Why ELA is not Different from Bank Deposits

Truth is, when most of us hear about Emergency Liquidity Assistance (ELA), our minds go back to March 2013 when the Cyprus haircut was first announced; we think of ELA as a trouble indicator, one which signifies that a bank is desperate enough to obtain it from the Central Bank, and subsequently, that the bank which obtains it is about to collapse. Yet, even though some parts of this story are correct, both the conclusions usually reached as well as the consequences we think ELA funding has, are, most of the times, unreasonable.

First things first: banks operate with deposits and loans, with the available money in the economy. In addition, they also tend to create money themselves, by the power of credit. What basically happens is that banks, using liquidity (i.e. available money) from their deposits, loan out funds to people. This occurs until the regulatory capital requirement hits. What liquidity means though, is that banks cannot perform their day to day business without money. Imagine going to a bank only to find out that it has run out of money, just like what happened in the US during the Great Depression or in the UK during the 2008 crisis. In order to avoid panic, the Central Bank usually steps in when there is a large outflow of deposits providing liquidity to its banks.

Here's what should be noted though: running out of liquidity is nothing unusual for banks. That's why interbank loans and discount windows exist. In the first case, the bank obtains a short-term loan from another bank with more liquidity available in order to maintain a minimum until more money are returned (via deposits or through loan installments) while in the second case, the same occurs but the bank borrows from the Central Bank. In both cases, borrowing from either source actually has less cost for most banks, especially in the periphery (in countries like Germany and the UK, the interbank lending rate is usually very close to the deposits rate).

Thus, what liquidity needs mean is that there is a positive shortfall in the assets minus liabilities, and the bank has to cover it; whether this cover-up comes in the form of deposits or interbank/Discount window loans is irrelevant to the bank. Banks however, deal with other banks the way they deal with other customers: if they do not believe that they will repay, then they will not lend. Hence, when banks are not very stable (and this might just be a perception not reality), other banks might refuse to lend them forcing them to turn to the ECB discount window (the same might occur if a bank just thinks that it might need a large amount of funds, regardless of its state). The only issue here is that banks have to provide some collateral in order to receive the loan. This collateral is usually in the form of government bonds; when the bond has been rated as garbage, the bank cannot offer it for collateral.

At that time, the ELA comes in play: the National Central Bank (NCB), which usually operates in a strange dependent/independent relationship with the ECB, offers lending and accepts other forms of collateral (e.g. loans). The reason behind this lending is simply that the National Central Bank does not wish for the specific bank to bankrupt, as the costs will be much higher than the benefits (note: the decision of whether to offer ELA or not is 100% up to the NCB. Still, Central Banks do not enjoy making the decision of whether a bank will bankrupt or not so they just offer the funds. Nevertheless, this is not a bad policy in general). While this is a burden for the bank, it actually is much better than the alternative, i.e. deposits. Given the perception (either wrong or right) that the bank is in trouble, it will have to offer huge deposit rates to attract customers; in Greece and Cyprus rates often exceeded 4 or 5%. In contrast, the ELA is offered at Euribor plus 1-1.5%, a total of less than 2%.

We consider ELA to be troublesome because it is a loan, and because liquidity is something we usually do not understand. How can ELA lending be decreased? Simply by bonds moving from garbage to investment grade categories allowing banking institutions to access the ECB discount window (which is just cheaper, otherwise it is just as lending as the ELA), by regaining the market's trust and have more people trust their money to the bank or simply by increasing the money in the market thus increasing liquidity. The latter can only take place through increased bank lending, something which needs both willing lenders and willing borrowers.

If anything, ELA just signifies trust in the bank: if we believe that the bank is going to make it, then it will be able to repay ELA money with no trouble at all. If we do not and the bank does not receive any deposits or more so money are withdrawn, then the bank will not be able to repay. The same holds from the Central Bank side which is really out of options: it cannot really withheld ELA and allow the bank to fail (see Lehman Brother and the steps taken by the Fed afterwards).

Deposits and ELA are materially the same thing for the bank. It's trust which distinguishes between the two; market's on one hand and the Central Bank's on the other. If the latter is regained then the bank survives; if not then it fails. In any case, ELA has nothing to do on whether the bank is viable or not in the future.

Does QE mean money printing?

Although the debate on the effects of QE on the economy and whether QE is deflationary or inflationary has (at least in my mind) been settled, there seems to exist a rather going "concern" on whether the buying of government bonds from the Central Bank equals money printing. Whether it does or it does not have separated people into two camps: those who believe that too much QE can lead to hyperinflation and those who believe that it will cause nothing of this kind.

But first things first: QE, although usually defined as the purchase (by the Central Bank) of government bonds in the possession of commercial banks. Yet, there is also an additional point: the one where the Fed purchases new bond issues. To see why this points holds see the following breakdown:

As it is obvious from the above, the only major change in the categories is the increase in foreign demand for US debt and the increase in the Fed's share of debt. Essentially, as many have argued before, when QE is initiated, collateral in the form of government bonds becomes more scarce in the economy. This is supposed to make the banks focus their funds elsewhere, meaning an increase in lending. These operations are usually conducted by the Fed either at the expiration and the re-introduction of a bond or by direct "investment" in the markets.

The point to be made here is that if the bonds are purchased from the pile of existing bonds then QE is nothing but an asset swap: cash is exchanged with bonds (both at zero risk for the bank). This does not mean an increase of the money supply whatsoever. Yet, if the government decides to issue additional bonds (remember the whole "raising the debt ceiling" debate?) then the Fed is essentially creating new money by purchasing some of them.

Remember that in order for newly printed money to enter the market it has to either be channeled through government spending or by throwing these amount off a helicopter. (If we choose the former then Monetarism and Keynesianism are essentially saying the same thing.) Thus, if the Fed purchases bonds from new issues, then it is essentially creating new money to enter the market via the government spending channel. Here, we are talking about money which did not exist before. Again, if it was a bond rollover then we would be talking about an accounting increase in cash and a decrease in government bonds (both on the asset side of the balance sheet) which have no effect on the money supply. If the money is lent, then we have an indirect increase in the outstanding amount of money in the economy, via the money multiplier, yet, this is not money printing. It is printing only if the Fed purchases new bond issues.

Now suppose that the Fed buys some new bond issues. Should we experience hyperinflation? The answer is no and not because increasing the money supply does not mean an increase in inflation. It is simply because of timing. Since the money base (M0) is just about 1/3 of the broad money in the economy (MZM) the effects of a rise in M0 just offset the decrease in MZM due to deleveraging. This is the major reason why the money supply in the US has been increasing over the last year despite the decrease in loans. It is just now, that the increase in bank lending has returned to its "normal" growth rate, that QE has began tapering.

Is QE a panacea? Obviously not. As already said, it may cause short-term asset bubbles and disinflation as a result of increased investment in the stock market. Still, those are just short-term effects and compared to the contrary (in the case of the US, a huge depression). In addition, just like fiscal stimulus, it can only be implemented when times are bad. In booms, QE and fiscal stimuli can cause private investment "crowding out" thus forestalling growth and creating additional inflation. In booms, the latter two tend to cause more damage than good. The two camps referred to at the beginning of this article can both be right but at different times: when times are good, QE can cause high inflations. When times are bad, it does not.

Overall, QE remains a good idea, despite its short-term side effects. The big question of whether the ECB will be able to apply something like it in the Eurozone remains to be answered.

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.