Viewing Bank Liquidity in a Proper Light
By Al Davis
Recently there have been a number of posts on social media regarding the tightening of credit from banks. The reasons given relate to several recent bank failures and attribute this tightening to banks’ being less willing to take “risks” with depositors’ money. The truth, however, is that banks do not need deposits, in the form discussed, in order to make loans.
In today’s modern economy, most money takes the form of deposits, but rather than being created by a group of savers entrusting the bank with holding their money, deposits are actually created when banks extend credit — which means making loans. As Joseph Schumpeter, the infamous Austrian economist, once wrote: “It is much more realistic to say that the banks create credit; that is, that they create deposits in their act of lending then to say that they lend the deposits that have been entrusted to them.”
Accounting for Deposits
When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the asset side and one on the liabilities side. The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the deposit holder. Contrary to popular thinking, loans create deposits.
If loans create deposits, then are banks creating money, which is the sole right of the central bank? The answer: maybe. The central bank controls the money supply by establishing financial reserves for each bank. As the loan and deposits increase, the reserves that the bank must hold also increase.
The reserve ratio, set by the central bank, is the percentage of a commercial bank’s deposits that it must keep in cash as a reserve in case of mass customer withdrawals. In the U.S., the Fed uses the reserve ratio as an important monetary policy tool to increase or decrease money supply.
The truth, however, is that the reserve requirement does not act as a binding constraint on banks’ ability to lend. The reality is that banks often first extend loans and then look for the required reserves later. But, as we have recently seen, if there should be a “bank run,” where most or all depositors at once demand their money, the demand may exceed the reserves on hand, leading to potential bank failure.
Putting Up Guardrails
So, if bank lending is not constricted by the reserve requirement, then do banks face any constraint at all? The answer is yes, the first being profitability. Given a certain demand for loans, banks base their lending decisions on perception of the risk/return tradeoffs. This is one of the main reasons to match the lending institution (bank) to the requirements of the loan requested. Different lending institutions have differing views of the risk/return tradeoff. For example, certain lenders believe that commercial construction is too risky due to the requirements for progress payments and retainage. These lenders believe that recovery would be difficult in the case of a loan that defaults. Other lenders have industries that they both favor and deem as too risky.
If bank lending is constrained by anything at all, it is capital requirements, not reserve requirements. Since capital requirements are specified as a ratio whose denominator consists of risk weighted assets, they are dependent on how risk is measured, which in turn is dependent on subjective human judgment.
Calculating Risks
Subjective judgment combined with ever increasing profit demands may lead some banks to underestimate the riskiness of their assets. Thus, even with regulatory capital requirements, there remains a large amount of flexibility for a bank to lend. This was, in large part, what caused the recent bank failures we have read and heard so much about.
Before deciding to make a loan, a bank does a thorough credit check on the respective individual or institution. In the case of lending to an institution, a lender will review the institution’s balance sheet, profit and loss statement, credit history, cash flow, and, in many cases, the value of the company’s assets that can be used as collateral against the risk of the loan — and, of course, the purpose of the loan. They will then measure the results of their due diligence against their institution’s risk/return profile.
The tightening credit we appear to be seeing in the small and medium business market is due to both risk/return profiles changing at many banks and the increasing capital requirements being placed on some banks by the Fed. If you perceive potential difficulty in obtaining a new loan or loan renewal in this changing market, it’s always a good idea to ask for help.
Al Davis serves as Principal at Revitalization Partners LLC, a corporate and board advisory firm that specializes in restructuring and receiverships. He is a Court Appointed General Receiver in the State of Washington as well as an interim CEO and advisor to middle market companies. He can be reached at adavis@revitalizationpartners.com or 206.903.1855.
