The Irony behind NPLs and Lending

This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.

NPLs are loans for which "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. 

The correlation is obvious as can be seen in the case of Greece:

Source: CEIC Network

NPLs as a percentage of total gross loans. Source: Index Mundi

The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a higher risk weight than before. Thus, the higher the NPLs the lower the banks' ability to lend out more money.

The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without retracting money from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.

How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking  at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.

As said before, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the UK experience), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.

Real Life Effects of Deflation

Deflation is defined as the decrease in the level of prices:

As economic theory dictates, the causes are a fall in the money supply, in addition to (in the short-run) a fall in wages and salaries.

Compensation of Employees (aggregate) Source: ECB

Just like any other economic happening, there are those who claim that any type of deflation is disastrous and should be avoided at all cost while others believe that it is wonderful (since it lowers prices) and we should embrace it. As usual though, they are both wrong. The answer, simply put, is that it depends on the severity, duration and the overall state of the economy at the time when deflation is manifested. What follows are three points on the effects of the current rates of deflation on the real economy of the Eurozone.

1. As long as deflation is not severe and not persistent then the effects on consumption are small.
There is no person who would be willing to forgo a month's consumption of food just because it would get cheaper next month. Parents do not tell their children "you will not attend university now because it will be 2% cheaper next year". We have some basic needs which we will continue to satisfy as long as the deflation rate is not so severe so that an apple will be worth 50% less tomorrow than it does today. Prices fluctuate every day and a deviation of 1-2% per annum for a short period of time (e.g. 1-2 years until an economy gets back on track) does not really change our incentives for non-durable consumption.

Nevertheless, there is an effect on what we call durable goods (e.g. houses, automobiles, etc) but these are just a fraction of what we purchase (approximately 1/3 of our purchases are of durable goods). Even though 1/3 may appear to be large, remember that the reduction in price is more severe in some sectors than in others; automobile prices have not dropped by much (if any) while real estate prices have sunk compared to 2006. In addition, when a person has lower income than before, the first thing he stops purchasing is durable goods, not everything else. Thus, the drop in durable goods consumption can be seen as a natural reaction to the overall drop in confidence, investment and subsequently wages. Still, if deflation persists and becomes even higher in 2014-2015, a large drop in the consumption of durable goods might signify a reduction in investment, resulting in more wage losses and thus creating a vicious cycle.

2. Deflation has a stronger effect when households and non-financial corporations are heavily indebted.
The reason is simple: given that aggregate wages have dropped, prices also drop, triggering another round of wage drop and so on. Although this is an issue for durable consumption as discussed above, it is also a problem when it comes to debt as it takes more money in real terms to repay the amount owed. Thus, if in a country most of its citizens are over-indebted (see all periphery countries) deflation is bad because it makes repaying that debt even harder. Not only that, but it also creates a "death spiral": the more people try to repay their loans, the less they consume and thus prices and wages fall even further making the real amount they owe even higher. This is exactly what happened with austerity policies: less spending means less consumption thus less income for the state, leading to higher deficits and debt and forcing new austerity measures once again.

3. Deflation equals lower prices but it does not mean it's good for us.
This is one of the most common fallacies ever: if prices fall then it is great. It is most of the times but it always depends on the reason prices fall. If they do because raw material are cheaper or because of a productivity rise then great. But if they happen because people have less money than before then your purchasing power is most likely hurt in the short run (prices usually do not respond fast to shifts in consumption, even if those are permanent). In addition, if we shift from inflation expectations to deflation expectations then what we will see is less and less consumption, leading to lower wages and then lower production. This is the time when deflation gets serious as, with higher rates, we can actually see the economy reach a halt.

What should be noted is that the severity of deflation has a direct effect on the magnitude of the above. If deflation is at a very moderate rate of 1% per annum for a year or so, then most likely its effects on consumption and loan repayment will be very small; more or less of the same extent of what happens in the economy during every other recession. Only if deflation persists, becomes larger and is embedded in expectations will we need to seriously start about the future of the economy.

In order not to come to the worrying part though, policy (here's looking at you ECB) should be re-addressed so that confidence in the region is re-instated. Otherwise, we will soon see if markets can adjust fast enough not to cause any major casualties.

Banks vs SME's: Who's the economy after all?

The title of Wikipedia's article on the crisis stars with a word which sums it it all up: Financial. What this means is that unlike others mishaps of the past, this time the trouble was mainly brought by financial institutions who could no longer survive. And since banks are not just like any other institution in the economy (in the sense that they provide the service of moving funds from one place to another, addition to lending) their importance was not big news to most (it was to some who believed that rescuing them was bad. Truth is, if Bernanke hadn't then we would be far worse than the 1930's).

In Europe, even though some of the troubles in the periphery are attributed to excess government spending, the truth is that the financial sector has also been a major cause of pain in at least half the economies in the EU (note that it has also been a problem in the UK, Germany, the Netherlands and Belgium, countries which do not often get the bad publicity of being in trouble). As in the US, governments in the EU rushed to save the banks, in most of the times with good reason. Yet, the emphasis on the banking sector has not stopped there; policymakers' preferences shifted to paying more attention on what the banks need instead of what is necessary for 99% of Europe's businesses: SMEs.

Unlike large businesses, who usually have ties with multiple banks, usually both domestic and abroad and have open lines of credit reaching hundreds of millions, SME's are faced with small business loans and very small credit balances. The increased capital requirements forced on banks and the now extremely picky procedure for securing a loan has brought many SME's to their knees. As the number of loans to the private sector is reduced, the SME owner finds himself without any sources of funding; while the data show that banks are doing better with regards to their loan portfolio, the market has in fact been suffocating.

The sad truth is that while we favour the survival of banks, we should remember that these institutions are mere intermediaries; it is true that the economy will freeze if banks collapse, but the same will occur if more and more SME's bankrupt day after day. Big businesses do not see their lines of credit diminished, but those who count the continuance of their day-to-day operations on checks who take days to clear, struggle with the reality of dying any time soon. Troubles are many, starting from the number of days required for a check to either be returned or cleared varies significantly among countries, (when it could essentially be done in less than a day in most), the increased fees required by banks to either send money abroad (even though SEPA is a major improvement) or to maintain certain accounts and finally the lack of any additional funding are major causes of headaches for people who do not have.

Since the emphasis is on the banks and not on the businesses, confidence that the economy will do better in the future is hard to build. How can the average Joe (and it is on his spending and his investment that we really count on) be convinced that things are doing better when he sees his company in the red, his friends and associates losing money and the business environment he lives in become harsher every day? We cannot de-emphasize the importance of banks but banks are nothing more than a small part of the economy; and since lending is limited (even in the best case scenario) we cannot be just focus on them and expect everything to go better.

I've said it before: we are at the ZLB so monetary policy is out of the question and our governments are constrained on spending making fiscal policy is not an option. All we are left with is confidence; yet, it cannot be raised if banks will not lend and make life miserable for millions across the continent. Yes, we need banks for the economy to move; but banks and the economy need businesses even more if we are ever going to see better days.

Austerity Strikes Back

The tale of the hard-working North vs the lazy South has been cited again and again during the past couple of years, mostly from Northern politicians who saw the on-going crisis as an opportunity to promote their own agendas. At the core of this "argument" was the self-assuring conviction that "we do not need them (the South), they need us". Through an array of measures mostly aimed at austerity in order for state financials to regain their vigor, the North is surprised at the increasing debt-to-GDP ratio in the short-run and is accusing some of the South for not pushing through enough reforms.

As has been explained before, when GDP goes down, debt has to decrease by much more in order for the debt-to-GDP ratio to remain constant. Yet, this will obviously not be the case as the economy contracts much faster than the GDP can be reduced. In addition, when policies are based on austerity, results are usually much harsher for citizens than when they are not. Even though many have failed to see it at the time of implementation, austerity measures in the periphery also affect the North. The simple rationale behind this is that the North was (until now) basically exporting while the South was largely importing goods; the heavy reliance on each other was more than evident as in 2010, no country in the Eurozone had less than a 57% share of intra-EU exports.

Yet, many continued to think that a heavy reliance on exports was a sign of a "vibrant economy" which would lead to higher wages and higher domestic demand. The brief answer is a big fat no. You see, the issue here is that heavy reliance on exports means heavy reliance on the well-being of your neighbours; if your neighbours are poor it means that they buy much less from you than if they were rich. Simply put, reliance on exports means that if they go down, they take you down with them. 

The issue is not new. Some of us have already discussed this in detail, and warned that this situation cannot go on forever. We were (unfortunately for the citizens of the North which are not to blame for the mistakes of their governments) correct. The latest data show something quite startling: Retail trade in December 2013, the month which generally signals the peak in consumer spending, has decreased by 1.6%, compared to November.

In monthly terms, Portugal and Spain were the leaders in the drop, although this did not come as a surprise. The "surprise" is that Germany, Austria, Belgium and Finland have also seen a sharp drop in retail spending. What is even more astonishing is that on a year-to-year basis,  Germany, Belgium and Finland lead the race in the drop. As if this wasn't enough bad news, the bank de-leveraging procedure which has been going on in the periphery appears to have started in the North as well. Germany, Austria and France saw total bank loans to non-financial corporation reduced by 1%, 1.1% and 1.5% respectively, and even if this is not large compared to what happened in the periphery (and Slovenia with the extraordinary 23.8%) it is indicative of the worsening situation in the region.

As a result of de-leveraging and the decrease in spending, inflation in the Eurozone has dropped to 0.7% on an annual basis. Even though just 4 out of 28 countries experience deflation, the rest are barely above 1%; only Austria is close to the ECB mandate of 2%.

North's problem can be reduced to two simple words: no demand. You see, as others also note as well, while banks are not currently in a large need for de-leveraging and are more than willing to lend their excess funds, they cannot do it in their domestic markets as people, in contrast to what most monetary authorities would suggest, are not willing to borrow even at near-zero rates. Less borrowing means less spending, or in economic terms less demand. This results in deflation, which in its turn ends up being a self-perpetuating situation (unless this is stopped as Irving Fisher noted in 1933). As consumption comprises more than 2/3's of GDP, output falls when consumption is reduced.

The situation has begun evolving in Finland where output decreased by 1.1% in November 2013 compared to the previous year, with the same thing occurring in October 2013. The 0.4% contribution to GDP growth led by net exports in the country in 2012, is unlikely to be repeated until demand in the South picks up. With the main forces of the decrease in the 2013 GDP being domestic demand and inventories (both driven by consumption and demand) the path appears to be same as Germany where net exports are expected to take growth down with them in 2014. Even though the country's trade balance has also fallen in December, the effect of local demand, which fell by 1.6% has taken its toll in factory orders in the last month of 2013.

As the gains from trade are not translated into higher domestic demand (either by credit or directly), these have to be tunneled somewhere: housing prices in Germany have soared by at least 25% (in some cases more than 35%) since 2008. The Lehman story has taught us that housing bubbles are not a good thing; actually Deutsche should remember its experience better. With the rest of the Eurozone decreasing imports and domestic demand where does the North expect to ship that 20% of GDP in intra-Eurozone exports and how is it going to sustain the level of GDP currently obtained if domestic demand is also shrinking?

Capping Banks' Rates

I've recently been in a discussion win which some academic proposed an interest rate cap for bank loans. When I asked whether he meant during the crisis or in general, his answer was "of course in general". His argument was that given the Modern Portfolio Theory which states that specific risk can be diversified away, when banks have a large amount of people as loan-takers then their individual risk will be diversified away and all you will be left with will be systematic risk which you can do nothing about. Thus, if the risk you have is just the latter, why should the banks charge different interest rates to lenders?

Although at first the idea might sound appealing to some, (it also abides with the "banks are bad people are good" motto), the problem with these kind of statements is that it shows a basic misunderstanding about how both the banking system and the risk-reward relationship actually work. To begin with, even in academia, higher risk is associated with higher reward. The basic reason is that you require a higher expected return to invest in something which will have a higher probability of costing you money. Simply put, if the risk of losing money is 10% one will surely ask for more potential money than if the risk is 5%. Thus, if the bank chooses to lend money to someone who has a 10% probability of defaulting then it makes sense to charge a higher rate than the one to be charged to someone whose probability of defaulting is just 5%.

"Sure" the academic would go on "but that risk can be diversified away". Well it depends what you really mean by that. Suppose that you have a stock market with stocks, between which you have to distribute your funds, having the following risk-return relationship:

Now suppose that someone told you that regardless of the risk, all stocks would have returns of exactly 6%. Where would you put your money into? Any reasonable investor would not be foolish enough to put his money in any stock which has a return of more than 6% in the above scenario because he knows that he will not be compensated for the risk he will assume. Thus, stocks 1,4,7,8,9 and 10 would have no-one to purchase them since their return would not be sufficient for the risk the investor assumes. In addition, stocks 2,5,6,11 and 12 would receive too much attention from investors since the risk they are posing is very little compared to what the capped return has become.

Let's put this is into banking perspective: instead of stocks, we have loans. Loans with higher expected return are those with higher interest rates, as for example business lending. If we cap the return banks can have at e.g. 6% then there will be loans which will not be issued, although in normal times the bank would most likely assume that risk and provide the funds (at a higher rate of course). What would this mean: essentially, those who have safe assets they can put as collateral, such as real estate or cash, would get funding while those who do not (for example 90% of the population) will not. This policy is not that terrible to the banks as they can adjust for these shortcomings; it is much more hazardous to the ordinary person who does not have collateral and cannot borrow at the low rates the bank will offer.

Why can't we force the bank to lend to the little guy you might inquire. Simply because the little guy bears more risk than the "big" guy. The bank has the discretion to reject any loan application it does not fit its risk-return profile. Forcing the bank to take up any loan while at the same time capping the rate is not a good idea; unless of course we really want another sub-prime lending crisis. 

In addition, high risk loans require higher capital requirements: business and consumer loans without any guarantees require much more than the 60% it is required for guaranteed ones. But the banks still give them. Not too many of course but they do. The thing is that if you take out all of the high risk loans you will be left out with no new Facebook, Google or Twitter. To get big you have to start small. And small without any lending is just tiny.

The reader would notice that my question was on the timing of the policy: if this is just a policy to be implemented as a short-term one I would have no problem against it. Why? Simply because just after a crisis banks are less willing to lend, and if they do then they lend to those who has a very low risk profile (i.e. the "big" guy). You don't have to take my word for what I described in the previous sentence; Hyman Minsky and Joseph Stiglitz said it much better, more than 30 years ago. Thus, as banks are less willing to give out funds, it would be much better to cap the rates during a crisis than after or before it for the simple reason that it would be much better for the existing loan-takers. It would take the burden off their shoulders, create an additional boost in consumption (or increase savings), thus moving us out of the recession. 

The short-term nature of this cannot be over-stated. If such policies are to be followed in the long-run then we would be in a situation where those who have will get more and those who haven't would get nothing. This is not only unfair it is also economically inefficient as, growth would also be threatened under such a scenario as no new high-risk projects would be assumed. Summing up: capping bank rates is good for the short-run, but only during a severe banking crisis; otherwise it does more destruction than benefit.

Is the Interest Rate Inflationary?

This is a post I probably shouldn't write given the previous two ones on banking (here and here). It is, nevertheless a question, or more often, a "conclusion" I usually get when when a discussion on inflation arises. As most people have developed a somewhat irrational, deeply rooted fear of inflation perhaps instilled by the extreme rates of the 1980's, anything that appears it might assist in an increase in inflation scares them deeply. It is a reaction which runs deep in human psyche: if the extreme hurts us, then we do not even accept an infinitesimal quantity out of fear of escalation. Even so, truth is that the interest rate paid on loans is anything but inflationary. Allow me to demonstrate:

Suppose we have an economy where a bank has 60 units of currency in cash (not deposits, this is a very simplistic model). At a given time 0, a worker borrows the 50 units and builds a lemonade stand to sell his homemade lemonade from lemons he gathers at home (making his cost, other than personal labour, 0 units of currency). Lemonade is the only good for human consumption sold in this simple economy. The worker uses the proceeds from the stand to repay the loan; given that the bank wants to make a profit from the loan, it charges the worker an additional 10 units. If the loan duration is 10 years, then the total amount to be paid would be 60 units, or 6 units per year. Thus, the bank is making a profit of 1 units per year, while the worker is forced to pay half a unit per year as the cost of borrowing. 

At first, this might appear as unsustainable: how is the worker ever going to earn 6 units per year in such an economy? This most straightforward of questions, represents one of the parts of economics most people fail to see; the inability to comprehend the full circle of money, results in incomplete models and flawed understanding. The better question here is what the worker does with the money he borrows. If he could just build the stand and equipment on his own what would the point of borrowing be? He could just chop wood on his own, manufacture the screws, the nails and the hammers needed, create the juicer and cups he would need and make some boxes to keep his lemons in and have no need for extra money, just extra time. Yet, our worker cannot do all that; more so, he does not have to do all that because he purchase them and that is why he is borrowing the money.

The worker, goes to the manufacturer's shop, where, using the 50 units he just borrowed, he buys everything he needs and goes down the road to set up his shop. Although the manufacturer can create all these goods and sell them, does produce any lemonade; either because she does not have the time, the expertise, the raw material or even because she is just bored to do so since she can simply purchase it with the 50 units of currency she just got from selling her merchandise. She thus breaks the total amount to 10 annual purchases of 5 units' worth of lemonade.

Let's now consider the bank: the bank currently has 10 available units, expects to get an additional 6 every year. Yet how does the bank consume? The answer is rather simple if one considers all that exists in a bank branch. It has to pay for its employees, rent, electricity, office supplies and other equipment. For simplicity, we assume here that the bank only has to pay an employee, with a salary of 1 unit per year, with the employee spending the money in the only available good for consumption in the economy, i.e. lemonade.

The transactions for each of the 4 involved in the economy in year 1 looks like this (total money means total money available for spending):

In year 2, the same chain of  even would again unfold:

Finally, at year 10, the balances would become:

Note that here, the amount of money in the economy, as stated at the beginning, is not customers' deposits. If they were, the reader will remember from here, that when a new loan is issued, money in the economy is increased and from here, that when that loan is repaid the amount of money is reduced back to its original levels, until the amount is again re-lent. In this model, where the bank just lends out cash, money is not reduced with debt repayment, yet although the interest rate appears to create money out of thin air, all it does is in essence re-distribute money in the economy.

When a loan is repaid, the bank's income is the spread (i.e. the difference) between the deposits and loans interest rates. This money is nevertheless not withheld from the economy: they are either paid as salaries and wages to employees, or spent for equipment, rents, etc. These are all included in the bank's costs one might suggest. True, but even if we use just net profit as a measure, money is almost never left sitting idly in a safe-box. The part employed as retained earnings is used to facilitate expansions, upgrades and other stuff which will make the bank more competitive in the future. This is nothing else but consumption, albeit under a different name. Even if retained earnings are not used for consumption and are just put in marketable securities, it really makes no difference, since even marketable securities are a form of consumption (they are, in essence, a short-term loan). How about the rest of the money? Well, we shouldn't forget about dividends right? Banks pay dividends to their shareholders who are able to employ that money as they please, meaning either spending or investing it. When interest is charged, nothing leaves the economy as many would like to believe; it is just distributed differently, just like when you and I decide to spend or save.

An increase in the money supply and thus in inflation, occurs only when new loans are issued and not when the repayment means that the borrower will have give back more money (in nominal terms always) than he borrowed. The conclusion is that money does not really stay in a bank's box when the latter charges interest and receives its profit: it is mere re-distribution. Obviously, whether this re-distribution is the optimal from the society's point of view is something completely different and certainly beyond the scope of this article.

Note: The same situation would also hold if the bank was lending customer deposits, yet the amount repaid would have to be re-lent at the same time to keep money supply stable. This does not mean that the interest rate would have any different function: it would again be just a re-distribution of funds.

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.

The Banking System Made Simple

One of the most popular discussions on the web is banking. Numerous commentators have been commenting on how banks work or how we perceive that they work. These views are occasionally correct while they are also occasionally wrong. In addition, a relative confusion on how bank loans are created or why deposits are needed by the banks appears to exist. What follows are three simple examples intending to indicate how banking really works, how deposits and loans are created and how the Central Bank functions in a financial system.

In all examples, we assume (for simplicity) a closed economy where banks face a mandatory reserve requirement of 10% and a Tier 1 ratio which cannot fall under 10%. It is also assumed that the money needed in the economy for transactions is on average a fixed amount M (already existing in the economy) and all loans have a fixed risk weight of 40%. 

Note: all of the above assumptions can be altered with no change to the conclusions reached.

Example 1:One-Bank Economy

In this economy we have a bank which has in its balance sheet deposits of 100 units of currency with its equity being 10. In period 1 it decides, according to the regulations imposed above, to lend out 90 units. These units, we have just one bank in the economy will be deposited in the banks' accounts. A simple balance sheet would indicate the following:

Then, the bank would continue to operate under the same way until it reached the limit of 10%. This limit is nevertheless not the one imposed by the reserve requirements but by the Tier 1 needs. The reserve requirements would, under these assumptions, allow the amount of loans available in the economy to reach 1000 units had there not been for the Tier 1 ratio which essentially forces the bank to stop at 250 (for more details about the money multiplier see this). The "final" balance sheet would look like this:

Example 2: Two-Bank Economy

Now let's suppose that 2 banks exist in the economy, both having a 50% share of the market. Their equity values would be 5 each and their starting deposits would be 50.

In the first period of time, each bank will lend 45 units to the public. Each bank knows that it controls only 50% of the market thus it makes sense to expect 22.5 of those units to be deposited in its rival. Yet, the total amount of loans in the economy has not been altered even though the banks are now more and lending less individually. Total loans will still be 90 and they will be divided equally between each bank. Thus, each bank now knows that if the other bank lends as much as it will they will both get back in the form of deposits as much currency as they have provided as loans. In addition, the number of banks is irrelevant to the conclusion, as is their market share. If we had 10 or 200 banks in the economy total loans would still be 90 and the market share would have been the same after the lending as it was before. More still, the situation would not have been altered even if market shares were unequal. 

With some frictions, this is what most commonly occurs in real life: as banks do not have the same amount of loan applications or do not grant the same amount of loans in each period of time, market shares are continuously changing. Thus, although banks (usually) want to lend until their Tier 1 limit is reached, they cannot do this as easily (either because of lower demand or because applications do not match the perceived risk-reward profile needed) thus making market shares and loans growing at different paces in every bank. In addition, reputation makes a great difference; banks who were leading the market once are now mere followers as clients view others as better alternatives.

Example 3: Two-Bank Economy with a Central Bank Providing Liquidity

Assuming that the previous initial conditions hold, the situation should theoretically be the same. Yet, reality is different. Since the Central Bank can provide liquidity (what is called ELA in the Eurozone) for banking needs then it means that the banks can allocate their loans based on demand and not based on their liquidity constraints; what the Central Bank essentially does is eliminate the liquidity constraints in the short-run by lending banks. 

The situation would unfold as following: In period 1, banks face increased demand and decide that they should lend 60 units each instead of the 45 they are allowed by their liquidity constraints. This means that the Central Bank has agreed to lend an additional 21 units of currency (additional 10 to cover for the difference from 50 to 60 and another 11 so that they can have their regulatory minimum and not fact trouble in their day-to-day operations) to each bank with the banks promising to return it at a later date. The banks' balance sheets would now look like:

Notice that the Tier 1 ratio was 28% in Example 1's first period while it is 21% now. The reason is simple: more loans can be generated in less time using the Central Banks' available liquidity. 

A question is how the Central Bank will get its money back; after all this funding is nothing but a loan to the bank. Notice now that the bank who received the funding still has received 60 units of capital as deposits back. Now, according to the rules, the bank only has to maintain 11 units (10% of total deposits, i.e. 110) for liquidity. This means that it can afford to give the liquidity back to the Central Bank, hold the regulatory minimum for liquidity and still have 28 units (60-21-11) at hand which it will be able to lend in the next period.  That is if the bank does not get any more funding from the Central Bank to boost its loans.

As with example 2, in reality things are a little different. Banks not only borrow from the Central Bank but from each other as well, since their liquidity is changed every day (as stated before loan grants and demand is unequal between banks) and they may find themselves in need of some extra cash or have some extra liquidity which they prefer to lend out in order to get some interest instead of having it idle.

From the above examples we can derive the following conclusions:

• Deposits matter with regards to liquidity. Yet, they do not matter to the amount of loans to be given. As the balance sheets have indicated loans cancel out since their creation is a simultaneous creation of an asset and a liability. Thus, the bank has no limitation to the amount of loans it can create other than the regulatory capital requirements (e.g. Tier 1)
• The amount of money given by the Central Bank will be returned to it, yet its effect will be permanent. If the Central Bank agrees to give X units of currency to the banks then the money supply will be increased by more than X permanently even if banks return it to the Central Bank. This happens because that money is created by the banks and even if the extra liquidity is returned the amount of loans in the economy would have still been increased.
• The starting value of deposits is irrelevant. It does not matter whether initial deposits were 10 units of 10 million units. The amount of loans to be granted will be exactly equal to the amount allowed by the regulatory requirements and not by the initial state of deposits (obviously, deposits have to be greater than 0 for this to work since the bank cannot print money).
• The more cash at hand and the more government bonds banks purchase the more money supply they can create since both instruments are of zero risk weight and are thus excluded from the calculation.
• Increased regulatory requirements at a given amount of equity, means that less loans can be created, thus making money supply will in general be less; an increase in the regulatory requirement (e.g. from 10% to 11%) means that ceteris paribus less new loans will be created in the future. This situation is evident in the EU at the moment.
• The only way for money supply to be increased is for banks to raise more equity. If it is raised then more money can be created in the economy.

As the reader has seen through this analysis, the way banking works is not as complicated as we usually think it is. Nevertheless, understanding how the banking system works is paramount to the economy and has been an issue which had received much less attention than it should have. As stated above, the examples can be very easily extended to include more complexity; yet understanding the larger image can most of the times provide us with more knowledge than by narrowing our focus to the specifics of banking.