Understanding central banks and monetary science Part 1

Discussion in 'Economics' started by FireWalker, Feb 17, 2013.

  1. They print it.
    We work for it.
  2. they print it for you to borrow

    but when you pay it back

    they just throw it in the furnace
  3. Ed Breen

    Ed Breen

    The linked blog article fails to make the proper distinction between reserves required for bank liquidity and Capital reserves that relate to fractional banking; how much a bank can loan. Reserves for liquidity (to have adequate present cash to meet withdrawal requests under normal operations), is based on a bank's deposit profile. Banks are required to hold more reserves for liquidity against demand deposits and less reserve for liquidity for term deposits. These reserves for liquidity show up as 'required reserves' in aggregate bank balance sheets; they are a function of a bank's deposit profile and they have nothing to do with a bank's lending.

    Capital Reserve, is really capital adequacy. By regulation Banks are required to maintain a level of capital that can vary depending on the risk profile of the bank. Capital adequacy is measured in three Tiers, Tier 1, Tier 2 and Tier 3. The most important measure is Tier 1 capital, which is most liquid and where its value is determined by market operations. The amount of Tier 1 capital generally limits both the amount of deposits a bank is allowed to accept and the amount of loans a bank is allowed to make. 'Capital Reserve' is a ratio of a banks capital (essentially its equity) to its loan assets outstanding. New banks and risky banks have been required to have Tier 1 capital of 10% of their loans. Larger, established banks, with good risk profiles in thier asset portfolio are allowed to have capitla ratios much less than 10%. Lately, the money center banks have been increasing thier capital ratios in response to Basil III and more conservative national regulations.

    Northern Rock suffered a capital crises more than a liquidity crises. They had a run on the bank becuase the bank's asset base of securitized mortgatges (RMBS &CMBS) was seen to be worth much less than what those assets were previously (pre financial crises) thought to be worth. As the RMBS and CMBS is written down the bank takes the losses against capital. These losses threatened to make the bank insolvent. Because there was a fear that the bank would become insolvent and so unable to borrow to meet its liquidity needs in the event of a run...the run intensified. If the Bank had not taken such a hit to its capital adequacy by the write down of its asset portfolio it would have been able to borrow the money to stave off the run. The bank had plenty of liquidity for normal operations, it was only when the question of its capital was raised that the run began. Other banks would not lend Northern Rock money because they also feared that the bank might be insolvent...so the government came in and sured up its capital.

    It should not be understood as liquidity event...it was a solvency event. Solvent banks can overcome a liquidity event, insolvent banks cannot.
  4. True but how do you expect me to go into that detail in a limited amount of words and also cover the mechanism used to control money supply. You are expecting too much of me as a writer to one include all of that in an article and to keep people reading. That is the real art of the writer. The article is sufficient to cover the relationship between bank reserves, whether that be capital reserves, reserve requirements at the central bank or the details of the tiers of the former, and the overall macroeconomic control of the central bank in trying to reach inflation targets and how that has created difficulty (as you term (correctly) insolvency) in banking.

    I could have also if I wished gone into detail as to whether the central bank really controls interest rates or whether they are controlled by the market and the demand for credit. However like I said I only have a limited space to explain it and keep people interested.

    It was a good enough article for you to understand to give a critique, which is very informatve thank you.
  5. Ed Breen

    Ed Breen

    Morganist, the article was well written but to my sensibilities it was misleading in that it allowed the reader to think that the Capital Reserve requirement is directly related to liquidity. It is a common mistake for those who comment on banking to confuse the deposit reserves with capital adequacy and to incorrectly assume that loans are materially funded by bank deposits and that deposit reserves limit lending (not true). Some people also think that that banks post a reserve against each loan they make; which they do not. So, I think the challenge for a writer on this topic is to explain that a bank's capital determines how many deposits it can take, and how many loans it can make. The reserve capital it keeps in its vaults is simply a function of its demand deposits and has nothing to do with its ability to make loans or even how much leverage it gets on its loans and in fact the reserve for deposits has nothing to do with whether a bank can withstand a bank run...that depends on its solvency, its capital adequacy. Glad we could clear that up.
  6. You are the only person I know other than me that has been able to identify the difference between a credit crunch and a bank run. See below.


    Also read the below.


    You have also missed out the impact risk has on the lending mechanism read below.


    I am grateful for your responses and find them really informative. The problem I have is trying to explain the general process in a simplified way many people can understand. I think with a collection of articles that becomes possible, however with stand alone articles there is always going to be limitations.
  7. I hope you didn't miss the pair* on CSpan. It was sad to see the moderator didn't have the Q's for their A's.

    Simpson brought up the "tipping point". Real control is a funny thing.

    * Simpson and Bowles.
  8. Ed Breen

    Ed Breen

    I don't know how anyone can confuse a credit crunch with a bank run. A bank run is when a bank's depositors or counter parties want to withdraw their funds or dealings with a bank. They do this because they fear the bank will not be able to borrow money to fund withdrawals becuase they fear the bank is or will become insolvent.

    A credit crunch on the other hand is when banks raise leverage ratios on collateral assets in order to underwrite new loans or when banks withdraw from lending on asset classes entirely.

    So a 'bank run' is something that happens to a bank as its deposit customers withdraw and a 'credit crunch' is something that happens to borrowers when the bank begins to withdraw from lending. How can you confuse those two things? You need to start hanging out with different people.
  9. Look at the other articles in the next link and the relationship with risk. I have another on rehypothecation too. I have got round to the over valuation of assets yet other than that. However I find this a difficult topic to discuss as the area is debated. I think it depends on the concept of endogenious and indogenious growth theory and whether the market creates credit demand or the central bank does. I also think that the way banks classify assets is part of the problem. The Asset Based Reserve Requirement by Thomas Palley is something I have identified in the past to explain the criticisms I see there.

    Perhaps I may have not been clear on the exact term or details of deposits. However what I was trying to explain was the relationship between the banks ability to make good on withdrawals and the centrals banks actions to enable that.

    Like I said I think this more a debate as to the level of detail or correct term I could have used to determine the relationship I am trying to explain. Other than that the topic is debatable.
    #10     Feb 26, 2013