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Limits & Losses

Summary of Limits & Losses

A lot of misconceptions exist about the regulations that control the behavior of Federal Reserve member banks. A number of factors influence the behavior of Federal Reserve member banks—these factors include the large number of bank regulations. This summary, and the presentation that follows deals with three questions regarding the regulation of bank behavior:

  1. What limits the growth of bank deposit liabilities1? Why can’t banks increase “deposits” indefinitely?
  2. What limits the amount of notes that any bank can acquire? Why don’t banks make more “loans,” even with strong demand2?
  3. What effect do “bad loans” have on these limits? Who absorbs losses when customers default on their notes?

Transactions

Before I address these questions I will review three significant bank transactions, two of which affect deposit liabilities and one of which does not.

Accepting Deposits

First, when a bank accepts cash or checks (drawn on another bank) it increases its deposit liabilities. Both of these transactions simultaneously increase bank reserves. Cash received as a deposit gets placed in the bank's vault, considered part of the bank’s reserve requirement. When a customer presents a check for deposit, the bank on which that check is drawn transfers an equivalent amount of reserve deposit liabilities from their account at the Federal Reserve to the account of the receiving bank. Thus, in both situations (cash and checks) deposit liabilities and bank reserves rise by an equal amount.

Acquiring Assets

Second, as a part of their business, banks acquire assets that generate income. Those assets include notes that they acquire from their customers—classified as “risk assets.” As with any business, banks must have a way to pay for the assets they acquire. Banks have the unique capability of actually creating money to pay for these notes (done with a simple ledger entry — essentially creating money out of nothing).

In this transaction, however, unlike accepting cash or check deposits, the creation of new deposit liabilities does not simultaneously create an equal amount of bank reserves.

Buying Securities (from the Fed)

Third, when banks buy securities from the Federal Reserve Bank, that transaction has no effect on their deposit liabilities. This transaction consists of exchanging one asset for another—securities increase, bank reserves decrease.

Understanding these transactions provides a background for understanding limitations on deposit liabilities assumption and asset acquisition.

Limitations

As a highly regulated business, banks have fairly strict limitations—beyond their own good judgment—on both the amount of deposit liabilities they can assume and the amount of risk assets they can own.

Limitation on Deposit Liabilities

Banks can add to their deposit liabilities only within the limits of the reserve requirements set by the Federal Reserve. Those reserve requirements dictate that the bank maintain bank reserves (in cash or deposits at the Federal Reserve Bank) as a certain percentage of total bank deposit liabilities. Thus, the amount of reserves limits the capability of banks to create additional deposit liabilities—each additional dollar of deposit liabilities created reduces the capacity for future additions.

Limitation on Risk Asset Acquisition

Bank regulations require that a bank have total capital amounting to a given percentage of its risk assets. Thus, the amount of a bank’s capital acts as a limitation on the amount of risk assets the bank can acquire, regardless of their deposit liability situation. A bank can find itself in a situation in which it cannot, without violating banking regulations, acquire any new notes.

Interactive Limitations

As we have seen above, the only transactions that increase deposit liabilities without increasing total reserves consist of those in which a bank creates new deposit liabilities for the purpose of acquiring additional assets. As the capacity of a bank to create new deposit liabilities declines so does its capacity to acquire new assets.

In addition, as a bank's portfolio of risk assets increases, its capacity to acquire more risk assets declines—as dictated by the capital ratio. As the bank's risk asset acquisition capacity declines the bank's practical capacity to create deposit liabilities also declines.

Because asset acquisition depends on deposit liability creation and because deposit liability creation serves the objective of asset acquisition the two limitations outlined about become interdependent (or interactive.) This means that bank reserves create an indirect limitation on the acquisition of risk assets, and bank capital creates an indirect limitation on the expansion of deposit liabilities.

Losses

How do "loan losses" affect the interplay in the limitations on asset acquisition and deposit liability creation?

"Loan Losses"

The manner in which banks deal with loan losses, although fairly straightforward, seems to create a certain amount of confusion. In simple terms, all loan losses cause a reduction in bank capital. Bank owners bear the entire burden of losses caused by defaults on note payments. These losses, however, have no effect on either bank reserves or deposit liabilities.

The term loan loss reserves causes some of the confusion about how banks handle loan losses. The term loss reserves refers to a portion of the capital account set aside for anticipated losses. This account has no relationship to the account called bank reserves, which refers to cash in vault and the account balance with the Federal Reserve. Loan losses have no effect on bank reserves.

Effects of "Loan Losses"

Small to moderate losses do not jeopardize the continued operation of the bank. They do, however, have an effect on the loan acquisition capabilities of the bank.

Remember, the level of bank capital limits the bank’s ability to acquire risk assets (mostly notes.) Because they reduce the amount of bank capital (thereby reducing its capital to risk assets ratio), loan losses cause a reduction of the capability of banks to acquire notes. The interactive nature of the limitations on asset acquisitions and deposit liabilities means that the reduced asset acquisition capacity also reduces the bank’s capacity to expand deposit liabilities.

Loan losses affect not only the owners of the bank; they also affect customers' ability to acquire new funds in the future. This effect of loan losses occurs regardless of the position of the banks reserves. The bank may have the technical capability of expanding deposit liabilities, but it may not be able to use that capability because of the limitation on its note acquisition capacity.

Effects of Large Losses

Banks absorb a significant number of loan losses in the normal course of their operation, but, in aggregate, these losses usually do not amount to a significant amount of the bank's capital. On occasion, however, either because of poor bank management or detrimental economic environment, banks suffer sizable losses—putting the survival of the bank at risk.

The management of a bank does not get to determine whether or not their bank continues in operation after large losses. Bank regulators monitor the bank's capital ratio and when the bank does not meet those limits the regulators will close the bank.

So, how do the regulators deal with the problem of closing a failed bank?

Bank Closures

Buyer

In most cases, rather than closing the bank and absorbing the deposit liabilities, the FDIC will prearrange the sale of the bank assets to a larger bank in exchange for the assumption of the deposit liabilities of the closed bank by the acquiring bank. These bank sales frequently occur over a weekend so that no interruption of service occurs for bank customers.

There are, however, situations in which the losses of the failed bank are so great and the quality of its the loan portfolio is so low that no buyer can be found. How does the FDIC deal with such a situation?

No Buyer

In the fairly rare cases in which it cannot find a buyer for an insolvent bank, the FDIC must sell the assets of that bank—for whatever they can get. It then pays off the bank's deposit liabilities. In the case of small bank failures, this does not cause a problem for the FDIC, for they have a certain amount of resources to accommodate these situations. But, large and extensive losses can prove problematic.

In even more rare situations, bank failures may exceed the capacity of the FDIC to pay off deposit liabilities. In cases like this, the government has a real obligation to protect the deposit liabilities. That obligation revolves from the responsibility to maintain the stability of the nations money supply, a good portion of which exists in deposit liabilities. If the government allowed large bank failures to occur, the money system, and thereby the economy, could collapse.

Conclusion of Limits & Losses

Transactions

Some bank transactions increase bank reserves and others do not. The transactions that relate to limitations and losses, and do not affect bank reserves, involve the acquisition of risk assets from entities other than the Federal Reserve3.

Limitations

This two-sided transaction — of creating deposit liabilities in order to acquire notes — has limitations on each side. The level of bank reserves limits the deposit liability creating capabilities of a bank, and the level of bank capital limits the note acquisition capabilities a bank. These two limitations work interactively to limit the overall expansion of a bank's balance sheet.

The interactive nature of these limitations has a significant influence on why banks don’t, at some times, make loans. Sometimes they have plenty of capital but they don’t have sufficient excess reserves to expand deposits; at other times they may have plenty of excess reserves but they don’t have sufficient capital to support more risk asset acquisition.

Losses

Bank losses, which reduce bank capital, have an effect on these interactive limitations. When a bank absorbs losses large enough to reduce its capital ratio to, or near, the regulatory limit, it becomes more reluctant to acquire new notes (”make new loans’). If a large segment of the banking system absorbs losses, the government faces the choice of either supporting the bank's capital (i.e. a bailout) or paying off deposit liabilities to avoid the collapse of the money system.

As much as we abhor having taxpayers bailout any industry, we must consider the system in which that industry operates. The government has created the shaky monetary system, which gives it the responsibility to support it. When faced with the choice between supporting bank capital—i.e. a bailout—or paying off bank deposit liabilities, supporting bank capital requires far fewer dollars from taxpayers.

Too Big to Fail

In a truly competitive environment letting poorly operated banks fail makes perfectly good sense, but in the existing banking system, in which the government has institutionalized fractional reserve banking, legislators have little choice in the face of large bank losses other than bank bailouts. In this banking system, advocating eliminating the “too big to fail” policy amounts to naïve chest pounding, and breaking up large banks just spreads the problem around—and creates other unintended consequences. Politicians must support the flimsy system they have created.

My Solution

Eliminate all the problems caused by excessive money creation and bank failures by simply getting government out of the banking business entirely. Close the Federal Reserve, stop chartering banks by the federal and state governments, and eliminate the FDIC and other government guarantees.

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


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 deposit liabilities from the bank upon which a check is drawn.

2 Banks don't really make loans. They buy the notes of debtors. I will explain this process in this summary and the presentation.

3 When banks buy securities from non-bank entities it has the same effect as when they buy notes. I have focused on notes because they are considered a risk asset.

Note: This page summarizes extensive information provided in the presentation on Limits & Losses but does not replace the detail. I encourage you to spend the time—now or in the future—to study the full presentation.

Proceed to the complete Limits and Losses presentation.

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