Economist Steve Hanke, writing at Globe Asia, uses a lesson in reading banks’ balance sheets to predict a coming recession:
For a bank, its assets (cash, loans and securities) must equal its liabilities (capital, bonds and liabilities which the bank owes to its shareholders and customers).
In most countries, the bulk of a bank’s liabilities (roughly 90 percent) are deposits. Since deposits can be used to make payments, they are “money.†Accordingly, most bank liabilities are money. To increase their capital-asset ratios, banks can either boost capital or shrink “risk†assets. If banks shrink their “risk†assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.
The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank deposit for new shares. This reduces deposit liabilities in the banking system and wipes out money.
So, paradoxically, the drive to deleverage banks and to shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios.
By pushing banks to increase their capital-asset ratios to allegedly make banks stronger, the establishment has made their economies (and perhaps their banks) weaker. This is certainly the wrong medicine to prescribe when the economy is weak.
One of the things I’ve noticed in reading analyses of the economic downturn is the sharp dichotomy in views between economics professors and finance professors. Hanke is, essentially, a finance prof (”Applied Economics”).
You may find these be fine points, but this guy is making assertions about mechanisms that simply are not true, unless we just have a wording issue.
“Since deposits can be used to make payments, they are “money.†Accordingly, most bank liabilities are money. To increase their capital-asset ratios, banks can either boost capital or shrink “risk†assets. If banks shrink their “risk†assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.”
No way. There is no reason that if banks stop making loans (risk assets) that depositors will simultaneously withdraw deposits. (And put them where, by the way?? In a mattress??) Better: The velocity of money will decline if they do not use their deposits. This phenomenon was pointed out by me, a John Mauldin piece, and I believe you, Dave, about 2 – 2 1/2 years ago. The distinction matters for two reasons: 1) if banks assets are actually suspect, forget the “money is destroyed” or velocity issues – they are simply shoring up their balance sheets and 2) if velocity picks up to normal historical levels – what about inflation??
“The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank deposit for new shares. This reduces deposit liabilities in the banking system and wipes out money.”
Really?? The first assumption, that the money to buy shares comes from bank deposits (money) is suspect. Maybe it came from the sale of GE stock (not money, but another long term semi-liquid asset). Secondly, the money buys little slips of paper called stock certificates. Where does he think that money goes, into the sewer, never to be seen again? I would suggest that the stock of money, however measured, is not a material function of bank equity issuances.
This is the only thing I found interesting, although I’m doubtful it is correct:
“By pushing banks to increase their capital-asset ratios to allegedly make banks stronger, the establishment has made their economies (and perhaps their banks) weaker.”
So the argument is that if the banks shut down loans its a self inflicted wound that their existing loan portfolios will crater with the economy. Hmmm. I have to admit to extreme bias gained through 20 years of being in this business. Bad credit is bad credit is bad credit. Credit is extended with a buffer zone for underperformance. I find it hard to believe the the banking industry is choking its own neck. Rather, their poor credit decisions are local, and would be manifest despite the velocity of money. New loans? Thats a different story.
Hanke makes a glaring error which poisons his entire analysis:
“For a bank, its assets (cash, loans and securities) must equal its liabilities (capital, bonds and liabilities which the bank owes to its shareholders and customers).”
Bank reserve requirements are entirely irrelevant to the lending process because banks are NOT reserve constrained. They don’t go checking their asset/liability ratio before making a loan; when they find a credit worthy customer they simply credit his account and obtain the necessary reserves later through either the Fed Funds market or the discount window.
Hanke appears ignorant of the fact that deposits do not create loans.
Um, Ben. Yes, banks do that on a day to day basis simply because its impossible to shore up their reserve requirements intra-day. They shore it up daily. (See: the bank window.) But on a longer term basis they are most assuredly constrained.
The issue at hand is different; it is whether or not they have reduced their lending activity – their excellent deposit position notwithstanding – in an effort to get balance sheets “fixed” with a currently non-publicly acknowledged latent asset write-down……….or just to play the current arbitrage.
But thank you for playing.
No, I’d hoped you would jump in.
@Drew
On any day banks can obtain reserves in any quantity needed. Long-term or short it makes no difference, which is exactly why Canada doesn’t even have reserve requirements. Banks are capital constrained, not reserve constrained.
Ben –
Stop and think for a minute. Can the Bank of Podunk, IL go to the window and draw resreves sufficient to support making a $500MM loan to General Motors, just like Bank of America?
@Drew
You have to understand that reserves aren’t used to make loans. They are set aside for very specific uses such as covering liabilities, clearing payments, et cetera. That’s why banks aren’t reserve constrained.
Loans, however, are capital and are most certainly constrained as you point out.
It basically works like this: The bank decides GM is credit worthy and approves the loan. It then credits GM’s account at the bank with the $500 million which literally comes from nowhere, they just push a few buttons and PRESTO. The bank now has a liability (the deposit it made into GM’s account) and an asset (the loan itself). At the end of the business day the bank checks its reserves to determine whether it meets its requirements. If not it may borrow reserves from other banks, or it may borrow at the Fed’s discount window. Either way the reserves have to be repaid and will be as the loan itself is repaid.
The loan and the liability together net to zero, which means that while the bank has given GM dollars to spend, the entire process is endogenous to the banking system and no money is actually created. Once the loan is repayed the liability is extinguished and the “money” the bank loaned out literally ceases to exist.
In this way loans actually create deposits, rather than deposits creating loans as we’re all incorrectly taught.