are making fewer loans than they did previously. In other words they are reducing the loaned stock of money.

The worst part is that this is dangerous as the Federal Reserve seems determined to entice banks to lend money by creating tons of it. The banks are worried that they will malinvest this money like they did in the previous decade.

6

Not necessarily. Its reserves are its deposits with its regional Federal Reserve bank, plus its vault cash. Generally, banks do not reduce their reserves. Rather than reduce reserves and make a loan worth that amount, then wait on deposits to make new loans, the bank is usually better off simply creating a larger loan out of thin air. If I have $100 in reserves, no liabilities (all accounts have a $0 balance) and a 10% reserve requirement, I can make a $1000 loan by crediting one of my client’s accounts that amount.

Compare this with cashing out all but $10 of my reserves and making a $90 cash loan. Of course, that cash might get spent and re-deposited in my bank. Then I would make an $81 loan. Thus I would have $19 in reserves against $171 in liabilities. Done to infinitum, you will end up the same as above - $100 in reserve and $1000 in liabilities.

As far as assets and liabilities go, they are matched. For every liability created (every dollar in a checking or saving account), a loan is also created, or a reserve is held, which is an asset to the bank. The big problem with fractional reserve banking is that asset maturity and liability maturity never match. Liabilities are always mature, available to be called in at any time. The assets (besides the reserves) on the other hand, have firm maturity dates mostly in the future.

7

This is not the full story. Some banks have been given implicit full protection by the United States government. If FDIC insurance is still preventing bank-runs, the bailouts should be pushing banks to lend, regardless of risk.

I think a more important issue is this: the Federal Reserve now pays 1% annual interest on reserve accounts with the FED. The Term Auction Credit program allowed banks to increase reserves by selling crappy loans/assets to the FED who monetized them, but prevented inflation by simultaneously selling treasuries and removing that money from circulation. Since the FED has run low on Treasuries, it has moved to a policy of full-on inflation, it seems. Bank reserves have skyrocketed since September began. The result is that the effective federal funds rate is now lower than its 1% target (currently almost 0), which is also lower than the interest the FED pays on reserves. Why loan at all?

As far as the economy goes, consumer credit delinquencies are rising sharply, housing prices are still falling, unemployment is up, and there is little doubt of a full-scale recession. Who are banks supposed to lend to? It seems no one is making risk-free profits over 1%. Heck, they can’t even lend to the government at that rate.

Finally, banks know they’re going to have to eat losses eventually, although they are not sure when. Why loan out your reserves, if you may have to borrow them back at a higher price to cover losses as they occur? Why not just sit on risk-free 1% returns on the cash you need to cover losses?

All I know is expect to see a meltdown as soon as this 1% interest on reserves disappears, or risk winds down and credit yeilds go up, so as to make loaning against reserves more favorable than sitting on reserves. We could literally see the money supply come close to doubling in a 1-3 year time period.

8

Yeah, I was ignoring the startup capital and capital requirements of the bank, for simplicity… so I was presuming that all loans were made on the basis of deposits - and indeed the vast majority of them are. Banks primarily lend out other people’s money (not their own) which is why it’s such a big deal when banks go bust. They have other people’s money hostage and they can use that leverage to demand the government bail them out (leverage the auto industry and you and I don’t have if we make losses).

The only difference between your example and mine though is that the initial $100 to get the ball rolling comes from a depositor in my example, where it comes from the bank’s shareholders in your example. I don’t think this has any impact on the reserve requirements of the bank… it would delay the point at which the bank failed due to insolvency though since if the bank started off with $100 in capital then they could potentially wear up to $100 in losses on bad loans before they hit rock bottom (although they might run into issues with reserve requirements).

Other than that though, did everything I described above sound pretty much right? If you know anything about capital requirements, by the way, I’d be interested to learn a bit more about those… or if you have any links to further information about this.

Yeah, I think perhaps you just made a typo in your original reply… you referred to the loan that the bank extended to someone as a liability. For the person borrowing the money from the bank it is a liability, however from the bank’s perspective it is an asset.

9

Interesting stuff… the finer details of how the Fed tries to squirm its way out of the mess using Keynesian policies that are doomed to fail eventually. The only real question is, “When - sooner or later?”

10

I’m not so sure this is true. If I deposit $100 cash in a bank, the bank has $100 cash reserves and $100 liability. In my view, the bank can now make a $900 loan by adding $900 to a borrower’s account, without receiving any further deposits. In your viewpoint, the bank could only lend out $90, which would have to be re-desposited, then the bank could loan off of that to infinity, and we’d end up in the same place. I think banks can do it either way if they so choose, but it seems much simpler to do it my way. Of course, the bank might be nervous that their borrower may choose not to be a deposit-holder at their bank. If he receives the loan as a demand deposit liability, he could immediately ask for this to be cashed, forcing the bank to loan money to stay above its reserve requirement. Doing it as you described would spread that risk significantly among many parties. On the other hand, the bank could simply make 9 $100 loans to 9 different people.

To be honest with you, I have been looking today to find firm figures on reserve requirements and simply can’t find anything that’s not chuncks of sporadic data. I can find the current reqs, but not historic. I figure any way you square it, it’s going to be a mess.

It appears the FED classifies bank liabilities according to three sizes, similar to tax brackets. The first __ dollars of liability have 0% reserve requirements. Liabilities above that but not in the highest bracket have 3% reqs. Liabilities above that require 10% reserves. These are only on demand deposits, not time deposits, or savings deposits, which are 0% for all institutions. So, total reserve requirements do not simply depend on total demand liabilities, but also the number of the institutions holding them.

Making matters more complicated is sweep programs of banks. These are used to temporarily move checking deposits into savings accounts or money market mutual funds to earn interest and avoid reserve requirements. They effectively lower reserve requirements de facto. Sweeps data is kept for the version that has been in place from '94 - today, but not for other ones.

http://www.federalreserve.gov/monetarypolicy/reservereq.htm

http://research.stlouisfed.org/aggreg/swdata.html

Considering that the number of banks has steadily decreased in modern times, that the money supply is steadily increasing, and that the lower (now middle) reserve requirement bracket has been on average shrinking since '94, you’d suspect that this would increase the reserve requirements of banks. Somehow the exact opposite has happened since about '95. I’m very confused by all this myself.

11

The same is true if the $100 comes from a shareholder. Banks are separate legal entities to their shareholders. In my example the liaibilty is a liability with respect to a depositor and in your example there is an equivalent liability vis a vis the shareholder(s).

Hm, and if that $900 is deposited in another bank you think that bank can then lend out $810 of it, which may indeed come back to bank number one etc. In this case, on the bases of $100 the banks might lend out up to $1710 with a 10% reserve requirement… which seems a bit odd. It may be that I’m not understanding how their capital affects the equation though.

Further, imagine a system where the $100 does actually start as a deposit (not shareholder capital) and after a few years the bank makes a hefty profit on fees and interest. Now the bank has $50 in “cash” and $50 is shareholder capital… you’re saying they can then lend out 100% of this and thus, without any extra reserves, simply because the money in the system is owned by the banks rather than depositors the banks can then increase their lending??? If that were the case then everyone would have an interest in chumming up with a banker, giving all their deposits to the banker (literally a gift). The banker could then “lend” 9 times that quantity right back to the depositor at zero interest (with a little kickback going back to the banker for their trouble… let’s say a nice rolex).

I’m pretty sure it doesn’t work like that though. I think the reserve requirements are the same regardless of whether a shareholder fronts up the original cash or a depositor fronts it up… because it is fundamentally the BANK that is doing the reserve banking and they have to keep reserves to cover their liabilities whether these are liabilities vis a vis shareholders or liabilities vis a vis depositors… I don’t think there is any distinction.