Where money comes from… the leveraging process – loose ends

Let’s not run before we can walk – after sleeping on it, I’ve realised it’s not yet time to explain the causes of the present Great Crunch.  This post is a continuation of yesterday’s slightly rushed effort.

I hope I established yesterday that, in the modern world of virtual money, said money is in fact created by what I termed the leveraging process, that is by banks lending against deposits.

This process can, I suggested, continue indefinitely:

(1) Adam deposits some money in a bank account.

(2) The bank lends Adam’s money to Bert.

(3) Bert buys a motor from Colin’s Cars.

(4) Colin puts the money from Bert in his account, held either at the same bank as Adam’s or a different institution.

(5) Dave borrows money from Colin’s bank and uses it to buy food from Eddie’s Eggs.

(6) Eddie uses the money from Dave to buy more supplies from Farmer Fred.

(7) Fred leaves the money on deposit in his bank account…

But what limits this process?

Part of the answer was provided last time when I mentioned the possibility of a run on a bank.  Each bank must keep sufficient reserves in case depositors wish to withdraw their money.  They keep most of this in the form of liquid assets – that is, assets they can sell easily – rather than as actual cash, though of course they need what you and I would consider a large amount of dosh for their day to day operations.  The sort of liquid assets the banks might hold are government bonds, which can be exchanged for cash very easily and earn a little interest in the meantime.

The first stage of the credit crisis arose in 2007 when the banks found they had insufficient liquid assets.  Assets they thought were reasonably liquid – mortgage backed securities – suddenly became very illiquid (difficult to sell), as everyone realised that they were not worth what everyone had hitherto had thought they were worth.

At this point the UK made a mistake that (hopefully) I will revisit in a few posts’ time (after analysing the Chinese Mistake and the American Mistake).  Against all the evidence of our TV screens that it was Joe Public who was withdrawing his money in a panic, the Government ruled that it was Northern Rock’s sudden inability to borrow from other banks against (perfectly sound, because the UK has not made the American Mistake) mortgages that showed NR were “reckless” and had a “flawed business model”.  A point they hadn’t happened to mention previously to the Rock’s shareholders. The central bank should have stepped in and lent to Northern Rock, because it was not insolvent.

Aha, a new concept!  Insolvency.  And you thought I was trying to explain leverage.  Oh, but I am!

A bank (or any other organisation or individual) is insolvent if its(/his/her) liabilities (the accounts for which someone may attempt to withdraw funds) exceed its total assets (principally the loans for which it expects repayment and interest).  If we simplify just a little, we can say a bank’s capital is what’s left after we add the amount it has lent out (assets) and subtract its customers’ deposits (liabilities) (and borrowings from other banks -but let’s try to keep things simple).

Where did this capital come from?  Well some of it came from the shareholders when they established the bank in the first place.  They may also have put more money into the bank over the years (as well taken some out as dividends, sharing in the bank’s profits).  But most came from profits over the years (excepting the profit share paid out as dividends) – the interest received on loans, for example, less the interest paid on deposits.

As well as paying interest, loans have another property – they may not be repaid.  A bank may incur bad debts.  Because of this risk, a bank cannot lend indefinitely.  There are limits to the leveraging process (told you I’d get to it eventually).

The amount of lending and borrowing (e.g. from depositors) a bank may carry out is limited by the amount of capital it has in case of bad debts.

Leverage (or gearing) applies not just to banks but also to any company – the gearing of a company is the ratio of borrowings to shareholders’ capital – to individuals, and to the economy as a whole (not to mention, most frighteningly of all, to the State).   All have illiquid assets – the bank has made loans it can’t always easily recall, the company may have invested in factories and machinery, the individual their education and house – and rely on an income stream to service (pay the interest on) these borrowings (the State’s revenues are taxes, but I won’t digress further along this albeit interesting and critical avenue!).  If any of these institutions or individuals have an insufficient buffer they are vulnerable to insolvency (and likely to a liquidity crisis as well) if  the income stream ceases or slows for a period (if sales volumes drop for a company or an individual becomes unemployed, for example).

The problem is, once some companies fail or individuals go bankrupt, their creditors – and in particular the banks – lose capital and can support less lending.  Deleveraging starts to occur.

So, an economy may be in a process of creating money – leveraging – or destroying it in the deleveraging process.

Just two more concepts before we round off: when money is being created, prices naturally tend to rise (more and more money chasing a similar amount of things, houses, perhaps, just as as a random example) and inflation is a danger.  What we’re about to see for the first time since the 1930s, is deflation, prices falling because too little money is chasing too many things.  The economists say this is to be avoided at all costs.  It’ll be interesting to see whether they manage this and if not (as seems likely) whether the consequences are as dire as they imagine.