The Creation of the Federal Reserve System (Part 2)

Yes if a bank doesn't have any capital it is not true. If the cost of borrowing gets too high than yes banks will lower their amounts of loans because of lower demand. But if they have capital and there are willing borrowers who meet their policy they will lend regardless of their reserve position.

When banks have excess reserves it is an asset that is not earning any interest. So they then try to loan them to other banks or leverage them for other interest bearing assets like T-bills or MBS's to get a return otherwise they are sitting on an idle asset.

Not to pay checks, to transfer to the recipient bank of the check. They do not put reserves in to our bank accounts.

Yes, physically they are the same thing, lol

Cash can always be converted to deposits and vice versa unless the bank makes loans/investments that default

No they lose their money, not their account values. And they lose their money because the bank lost money.

Both the bank and the depositor lost money.

Reserves can't cover write-offs. Only capital. If a bank has sufficient capital to handle loss of loans than your deposits are fine. If a bank doesn't than your deposits are at risk because the bank might become insolvent. It's not because the bank runs out of cash.

Because cash has nothing to do with the bank. Yes you do lose your money, but the money is lost regardless of the FDIC. The FDIC simply is insurance on your lost money and still will have to create debt in order to back it with an asset.

Sure it is

If you have $5,000 in cash and lend it to your friend. And your friend doesn't pay you back... did you lose $5,000 in cash?

Yes, because deposit accounts are exactly like cash.

Yes we do have reserve requirements to keep banks in check. That doesn't mean your deposit isn't money just like cash is money.

 

No, you cannot ignore step 6. When the borrower writes a check for the loan, Bank A looks like this:

A | L
Reserves $900 | Deposits $1000
Loans $100

No, it looks like this:

Reserves $900 | Deposits $1000

and the bank is insolvent.

Equity is the difference between assets and liabilities. When liabilities exceed assets, there is negative equity.

Where you saying something about accounting 101?

And the depositors lose $100 in money represented by their accounts. Because their deposits are only a claim on the assets, or reserves/cash of the bank, and if the bank does not have sufficient assets/reserves/cash, the depositor loses his money.

It is as simple as that.

Unless your bank fails and does not have the reserves to back up the deposit accounts. In which case, the depositors lose their money, and cannot use it to purchase goods and services in America.

As long as the bank has sufficient reserves, everything is fine. You make your purchases and withdrawals and the bank has the reserves to cover it.

But when the bank fails, and doesn't have the reserves, as you said, the depositor loses his money.

It is the reserves that effect the transactions. MMM step 6. The Account can be used for purchases only if the bank has reserves.

 

If they don't have the reserves, and cannot borrow them, it cannot make loans, because it cannot pay the loan check. MMM step 6.

That is what limits how much banks can lend.

Sure.

That is exactly how loan checks are paid. See MMM step 6.

The lending banks, however, do not expect to retain the deposits they create through their loan operations. Borrowers write checks that probably will be deposited in other banks. As these checks move through the collection process, the Federal Reserve Banks debit the reserve accounts of the paying banks (Stage 1 banks) and credit those of the receiving banks. See illustration 6.

If the bank doesn't have sufficient reserves (whether from deposits or borrowing) it cannot make the loan because it doesn't have sufficient reserves to debit.

OK, I wasn't sure what you meant because you were using the term "currency".

Unlike cash, which can always be used as cash. Therein lies the difference. Because deposit accounts are only claims on the bank's cash/reserves.

LOL, what differnce does it make if they have a worthless account value? They've lost their money. Which is why it is not just like cash.

OK

It results in a decrease in equity, but if the bank has sufficient reserves, no problem.

"cash has nothing to do with the bank"? LOL

Sure.

Please explain how deposit accounts are "exactly like cash" when you lose your money when the bank fails but you don't if you have cash.

No it doesn't. What means your deposit isn't just like cash is the fact that your deposit is a claim on the bank's reserves/cash whereas cash in your pocket is cash.

If the bank fails, your money in your deposit account is worthless. The cash in your pocket is still worth the same.

 

I'm talking about the banking system as a whole, not an individual bank.

 

OK. I'm talking about an individual bank.

 

If you give $5,000 to a friend and tell him that you want him to buy you stuff when you ask for it.

Say you want an iPad for $600 and you tell your friend... hey go get me an iPad.

Your friend gets you an iPad and gives it to you. You now have $4,400 left.

So your friend goes and gambles away the $4,400. You then ask your friend to go buy you a $2,000 car. Your friend says he no longer has the money.


Now do you consider the $5,000 you gave your friend as $5,000 in money or $5,000 in claims on the $5,000 you gave him?

 

It would be a claim for the $4400 I gave him to buy me stuff. (I got the IPad)

 

So the claim is for $4,400 in cash right.

So if I put $5,000 in the bank and purchase a $600 iPad.

I have $4,400 in claims and an iPad?

Based on this theory nothing is really money unless it's actually used. If you have $5,000 in cash in your wallet it is just a claim on $5,000 unless you use it and get something in exchange for it? Because what if you lose your wallet or someone steals it?

 

Sure they can. They do it all the time.

Reserves are the money the non-bank public uses. What do you think comes out of your account when you withdraw money? It's not money that was in your account, it's part of the bank's reserves.

I agree that many bad loans will cause a bank to go into negative equity, but that is not what actually causes the bank to fail. They gain toxic assets and their credit rating gets downgraded, but that isn't what causes them to fail. Its when their customers get spooked and run on the bank that causes it to fail.

If you don't mind going to jail for counterfeitting.

Sorry I (*)(*)(*)(*)ed that up. Let me try that again. These are assuming 0% interest loans:

If someone deposits $100 into a bank:
L=$100
A=$100 cash reserves
E=$0

If I loan $90:
L=$100
A=$100 ($90 in loans, $10 in cash reserves)
E=$0

That loan comes back in as a deposit:
L=$190
A=$190 ($90 in loans, $100 in cash reserves)
E=$0

I loan $81:
L=$190
A=$190 ($171 in loans, $19 in cash reserves)
E=$0

If loan #2 defaults, then I have:
L=$190
A=$109 ($90 in loans, $19 in cash reserves)
E= -$81 (toxic assets)

If loan #1 defaults after that, then I have:
L=$190
A=$19 reserves
E = -$171 (toxic assets)

It is mathematically impossible for bad loans to cause banks to fall below their required reserve ratio unless the bank is engaged in fraud. Negative equity does not cause the bank to fail unless it simultaneously doesn't have enough cash reserves to meet the demand that depositors are claiming on its reserves....who may very well be running on the bank because they realize how many loans are failing, how toxic its assets are becoming, its credit level being rapidly downgraded, etc. This is what caused Lehman to fail.

Ultimately, the problem boils down to inadequate reserves. Inadequate reserves at the wrong time will cause a bank to fail, regardless of it's equity (unless it has enough equity to bail itself out). I agree that holding many toxic assets will decrease the likleyhood of a bank being able to borrow reserves or getting bailed out (unless it is a large influential member bank that is deemed too-big-to-fail).

 

It is you who is confused.

Depends on how you define "money".

Only because the government says so. Without legal tender laws, it would be worth only the paper and ink that's printed on it.

It's good to see that you're finally admitting that there is no money in a deposit account.

This is where you have it wrong. The deposit is a claim on money, of which the claim gets counted as money by all definitions, excluding reserves/cash. There is no actual money in your deposit account by definition.

It is you who is confused.

That's true.

 

I don't follow the analogy you are making. If I have $5000 cash in my pocket, I have $5000 cash.

If I have $5000 in a deposit account, I have a claim for $5000 against the bank.

If I have $5000 owed to me, I have a $5000 note receivable.

The first case is different than the latter two, because I actually have cash. The latter two are both claims, though the claim against the bank is probably the sounder one.

If you lose your $5000 you no longer have $5000 in cash.

 

I honestly do not see the difference between having $5000 cash in your wallet or giving your friend $5000 to hold for you or giving the bank $5000 to put in an account for you. The only difference is one you have it on your person the other two you have it stored somewhere else.

Even though there is no difference between having a claim on the $5000 you gave to a friend to store for you than having a claim on the $5000 in your wallet. If you lose your wallet or your friend loses your money or the bank loses your money you have $0.

 

You gotta view the system as a whole to understand why this works. In your situation the bank is responsible for that $171 because $171 in deposits within the system that are not backed by any assets. It is insolvent regardless of how many reserves it has. The bank has to first sell all it's assets to try to make up the $171 or it gets taken over and $171 worth of deposits will be lost. Leaving the system with $19 in reserves and $19 in deposits.

Banks are capital constrained not reserve constrained.

 

Money is a commodity and exists in it's own right. Tobacco, for example, was "legal tender" money in America prior to the American Revolution and people paid their taxes with it. Whiskey was also legal tender money at one time and could be used to pay taxes. Spanish gold and silver coins were "money" in the United State well into the 1800's in the United States and commonly used in commerce although they were never legal tender. Gold dust and gold nuggets were money in California during the Gold Rush although they were never "legal tender" but were certainly used to conduct commerce.

Money has always been a commodity as it doesn't "promise" anything. A government backed promissory note that is redeemable in "money" can be "legal tender" but it is not the money that is promised. It is merely an IOU where the government says that it will redeem the note in money.

Federal Reserve notes are not "money" but their mandatory acceptance in lieu of money is based upon the legal tender laws where the US government states it is redeemable in lawful money.

Of note a Canadian Gold Maple Leaf is money and while it is not "legal tender" in the United States it can be accepted in commerce to pay debt and in exchange for goods and services by the People of the United States but that acceptance is voluntary and not mandated by law.

 

That's true, but banks can be insolvent through negative equity without their depositors knowing. As long as the depositors don't have any hints that the bank is insolvent or on its way to becoming insolvent, the bank will not fail. Hell, it doesn't even matter if the bank is insolvent or not - a bank run *for any reason* will always cause the bank to fail unless it can immediately liquify its assets (toxic or non-toxic).

The reason is because there is not actually money in deposit accounts. If there were, the bank would not fail. As Iriemon and I have been tirelessly trying to explain to you for hundreds of posts.

 

Except that banks have to produce financial statements and are monitored by various agencies, and will likely seize it under receivership before there is any run on the bank.

 

What about a bank like Lehman?

 

What about it?

 

Was it seized before it got run on?

 

I don't know. Was it?

 

I don't think so. Banks aren't always seized before they get run on.

 

but now banks have mark to model instead of mark to market.....effectively allowing the banks to lie about their true balance sheet

 

I didn't say there were always seized. But likely they are. Of the hundreds of bank failures since the recession, I don't recall reading about people standing in lines waiting to get their money out.

 

I can think of two reasons for that. For one, people can transfer their funds out of their bank electronically to somewhere else. There is no need to stand in line to get physical cash these days. Secondly, their deposits were insured by taxpayers.

 

Bank closures are almost seamless for depositors. Most depositors don't even know other than a letter stating the bank has been taken over.

Deposits actually increased during the Great Recession. That FDIC insurance sure doesn't hurt.