Balance Sheet Leverage, Interbank Payments, Risk On, Risk Off

[Joe Leote]

Four page reference on bank loan loss accounting shows the simplified accounting structure of a bank balance sheet and income statement:

Loan Loss Reserve Accounting and Bank Behavior

The cash account in the paper above is a poor term. It should be called the Reserve account and includes currency on hand (vault cash, teller drawers) as well as Central Bank exchange settlement funds which I call bank reserves.

This talk about bank accounting and operations is accurate although the discussion of bank capital (loan loss allocation) is overly simplified and Richard does not stress the importance of each bank's ability to make interbank reserve payments as it's primary liquidity constraint:

Banks exist to keep you in debt - here's how they do it - YouTube

In other words, banks have to pay interest to attract deposits to keep reserve payments flowing in the interbank payment system, and banks have to pay dividends to shareholders to retain equity claims which take the first loan loss in the bank's loan portfolio. Individual banks don't get a free lunch when creating loans and deposits from thin air although the bank sector as a whole has overdraft privileges with the Central Bank so loans indeed create deposits in the aggregate financial economy. But an individual banker will tell you his books have to balance and he faces capital and liquidity requirements. The bank itself resembles a non-bank financial intermediary which must borrow and issue equity to hold its assets or lose control over the assets if the intermediary is liquidated by market forces or resolved in bankruptcy.

Gold money under the gold standard would just be items in the bank and non-bank cash accounts held on balance sheets:

The Gold Standard Illusion: Why It Never Solved Money - YouTube

Gold is a non-financial asset, meaning it is not the liability of a counterparty, however the structure of financial intermediaries under the evolution of accounting and law means there is never enough gold to repay all creditors and equity investors in a non-bank or bank business venture when the creditors and investors all try to convert their long term risk positions into liquid money. The modern financial system generates credit and finance instruments when everyone puts on risk (risk on) and the balances sheets are forced to unwind or deleverage when everyone tries to take off risk (risk off). Gold could not be "printed" in a risk off market and banks would be forced to liquidate assets to convert investments into gold payments. Modern central banks can print money by buying assets from banks or non-banks, which we call Quantitative Easing or Large Scale Asset Purchases (LSAPs). Governments can print money by issuing net new Treasuries via deficit spending usually to stimulate the economy and/or help the Central Bank prevent rapid asset price deflation in a risk off market panic.

Joe

[Joe Leote]

The paper on the Loan Loss Provision shows that owner's equity is written down, on the liability side of the bank balance sheet, whenever the actual loan losses are acknowledged on the asset side of the balance sheet. The loan loss provision reduces the loan asset value and reduces the equity value compared to an accounting that lacks this provisional allocation of equity to absorb a possible actual loan loss. This helps us understand bank capital as an analysis of the bank balance sheet. In simple terms, bank capital is sufficient when the bank asset portfolio consists of high quality securities and loans with low expected default risk combined with sufficient equity cushion to write-off any future actual losses in the loan portfolio. If the bank holds a portfolio with low quality securities and loans it will not be able to attract uninsured depositors or equity investors who expect to take a "haircut" when the loan loss materializes. The change in perception of financial asset quality, due to changes in perception of credit risk, is what motivates investors to withdraw deposits and/or to cash out equity claims from a bank or bank sector. If the actual loan losses are small then the write-down against equity is acceptable loss and the bank can still attract sufficient equity investors, depositors, and other creditors to hold its financial asset portfolio. That is the market psychology of bank capital.

Joe