limits & losses

8/13/2019 Limits & Losses

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by James B. Berger

Limits & Losses

Introduction A lot of misconceptions exist about the regulations that control the behavior of Federal Reserve memberbanks. What limits the growth of bank deposit liabilities 1? What limits the amount of notes that bankscan acquire? And what happens to "loan losses?" And, finally, how do these different limitationsinteract?

A number of factors influence the behavior of Federal Reserve member banksthese factors include thelarge number of bank regulations. In this presentation I would like to address questions about threeinterrelated factors.

Banking Questions A great number of regulations exist that dictate the behavior of Federal Reserve member banks. In this

presentation I will address three important questions regarding the regulation of bank behavior:

1) What limits the growth of bank deposit liabilities? Why cant banks increase depositsindefinitely?

2) What limits the amount of notes that any bank can acquire? Why dont banks make moreloans, even with strong demand?

3) What effect do bad loans have on these limits? Who absorbs losses when customers defaulton their notes?

In the rest of this presentation I will address these three questions.

1 Throughout this presentation I refer to deposit liabilities where many would use the term deposit.In the modern banking system banks generally do not accept what we formerly referred to as deposits .They create deposit liabilities in exchange for either cash or the transfer of Federal Reserve depositliabilities from the bank upon which a check is drawn.

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Bank Limitations & Losses

Introduction to our First Bank Example

In order to discuss what regulations influence the answers to the three questions posed, we need ahypothetical bank as a model. The image above represents the model bank, which I have dubbed First

Bank. Using this diagram I will set up the elements of First Bank that I will refer to in the balance of thispresentation.

The left-hand column in the graph represents the amounts of dollars that the bank paid for assets ineach of three general categories:

$150,000 in reserves, which amount to the banks deposit balance at the Federal Reserve Bank. $50,000 in securities, consisting primarily of US government bonds. $400,000 in notes, representing the future obligations of bank customers to the bank.

The right-hand column of this chart represents the amounts and sources of the money used to acquirethe assets of the bank. For this example sources fall into two general categories:

$100,000 in capital, which represents an initial capital contribution of bank owners plusaccumulated earnings.

$500,000 in deposit liabilities, which includes both demand and time accounts. [Note: demandand time accounts have been included together because standard practice includes them ascomponents of the money supply.]

Jim Berger, February, 2014 Page 2


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TransactionsBefore we begin to address the questions posed at the start, I would like to review two primary ways inwhich a bank can increase its deposit liabilities:

By accepting cash or checks drawn on other banks.

By creating new deposit liabilities in order to acquire customer notes.

I will also show the effect that buying securities has on the banks balance sheet.

The Bank Accepts Deposit Liabilit ies

First, banks increase their deposit liabilities when they accept either checks (drawn on other banks) orcash for the account of either new or existing customers.

When First Bank accepts a check drawn on another bank for the account of a new or existing customer,the bank on which the check is drawn transfers reserve dollars, in an amount equal to the amount onthe check, into the reserve account of First Bank. In return for the reserve dollars deposited into itsaccount at the Federal Reserve, First Bank increases its deposit liabilities by an equal amount of moneydollars for the account of the depositing customer.

In this example, First Bank receives a check for $100,000.



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When a bank receives cash for the account of a new or existing customer they add the amount of thatcash to the amount of their reserves (referred to as cash in vault, also included in bank reserves) andthey create a deposit liability of an equal amount. (To keep it simple, I have not used a cash deposit forthis example.)

In all cases, when customers transfer funds to a bank, either in the form of cash or by the use of thecheck, the amount of deposit liabilities and the amount of bank reserves rise by an equal amount.

The Bank Acquires Borrower Notes

Second, banks increase deposit liabilities as a part of the transaction in which the bank acquires noteobligations.

Banks assume deposit liabilities for the purpose of making profitable investments, mostly in the form ofinterest-bearing notes from their customers. The banks acquire these notes by simply creating deposit

liabilities with a ledger entry to their bank records.

In the case of this example, as you see, deposit liabilities of First Bank increased by $200,000 to acquirenotes for future money in the amount of $200,000. The note also includes the obligation on the part ofthe note maker to pay interest. Over the term of the note, interest payments (paid by check fromanother bank) add to bank reserves and bank capital.



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Bank Buys Securities

We need to review one last transaction to clarify that it plays no role in the banks creation of depositliabilities (i.e. the increase of the money supply.

2) That transaction consists of the purchase and sale of

securities with the Federal Reserve Bank. In this case we show the effects of the purchase of securitiesby First Bank from the Federal Reserve.

As you can see from the comparison of this chart to the previous chart:

The purchase of $50,000 of securities adds to the amount in the securities account and reducesthe amount in the bank's reserve account.

This transaction has absolutely no effect on the amount of the deposit liabilities; thus, it has no directinfluence on the quantity of money. If the bank were to sell securities to the Federal Reserve, it wouldhave the opposite effect on both the securities and bank reserve accounts and still have no effect on

bank deposit liabilities.

It is important to understand the dynamics of this transaction in order to fully understand how theFederal Reserve influences the limitation of deposit liability creation (i.e. money creation). Banktransactions with the Federal Reserve do not by themselves result in an increase or decrease of deposit

2 Remember that the monetary aggregates (measures of the money supply) include deposit liabilities. Jim Berger, February, 2014 Page 5


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liabilities (or the increase or decrease in the quantity of money). The banks must act, within thelimitation of reserve requirements , to change the quantity of moneyby changing deposit liabilities.

Summary of Transactions

Deposit Liability Summary

Banks can increase deposit liabilities using two methods:

1. Banks increase deposit liabilities in exchange for the receipt of additional assets, usually in theform of bank reserves either cash or a deposit at the Federal Reserve Bank, and

2. Banks create new deposit liabilities (by ledger entry) for the purpose of acquiring bankinvestments, primarily notes from customers.

Summary of Securities Purchases When banks purchase securities from the Federal Reserve it has two simultaneous effects:

1. their securities account increases by the amount of dollars spent for those securities, and 2. their reserve account decreases by the same amount of dollars.

When banks sell securities to the Federal Reserve the effects are exactly the inverse.

Limitations of Deposit Liabilities and Risk Assets Using that review of the way banks increase their deposit liabilities as a background, I will now describehow banks determine the limitations on their ability to increase deposit liabilities and on their ability toacquire risk assets (primarily notes from bank borrowers).



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Reserves Limit Deposit Liabilit ies

The amount of reserves that a bank maintains, primarily at the Federal Reserve Bank, defines the limit ofthe amount of deposit liabilities of that bank. Bank reserves limit the amount of deposits through the

application of the reserve requirement, stated as a percentage of deposit liabilities.

Banks calculate the maximum of their deposit liabilities by calculating the inverse of the reserverequirement (i.e. dividing actual reserves by the reserve requirement). In the case of First Bankwith$200,000 of bank reservesthe bank could assume a maximum of $4 million in deposit liabilities basedon the 5% reserve requirement used in this model. ($200,000 divided by 5% equals $4 million.)

Although Federal Reserve regulations state the required reserves as the amount of reserves required interms as a percentage of deposits, the quantity of reserves the bank holds actually limits the amount ofdeposit creation by the bank. When the bank has a reserve balance ( actual reserves ) greater than theirrequired reserves they have excess reserves (actual reserves less required reserves = excess reserves) .

The amount of excess reserves a bank holds determines how much that bank can increase its depositliabilities before it reaches its limit. Banks can increase their deposit liability limitation (increase excessreserves ) primarily by two of the transactions that we reviewed before: 1) the transfer of reserves fromanother bank to cover a check transaction, or 2) the sale of securities to the Federal Reserve.

In our model, the required reserves of First Bank amount to $40,000 ($800,000 times the 5% reserverequirement.) First Bank, however, has $200,000 in actual reserves , so their excess reserves amount to



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$160,000 ($200,000 in actual reserves less $40,000 of required reserves.) Based on the reserverequirement alone, First Bank could hypothetically increase its deposit liabilities by $3.2 million($160,000 in excess reserves divided by the 5% reserve requirement.)

We will find out later that reserve requirements alone may not limit the capacity of First Bank to create

deposit liabilities.

If bank reserves limit deposit expansion, what, then, limits the increase in risk assets?

Capital Limits Risk Assets

The amount of the bank's capital dictates the limit of the amount of risk assets (e.g. notes) that a bankhas authorization to own. According to international agreement banks

3 must maintain a specific ratio of

capital to the amount of risk assets that they own. Similar to the calculation of the reserve requirement,a bank determines the amount of risk assets it can own based on the inverse of the current capital

requirements. Although the calculation is more complicated than in this example, for the sake ofexample, I have used a single capital requirement percentage applied to all categories of risk assets. ForFirst Bank, with $100,000 of capital, it can own up to $1.25 million in risk assets, primarily held in theform of notes. (That amounts to $100,000 divided by 8%.)

3 Known as the Basel Accords. The capital ratio I have used here serve only as an example. The details of theaccords do not matter for understanding the relationship described here. Jim Berger, February, 2014 Page 8


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Interactive Limitations

As you have probably already figured out, these limitations on deposits and risk assets operateinteractively.

In the last two slides I have demonstrated how:

1. the amount of reserves held by the bank limits its ability to create deposit liabilities, and 2. the amount of capital held by the bank limits the quantity of risk assets (or notes) that the bank

can own.

Bank reserves have no direct influence on the amount of loans that a bank can make, and bank capitalhas no direct influence on the level of deposits a bank can hold. But, bank capital and bank reservescreate interactive limitations on both note acquisition and deposit creation.

First, when a bank has no excess reserves (when its actual reserves equal its required reserves), it can no

longer create deposit liabilities with which to acquire notes.

Second, when the amount of bank capital drops to a ratio of risk assets equal to its required capitalratio, that bank has reached the limit of its note acquisition capabilities. The bank can no longer acquirenew notes regardless of the amount of excess reserves it holds.

The interactive relationship between bank reserves and bank capital means that the limiting factor withthe least "slack" determines the limit of deposit creation (monetary expansion) and note acquisition. In



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other words, when First Bank has no Excess Reserves but plenty of capital it cannot create depositsliabilities with which to buy notes. And, when the capital of First Bank amounts to only 8% of its riskassets it cannot acquire new notes even if it has plenty of excess reserves.

Summary of Limitations

The amount of First Banks reserves limits its ability to create new deposit liabilities; and the amount ofFirst Banks capital limits its ability to acquire notes. Since First Bank uses deposit liabilities to acquirenotes, these limitations become interactive. Thus, the amount of First Banks excess reserves can limitits note acquisitions and the amount of First Banks capital can limit its deposit liability creation.

This interactive relationship has become significantly important with the recent extreme expansion ofbank reserves. Based solely on their high level of excess reserves banks have an almost unlimitedcapability of creating new deposit liabilities. It would seem from this that they would also have thecapability of acquiring an almost unlimited volume of notes. So, why dont banks make more loans?

The relatively slim current capital ratios, however, severely limit the amount of notes banks can acquire.

That coupled with potential risk from existing loans makes banks highly reluctant to make new loans particularly risker loans. This provides an answer to that often asked question of, "Why don't banksmake more loans?" Even though banks have massive amounts of bank reserves, they do not havemassive amounts of capital to support note acquisition.

Note : It is my contention that with the reduction of bank reserve requirements and the immediateaccess to time deposits making them virtually indistinguishable from demand deposits the reserverequirements have lost their ability to limit deposit expansion and thereby monetary expansion. As aresult, the interactive limitation resulting from the levels of bank capital has provided the primarylimitation on deposit liability growth. Over the last couple of decades monetary expansion (MZM) has

progressed at roughly 7 1/2% per annum, which I suspect parallels the expansion of bank capitalthrough earnings. Monetary expansion of that same period has a relatively low correlation to thegrowth in bank reserves.

LossesThe question now remains, "What happens when "loans" go bad?"



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What Happens When Loans Go Bad?

If First Bank owned a note on which the signer defaulted, who would bear that loss? Would thedepositors suffer a loss? Would some sort of adjustment be made to the bank reserves? (You may have

heard the term loan loss reserves and confused it with the reserve balance at of the Federal Reserve.)Or, do the owners of First Bank have to absorb any loss in their capital account?

Lets first look at the effect of a moderate loss



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Moderate Loss

If First Bank suffered a loss of $35,000 as a result of note default, that would amount to only 4.375% ofthe banks risk assets (of $800,000) significant, but not terrible. That loss, however, would come

entirely from the capital of the bank 35% of the $100,000 of capital. The capital structure of thebank (a ratio of 8.50% of risk assets) would fall to near the threshold of the capital requirements. Thebank officers would become much more cautious about their future loan criteria.

But, would the holders of deposit accounts have any risk?

As a practical matter taxpayers guarantee the bank deposit accounts. Technically the Federal DepositInsurance Corporation (FDIC) guarantees the banks deposit accounts (with a few minor exceptions). Inthe long-run, because of the limited financial capacity of the FDIC, the government must guaranteethose deposit accounts.

What effect does this have on the banks ability to create more deposits and buy more notes?



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Effect of Capital Losses

This capital loss does not directly affect the banks ability to increase deposit liabilities. They still have$100,000 in excess reserves, which means they could hypotheticallyincrease deposit liabilities by $2

Million, but indirectly it does create a limitation.

Because of the deterioration of their capital, First Bank can add only $47,794 to their note portfolio.Since they cannot create deposit liabilities for which they get nothing in return, they will limit additionaldeposit liabilities to $47,794 to match the assets they can buy. Thus, capital limitations can limit depositliabilities (money) creation.

So, what happens if the losses grow?



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Bank Capital Absorbs Even Greater Losses

First Bank has already lost $35,000 of notes but now it loses another $65,000. The total amount of the

loan losses $80,000 would be absorbed entirely by the capital of the bank.Some or all of this loss might be absorbed by the bank's loan-loss reserve, which represents part of thebank's capital. Banks are allowed to accumulate a certain amount of loan-loss reserves on an annualbasis to protect against the possibility you of large losses. It still amounts to a loss of capital.

Capital Ratio Inadequate

You can see by the capital ratio after the loan-loss that First Bank can no longer meet its capitalrequirement. The bank regulators would consider this bank as insolvent. The FDIC would shut this bankdown.

But, rather than just closing the bank and absorbing the loss, the FDIC would, more than likely, pre-negotiate a sale of the bank's assets to another bank with stronger capital. As a part of that deal theFDIC would get an agreement that the new bank would take over the deposit liabilities. This transactionwould happen Friday afternoon and Monday morning the new bank would open for business.

The poor condition of First Bank might, however, cause prospective buyers to decline that offer



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No Bank Buyer In rare cases the FDIC cannot find a buyer for an insolvent bank and might have to liquidate its assets(i.e. sell the assets). When that scenario occurs, the depositors would not risk losing any of their money.

The deposit liabilities of the bank have the guarantee of the FDIC and ultimately the backing and

guarantee of the US taxpayers. Although the government has no obligation to protect shareholders orthe makers of notes owned by this bank, they have a very real and important obligation to protect thedeposit liabilities of the bank. Those deposit liabilities make up a significant portion of the nationsmoney supply.

Summary of Losses To summarize the points we have made about loan losses:

All loan losses, large and small, come directly out of bank capital (i.e. the shareholders suffer theloss).

Moderate loan losses have the effect of restricting the amount of risk assets the bank canacquire.

Large loan losses can cause the bank's capital ratio to fall below required the required minimum.As a result, regulators would classify the bank as insolvent and take one of the following twoactions:

Negotiate the sale of the failed bank's assets to another sound bank in exchange for theassumption of deposit liabilities and possibly other consideration.

If the FDIC cannot find a buyer for the bank, they might have to sell off the assetspiecemeal and pay off depositors from their insurance reserve. Excessively large losses,from one or many banks, could potentially shift the liability to taxpayers.

Summary of Limitations & LossesIn order to pull everything together, let me first summarize the information I have provided so farrelated to transactions, limitations on some bank activities, and the effect of loan losses.

Transactions We have discussed three types of bank transactions two of which affect deposit liabilities and one ofwhich does not. Those transactions consist of:

Increase of deposit liabilities and bank reserves by a transfer into the bank. Increase of deposit liabilities for the purpose of acquiring notes for investment. The purchase (or sale) of securities with the Federal Reserve affects only the reserve account

and not deposit liabilities.

Limitation We discussed two types of limitations on bank activity: limitations on the expansion of deposit liabilitiesand limitations on risk asset acquisition. The devices used for limiting these activities can also playinteractive roles:



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Bank reserve totals limit the deposit-making capabilities of a bank. Capital amounts limit the quantity of risk assets that a bank can acquire. The interactive limits resulting from reserve balances and capital accounts cause two ways to

limit deposit growth.

Losses Loan losses can have an effect not only on the bank and its owners but on larger segments of theeconomy:

Loan losses come directly out of bank capital. Reduced bank capital causes a reduction in the capability of banks to acquire risk assets. Large losses of capital can cause regulators to either sell or liquidate a bank.

Bank failures potentially shift deposit liabilities to taxpayers.

Conclusions

The Effects of Bank Limitations Banking regulations set limits on the level of deposits that banks can carry and the amount of risk assetsthey can own. There are separate limitations for each of these; however, it remains important tounderstand the interaction of these limiting regulations.

Limitation on DepositsTraditionally people have thought that the expansion of bank reserves drives the expansion of depositliabilities and therefore the expansion of the money supply. In fact bank reserves act as a limitation onthe expansion of deposit liabilities and the money supply. In other words the Federal Reserve cannotcreate money without the help of banks.

Limitation on AssetsPeople frequently asked the question, "Why don't banks make more loans?" The answer to thatquestion frequently exists in the bank's capital ratio. When a bank is at or near its minimum capital ratioit will be far more reluctant to make new loans or it may be prohibited from making new loans.

Interaction of LimitationsUnderstanding the interaction of the limitations set by reserve requirements and capital requirementshelps us to understand why banks react to the pressure to make new loans in the manner in which theydo. It seems that people more commonly recognized the ability of banks to make more loans because of

excess reserves, but they don't fully understand the limitation caused by the capital requirements.

I would argue that the reason banks don't make loans (and that the risk of hyperinflation remains low)results from the influence of bank capital requirements. When the current level of capital in banksrestricts the amount of risk assets the bank can hold, the bank will not expand deposit liabilities (therebyexpanding money) more than they are willing to (or capable of) taking on new risk assets.



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The Impact of Losses Loan losses have a much wider impact than just on the owners of bank capital. If the owners run ashoddy operation, they should lose some or all of their money. But the collapse of banks affects all ofthe bank's customers as well as the many people who rely on a sound banking system.

Deposits & Money Supply First, all banks teeter on a very small capital base. As I hope you've seen from this example, it takes arelatively small loss in the banks note portfolio to put it at risk of failure.

In the large scheme of things the deposits of each and every bank represent an important part of thenations money supply. To allow depositors to suffer any loss at all creates the very real possibility ofpeople losing confidence in the US money supply. To have this happen could have catastrophic effectson the economy at large.

Confidence in Money The confidence that people have in their banking system is a widespread influence on the stability of themonetary system. When one bank goes out of business, people frequently fear that other banks will dolikewise. For this reason bank regulators try to make the closing of insolvent banks as invisible aspossible.

When widespread bank failures occur they have the potential of leading to "bank runs." These suddenand widespread withdrawals can topple a banking industry balanced on a very limited amount of capital.

Government Underwrites Deposit Liabilit ies Second, it takes the sizable acquisition of risk assets in order for the inflation machine of the US bankingsystem to distribute the vast amount of money produced for nothing. Without the support of the FDICand the federal government they could not afford to take the huge risk they do with a large amount ofdeposit liabilities that they accumulate.

In chartering banks under a reserve banking system the government has allowed banks to be thecreators of the bulk of our money supply. Because of the important role that money supply plays in thestability of our economy, the government has taken steps to ensure the reliability of bank depositliabilities. The FDIC amounts to simply a smokescreen to assure bank depositors of the soundness ofbanks. In reality the FDIC does not have the resources to cover large-scale bank losses. By default, toprotect its own money supply, the federal government has underwritten the deposit liabilities of banks.If the FDIC cannot cover losses, the taxpayers most assuredly will.

Bailing Banks Bails Money Supply The reason the FDIC and the federal government cannot let large banks fail is not to protect the assetsof the bank nor its shareholders.

The government cannot let them fail in order to protect the veil that hides the basic insolvency of thebanking system as a whole. In order to get another bank to take on the deposit liabilities the federalbanking regulators must do something to protect the assets acquired by the new bank.



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A number of people make big talk about allowing banks that make bad loans to fail, but this positioncannot be defended within the current structure of our banking system. Allowing banks to fail couldcreate potential risks to the entire nations money supply and the economy as a whole. Employing thefree-market concept of "too big to fail" in our non-free-market system would represent an act ofirresponsibility.

My Solution My solution to the problems we have with our entire banking system consists of not trying to reform abad system but to transform it into an entirely new free-market system. Get the government out of themoney and banking system entirely. No amount of meddling or adjusting to a bad system will ever makeit good. We need a free market system in which the supply of money stays relatively fixed, anddepositors bear the risks inherent in storing their money in a financial institution.


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