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| Henry Travers as Clarence Odbody after 'saving' George. [A] |
Next day and with the $900 required in his account, Bo went to see Old Sven, first thing in the morning, intending to pay for the house with a cheque.
"Nah!" roared Old Sven, cantankerously. "I don't want no stinkin' piece'o paper. I want the money in my account at Buffalo City Bank!"
Taken by surprise, Bo tried to explain that from the point of view of who-gets-how much, to pay in cheque, with cash withdrawn directly from his account, or direct transfers is immaterial.
Seeing however that Sven would not back down, and feeling disappointed and irritated, Bo went back to Bailey's headquarters and only branch at Main Street muttering to himself all the way.
A Nightmare on Main Street
Upon hearing from Bo, George Bailey, looking up from his coffee cup, said reassuringly: "Don't you worry, son!"
"That's what we'll do: We'll advance $900 from your account to Buffalo [City Bank], instructing them to credit Old Sven's account".
Because the $900 balance in Bo's account is a liability for Bailey's, Buffalo won't accept it, if no offsetting asset is transferred.
He must decide what assets to transfer. Not the loan itself, clearly: it involves a stream of interest payments. Besides, Buffalo could not want it: it could be a dud loan.
No. George must transfer $900 in liquid assets, so that Buffalo is sure Old Sven can withdraw the money and hide it under his mattress, if he so wishes.
Again, George must check Bailey B&LA's books. This is how Bailey's records looked like the previous day:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
+$100 | +$100 |
----------------+----------------------+-----------
Presumably, Bailey B&LA has performed other transactions before; it should have other assets and liabilities; there should be some net equities. But... that's not shown above! That's because those records show only yesterday's transactions. Technically, that's not a balance sheet.
In fact, Bailey's has an account with the Fed. Banks use these accounts to settle transactions involving other banks. In the US it's a licensing requirement.
If Bailey's own account with the Fed has a balance of at least $900, he can simply transfer the $900 to Buffalo, as a positive balance with the Fed is an asset for Bailey's: the asset needed for the transfer.
These transactions add this entry to Bailey L&BA's records:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
+$100 | +$100 |
----------------+----------------------+-----------
-$900 | -$900 |
Let's think about what's represented above. In nominal dollar values (and that's what's shown in the table) $900 is $900.
But those entries, even if showing equal amounts, refer to different things: $900 in the top-most asset line is Bo's loan; the $900 in the lowest asset line is the Bailey B&LA's Fed balance transferred to Buffalo.
Bailey's assets diminished, but its loan portfolio remains unchanged (Bo's loan is filed under A, inside the old wooden filing cabinet, just behind George).
What are the two $900 entries under liabilities? If it were vitally important, one could say the top-most is the "deposit that came into existence simultaneously with the loan (liability and asset)".
But George is a simple man; for him, it's unimportant what label to use, as long as the bookkeeping entries are right and they sure seem right to him. Besides, to say it was a deposit created "out of thin air", although technically incorrect, has two advantages: it's shorter and quite metaphorically descriptive.
So, unless a much better reason is advanced to be technically precise if idiomatically awkward, George (who can be pigheaded) will keep describing this as "out of thin air".
Anyway, the bottom-most $900 is Bo's balance, transferred to Old Sven's Buffalo account.
Let's note three things here:
- Bailey's liabilities diminished by the same amount as its assets ($900), therefore, Bailey B&LA's net equity did not change;
- Bailey B&LA's $900 balance with the Fed was there before George gave Bo the loan; it would still be there, had Sven not stubbornly insisted on having the $900 transferred to his account. It only became relevant due to the need to transfer funds from Bailey's to Buffalo. And its relevance is limited, as we'll soon see.
- Further, the third line only reflects transactions due to the transfer of funds from Bailey's to Buffalo. Keep this in mind, as it will be recalled later.
(Incidentally, in Australia as reserve requirements are calculated differently, it's possible that a bank would not need to do anything. See footnote 1.)
Additionally, the skeptical reader might ask what if Bailey's balance with the Fed had been less than $900? Say, $750?
Ah ha! Two problems! Maybe the line "unconstrained lending creates deposits" was wrong after all! Should we start pulling our hairs, running around madly and wailing desperately?
Feel free, but George seems confident: should there be any reserve shortfall, he has time to get deposits from the public (i.e. borrowing from depositors), loans from other banks or the Fed, as he did yesterday, as a matter of fact.
What about the shortfall in Bailey's account with the Fed?
No worries, mate. In the US, the Fed has an overdraft facility and it's legally obliged to back interbank transfers, should balances prove insufficient: interbank payments don't "bounce". Naturally, should Bailey's go into overdraft, it owes the difference ($150=$900-$750) to the Fed and must repay it real quick, and with interests, too. (A brief exposition is presented in the Appendix).
So, how will George get these $150 to pay the Fed?
Again, pretty much as he did yesterday when he needed reserves: by asking loans.
So, can George solve all Bailey's problems by borrowing? Not all, but most of them.
Could Bailey's keep this situation forever? Probably not: at one hand, the Fed charges interests for their loans; at the other hand, banks not only charge interests; unlike the Fed, they could also refuse to lend to each other (as European banks allegedly did just last year).
But the relevant question here is not whether there are potential limitations. Clearly, there are. That's the nightmare scenario.
The relevant question here is: is there any reason to believe banks are normally affected by those limitations? To me, that doesn't seem to be the case: most of George's nights are nightmare-free.
Buffalo: Show me the Money!
These are Buffalo City Bank's records:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
The +$900 asset is Bailey's balance with the Fed, transferred to Buffalo. To Buffalo it's irrelevant whether Bailey's had the $900, used an overdraft or had to beg for money: from Buffalo's perspective, they received a single amount and this amount is an asset for them.
The $900 liability is the deposit Buffalo was instructed to make in Old Sven's account. That money comes from Bo's account, but now belongs to Old Sven; therefore, it is Buffalo's liability.
Let's observe something: this line in Buffalo's records corresponds to the last line in Bailey's.
Bailey's and Buffalo's combined records:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
+$100 | +$100 |
----------------+----------------------+-----------
-$900 | -$900 |
+$900 | +$900 |
The two last lines cancel each other out, because what's a credit for bank one, is a debit for bank two.
Therefore aggregate balances with the Fed did not change. So, Bailey's lost its $900 Fed balance? Meh. Buffalo gained $900. In this sense, as mentioned above, the Fed balances are of limited relevance. [2]
Furthermore, these two banks' combined assets and liabilities did not change, neither did their combined net equity. In fact, their combined loan portfolios did not change, either; nor did their combined deposits.
To all purposes, we could just delete the last two lines in the table above and the end result would be exactly the same as the one shown in a previous post.
In other words, it doesn't make any real difference to consider two banks (and, no, I won't show this for more than two banks).
Considering two banks introduces a real-life complication, that's true; but it's a complication unnecessary to the understanding of the basic situation: i.e. when there are no liquidity problems in the banking sector.
Or to put this in a more graphical way: when considering more than one bank, "Bailey B&LA" can be interpreted as the whole banking sector.
Buffalo Sven's Wild East
Old Sven is not a particularly rational person and, against better advice, withdraws the $900, presumably to hide them under his mattress (as he is reputed to be stingy, too).
Buffalo had no problem to give him the $900 in cash, because the transfer was in liquid assets; this reduced both Old Sven's account balance and Buffalo's liquid assets balance (both by -$900).
These are Buffalo City Bank's records:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
-$900 | -$900 |
Buffalo did do not need pre-existing reserves, neither did it need loans from other banks or the Fed.
Buffalo's net equity change: $0.
Epilogue
Before jumping to his death, Clarence Odbody, George's guardian angel, talked George into how life is wonderful. Clarence gained his angel wings.
Appendix
This is how Bailey L&BA's records look like if the overdraft facility (not the reserves) is needed:
Assets | Liabilities | Net equity
----------------+----------------------+-----------
+$900 | +$900 |
+$100 | +$100 |
----------------+----------------------+-----------
-$750 | -$750 |
+$150 | +$150 |
-$150 | -$150 |
Third line: -$750 is interpreted as in the previous case (Bailey's reserves transferred to Buffalo).
Fourth line: +$150 is the overdraft for the difference between the $900 transferred and the $750 available in Bailey's balance (i.e. a loan from the Fed to Bailey's).
Last line: -$150 the balance of the transfer to Buffalo.
I know, this all can be a bit tiresome, but it's for a good cause!
Notes:
[1] Being in the US, Bailey's needs to comply with the fractional banking reserve regulations enforced by the Fed, most familiar to US economists (explaining why they explicitly mention them in their posts).
These regulations, in the US, require that reserves must amount to 10% of deposits kept "in the freezer" (i.e. liquid assets).
An eventual Bailey B&LA (Australia) would need to comply with the Australian Prudential Regulation Authority's regulations, contained in APS 201, establishing that ADIs (authorized deposit taking institutions) must keep reserves to "meet commitments and obligations under normal operations conditions" for up to 1 month, and are "capable of operating for at least five business days" under adverse circumstances.
These regulations, in Oz, boil down to require that reserves must amount to a proportion of deposits kept "in the freezer"; this proportion, however, is not necessarily 10%, but contingent upon predicted level of activity.
Call it Aussie slang: pretty much the same, but not quite.
[2] Clearly, if Bailey's used the Fed's overdraft this is no longer true. But, in this case, the combined banking sector owes the Fed and the debt is offset by their surplus balance.
Image Credits:
[A] "Henry Travers as Clarence Odbody after 'saving' George". Wikipedia.
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