Friday, November 21, 2008

Bill John and Pete

Before assuming that Bank No 2 described in my previous post, read this example.

If John returns from overseas and puts $10,000 in his check account, the balance sheet of the bank shows an increase of $10,000 under cash. If John were the first client of the bank, its balance sheet would look like this.

Liabilities
Deposits 10,000
Total 10,000

Assets Cash 10,000
Total 10,000

It is true that the bank also records a liability to John. However, because the bank has control of the cash, it has a stronger position. John has become a creditor of the bank, so he is now very dependent on the bank honouring its obligations.

If the bank thinks that John is unlikely to withdraw its money, it may make a loan to Pete. Its balance sheet would then look like this.

Liabilities
Deposits 10,000
Total 10,000

Assets
Loans 10,000
Cash 0
Total 10,000

Pete buys a truck from Bill, who deposits the cash he received in the bank. The bank’s balance sheet now looks like this.

Liabilities
Deposits 20,000
Total 20,000

Assets
Loans 10,000
Cash 10,000
Total 20,000

The banks cash to asset ratio is fifty percent, so the bank now complies with the Basel Accords. It easily meets the standards set by governments all over the world.

Despite this compliance, we now have a strange situation where the bank only has $10,000 cash, yet both John and Bill think they have $10,000 in the bank. If they both try to withdraw their cash out at the same time, they will not be able to get it. The bank cannot call in the loan from Pete, because he no longer has the cash. He has brought a truck.

Bill and John’s cash is not lost, but they cannot get hold of it when they demand it. The best the bank could do is to give $5,000 to both Bill and John and make them wait for the rest of their money. The bank could force Pete to repay his loan, but if he has to sell the truck quickly, he might only get $5,000 for it. John and Bill would then be in trouble, as one of them would have lost $5,000.

4 comments:

Anonymous said...

You are leaving out some of the bank's options, including the one which they use every day. If both Bill and John wanted more money back than the bank had, the bank would borrow it from another bank, almost certainly at a lower interest rate than they loaned it to Pete. They would still make money on the spread.

Also, your scenario assumes that they can loan out 100% of demand deposits. That is not "fractional reserve banking", because there is no reserve requirement.

RonMcK said...

I kept the scenario simple to make it easy to understand.

Bringing in another bank does not change the underelying argumeent. It could only lend a deposit that belongs to someone else.

Anonymous said...

Einstein once said that everything should be as simple as possible, but not moreso. There are pools of capital to be loaned that are NOT demand deposit checking accounts. It could come from CDs, it could come from an investment bank that raised money from selling shares. The bank itself could raise capital by selling shares.

There are ways to cover cash flows issues, which is very different from what we are seeing in the banking system now, which was loans made to non-credit worthy people and businesses. That is a solvency issue rather than a cash-flow issue.

RonMcK said...

The scenario is an illustration, not a proof. I want people to see that when they have money in the bank, someone else has a claim to that money as well.