Sunday, 1 September 2013

The Banking System Part II: Repayments and NPL's

On a recent post, I gave an overview of how the banking system works and how the Central Bank assists in increasing bank liquidity when the latter wish to issue loans but do not have the liquidity necessary for that. The story presented in that article is what happens when the banks issue the loan and the customers use (i.e. spend) the money to purchase goods and services. As any good lender, the bank is not really giving the money to the public without expecting them back. Unfortunately for the bank, this promise to return the funds is not always kept as many borrowers default on their debts. In this post, I examine both scenarios (i.e. debt repayment and default on debt) and their implications in the economy as a whole.

1. Repayment
It would be much more suitable to examine the outcome of debt repayment by presenting a simple example. Let's assume that at time 0 the bank lends 100 units of currency a borrower, Mr A, who spends it in buying equipment for his shop. A year later, Mr A has to repay the loan with an added interest of 5 units of currency. For simplicity we will assume that there are no installments, just a large payment at year 1; in addition we assume that the bank only charges the interest at year 1. (In essence we are assuming the loan to have bond-like characteristics to make this analysis simpler. The same conclusions could also be reached even if our model was more realistic in its assumptions). Now, as stated before, when the bank issues the loan, it creates a simultaneous credit entry (the amount owed to the customer) and a debit entry (the amount owed by the customer) in its books, with each entry cancelling the other out. 

The amount of money in the economy also increases by 100 units when the loan is withdrawn and used by the customer. Yet, at withdrawal time, the bank does not owe the customer anything any more since the money was taken from it. This leaves the bank with just one debit entry: the loan granted to the customer.

At year 1, Mr A's investment paid off and he has enough money to repay his loan. He goes to the bank, hands them 105 units and bids them adieu. The bank accepts the money, accounts for it in its cash ledger and crosses off the debit entry assigned to Mr A.

Now, overall, if the money in the economy at time 0 had been X, granting the loan would have made it X+100. At time 1, if nothing else changed, the amount of money in the economy would become X+100-100-5=X-5. The startling discovery appears to be that when borrowers return money then overall money in the economy is reduced. Is this true? The answer is a bit more convoluted than expected. 

Money in the economy appears to be decreasing but this is not a permanent effect: in a real economy with millions of participants, just when any Mr A repays his loan, Mr B,C,D or E is eagerly waiting for his loan approval to use the money for buying a house, equipment or a fancy car. Thus, although the amount of loans in the economy appears to be reduced, this is just trivial and very short-lived: the reduction in money will be quickly countered with the increased liquidity the bank will have; given that the bank has not reached its regulatory capital maximum, the bank will now have 105 units available for lending which will mean that the money supply will again be increased shortly (provided of course that the bank finds enough good opportunities for lending).

An interesting question is what happens if, say 10% of borrowers decide to repay their loans at the same time: the answer is that a large decrease in the supply of money in the economy will occur, with all the known consequences of that (liquidity crises, deflation, etc). The only reason this has not happened is that people do not operate in such a fashion; it is much easier to spread payments over  5-6 years and pay a fixed amount every month than live on a shoestring and repay the loan in 2 years' time. Since life is generally unpredictable and people generally prefer stability it should not amaze us why people do not rush to the banks en masse to repay their loans.

2. Non-Performing Loans (Bad Debts)
Now suppose that Mr A could not find any suitable buyer for the goods he produced and thus he cannot repay his loan, making it a non-performing loan (NPL) for the bank (the usual definition is that of a loan whose payments are more than 90 days past due). This means that the bank will never receive its money back. What does the bank do then? Accounting-wise, the debit balance is transferred to the bad debts balance (for the purposes of this analysis bad debts will be the name this account has, although in practice the name may be different) which in its turn appears as a loss in the bank's financial statements.

Remember that when a bank issues a loan, it increases the money supply in the economy and it transfers liquidity to the customer when he or she withdraws it. In the case where the borrower cannot repay the bank, the money in the economy is unaltered (at the moment) while the bank's liquidity is reduced. A reduction in liquidity means that the bank will not be able to continue lending at the pace it previously could. While a non-performing loan here and there may not cause any issues, having too much can cause the bank to fail. When the bank does not receive its money back it means that it has no longer the liquidity it was supposed to have, which means that it can no longer keep lending or even worse, it will not be able to repay the Central Bank (or other corporations) for the liquidity it has provided. As a consequence, the bank will face liquidity issues and may be forced to default if the Central Bank does not allow it to borrow more.

Even though the total amount of money in the economy will appear not to change, it's rate of increase will be affected if banks face liquidity issues; bank credit will be decreased which means that money circulating in the economy will also be decreased (when we talk about money in the economy we usually use measures which include savings. Yet, savings are not usually used for transactions). Thus, less money available for transactions means that consumption will be reduced forcing the economy into a recession. Add to this fear resulting from reduced consumption and the recession and the velocity of money is further decreased, making a perfect crisis. This is what's currently happening in the South of Europe: banks face too many NPL's and cannot (and do not want as they fear for even more NPL's) lend as much as before, reducing the money available in the economy.

Now, let's suppose that Mr A put his house as collateral for the loan, promising to hand it over to the bank if he faced trouble. The best case scenario for the bank (and possibly for Mr A as well) would be for Mr A to sell his house to someone and repay the loan, keeping the rest to himself. Yet, if Mr A cannot do that, the bank will have to confiscate it. The problem here is that the bank does not really want the house unless it can sell it quickly and at a price high enough to cover the loan. A bank with too many hard assets confiscated (houses, equipment, etc) may face liquidity issues if it cannot sell them fast and at a good price; this is exactly what happened to the US housing market in 2007-2008 when banks found themselves with too much assets and too little liquidity.

From the above two simple conclusions can be extracted:
1. Repaying bank loans may appear to decrease money in the economy but since banks can reinvest the money received to other loans the decrease is not permanent. In fact, it may trigger a larger expansion of credit if the bank has not reached its regulatory maximum (in some countries, banks have actually lent money to their employees so they could purchase new equity issued thus increasing the regulatory maximum)
2. A large percentage of non-performing loans to total loans can seriously impair the bank's ability to lend. This will also affect the overall economy by decreasing the money available for transactions, thus reducing consumption and the velocity of money, resulting in a recession. If steps are not taken to boost bank liquidity an even harsher recession is most probably going to occur since people will reduce their spending even more, out of fear and uncertainty.

As already said, the banking system is not as complicated as many like to believe. By understanding simple accounting and macroeconomics and admitting that everything is connected, financial crises are easy to explain, and occasionally forecast (timing is of course extremely difficult). Although it is seldom mentioned, banks provide the lubricant for the economy machine; without them, the machine would clog and unclogging it would require much more effort than if we just kept the lubricant at a steady pace. Yet, the lubricant should never be too much: this could lead to spilling and creating more of a mess than keeping the wheels turning. It is just as important to keep the lubricant at reasonable levels as it is to ascertain that we do not run out of it.


  1. I think your analogy with payments and repayments makes the same mistake as Clark;s analogy if being like a forest where investment and final production happen simultaneously and so time and so creation/destruction is irrelevant. You and he neglect how changes in debt matter at the margin, so an increase in debt issuance, or debt repayment, net adds to subtracts from money in circulation, as many circuitists writers such as Keen and Fontana argue.

    1. They may matter at the margin for the individual investor but they do not matter that much to the overall economy (emphasis: "not that much", not "not at all"). The point is that if what you describe happens the effect of a single loan is infinitesimal in a huge economy.