by James B.

Berger

Limits & Losses

Introduction
A lot of misconceptions exist about the regulations that control the behavior of Federal Reserve member banks. What limits the growth of bank deposit liabilities1? What limits the amount of notes that banks can acquire? And what happens to "loan losses?" And, finally, how do these different limitations interact? A number of factors influence the behavior of Federal Reserve member banksthese factors include the large number of bank regulations. In this presentation I would like to address questions about three interrelated factors.

Banking Questions
A great number of regulations exist that dictate the behavior of Federal Reserve member banks. In this presentation I will address three important questions regarding the regulation of bank behavior: 1) What limits the growth of bank deposit liabilities? Why cant banks increase deposits indefinitely? 2) What limits the amount of notes that any bank can acquire? Why dont banks make more loans, even with strong demand? 3) What effect do bad loans have on these limits? Who absorbs losses when customers default on their notes?

In the rest of this presentation I will address these three questions.

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. Page 1

Jim Berger

Bank Limitations & Losses

Introduction to our First Bank Example

In order to discuss what regulations influence the answers to the three questions posed, we need a hypothetical bank as a model. The image above represents the model bank, which I have dubbed First Bank. Using this diagram I will set up the elements of First Bank that I will refer to in the balance of this presentation. The left-hand column in the graph represents the amounts of dollars that the bank paid for assets in each of three general categories: $150,000 in reserves, which amount to the banks deposit balance at the Federal Reserve Bank. $50,000 in securities, consisting primarily of US government bonds. $400,000 in notes, representing the future obligations of bank customers to the bank.

The right-hand column of this chart represents the amounts and sources of the money used to acquire the assets of the bank. For this example sources fall into two general categories: $100,000 in capital, which represents an initial capital contribution of bank owners plus accumulated earnings. $500,000 in deposit liabilities, which includes both demand and time accounts. [Note: demand and time accounts have been included together because standard practice includes them as components of the money supply.] Page 2

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Bank Limitations & Losses

Transactions

Before we begin to address the questions posed at the start, I would like to review two primary ways in which a bank can increase its deposit liabilities: By accepting cash or checks drawn on other banks. By creating new deposit liabilities in order to acquire customer notes.

I will also show the effect that buying securities has on the banks balance sheet.

The Bank Accepts Deposit Liabilities

First, banks increase their deposit liabilities when they accept either checks (drawn on other banks) or cash for the account of either new or existing customers. When First Bank accepts a check drawn on another bank for the account of a new or existing customer, the bank on which the check is drawn transfers reserve dollars, in an amount equal to the amount on the check, into the reserve account of First Bank. In return for the reserve dollars deposited into its account at the Federal Reserve, First Bank increases its deposit liabilities by an equal amount of money dollars for the account of the depositing customer. In this example, First Bank receives a check for $100,000.

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Bank Limitations & Losses When a bank receives cash for the account of a new or existing customer they add the amount of that cash to the amount of their reserves (referred to as cash in vault, also included in bank reserves) and they create a deposit liability of an equal amount. (To keep it simple, I have not used a cash deposit for this example.) In all cases, when customers transfer funds to a bank, either in the form of cash or by the use of the check, the amount of deposit liabilities and the amount of bank reserves rise by an equal amount.

The Bank Acquires Borrower Notes

Second, banks increase deposit liabilities as a part of the transaction in which the bank acquires note obligations. Banks assume deposit liabilities for the purpose of making profitable investments, mostly in the form of interest-bearing notes from their customers. The banks acquire these notes by simply creating deposit liabilities with a ledger entry to their bank records. In the case of this example, as you see, deposit liabilities of First Bank increased by $200,000 to acquire notes for future money in the amount of $200,000. The note also includes the obligation on the part of the note maker to pay interest. Over the term of the note, interest payments (paid by check from another bank) add to bank reserves and bank capital.

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Bank Limitations & Losses

Bank Buys Securities

We need to review one last transaction to clarify that it plays no role in the banks creation of deposit 2 liabilities (i.e. the increase of the money supply. ) That transaction consists of the purchase and sale of securities with the Federal Reserve Bank. In this case we show the effects of the purchase of securities by First Bank from the Federal Reserve. As you can see from the comparison of this chart to the previous chart: The purchase of $50,000 of securities adds to the amount in the securities account and reduces the amount in the bank's reserve account.

This transaction has absolutely no effect on the amount of the deposit liabilities; thus, it has no direct influence on the quantity of money. If the bank were to sell securities to the Federal Reserve, it would have the opposite effect on both the securities and bank reserve accounts and still have no effect on bank deposit liabilities. It is important to understand the dynamics of this transaction in order to fully understand how the Federal Reserve influences the limitation of deposit liability creation (i.e. money creation). Bank transactions with the Federal Reserve do not by themselves result in an increase or decrease of deposit

Jim Berger, February, 2014

Remember that the monetary aggregates (measures of the money supply) include deposit liabilities.

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Bank Limitations & Losses liabilities (or the increase or decrease in the quantity of money). The banks must act, within the limitation of reserve requirements, to change the quantity of moneyby changing deposit liabilities.

Summary of Transactions Deposit Liability Summary

Banks can increase deposit liabilities using two methods: 1. Banks increase deposit liabilities in exchange for the receipt of additional assets, usually in the form of bank reserves either cash or a deposit at the Federal Reserve Bank, and 2. Banks create new deposit liabilities (by ledger entry) for the purpose of acquiring bank investments, primarily notes from customers.

Summary of Securities Purchases

When banks purchase securities from the Federal Reserve it has two simultaneous effects: 1. their securities account increases by the amount of dollars spent for those securities, and 2. their reserve account decreases by the same amount of dollars. When banks sell securities to the Federal Reserve the effects are exactly the inverse.

Limitations of Deposit Liabilities and Risk Assets

Using that review of the way banks increase their deposit liabilities as a background, I will now describe how banks determine the limitations on their ability to increase deposit liabilities and on their ability to acquire risk assets (primarily notes from bank borrowers).

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Reserves Limit Deposit Liabilities

The amount of reserves that a bank maintains, primarily at the Federal Reserve Bank, defines the limit of the amount of deposit liabilities of that bank. Bank reserves limit the amount of deposits through the application of the reserve requirement, stated as a percentage of deposit liabilities. Banks calculate the maximum of their deposit liabilities by calculating the inverse of the reserve requirement (i.e. dividing actual reserves by the reserve requirement). In the case of First Bankwith $200,000 of bank reservesthe bank could assume a maximum of $4 million in deposit liabilities based on the 5% reserve requirement used in this model. ($200,000 divided by 5% equals $4 million.) Although Federal Reserve regulations state the required reserves as the amount of reserves required in terms as a percentage of deposits, the quantity of reserves the bank holds actually limits the amount of deposit creation by the bank. When the bank has a reserve balance (actual reserves) greater than their required reserves they have excess reserves (actual reserves less required reserves = excess reserves). The amount of excess reserves a bank holds determines how much that bank can increase its deposit liabilities before it reaches its limit. Banks can increase their deposit liability limitation (increase excess reserves) primarily by two of the transactions that we reviewed before: 1) the transfer of reserves from another bank to cover a check transaction, or 2) the sale of securities to the Federal Reserve. In our model, the required reserves of First Bank amount to $40,000 ($800,000 times the 5% reserve requirement.) First Bank, however, has $200,000 in actual reserves, so their excess reserves amount to Jim Berger, February, 2014 Page 7

Bank Limitations & Losses $160,000 ($200,000 in actual reserves less $40,000 of required reserves.) Based on the reserve requirement alone, First Bank could hypothetically increase its deposit liabilities by $3.2 million ($160,000 in excess reserves divided by the 5% reserve requirement.) We will find out later that reserve requirements alone may not limit the capacity of First Bank to create deposit liabilities. If bank reserves limit deposit expansion, what, then, limits the increase in risk assets?

Capital Limits Risk Assets

The amount of the bank's capital dictates the limit of the amount of risk assets (e.g. notes) that a bank 3 has authorization to own. According to international agreement banks must maintain a specific ratio of capital to the amount of risk assets that they own. Similar to the calculation of the reserve requirement, a bank determines the amount of risk assets it can own based on the inverse of the current capital requirements. Although the calculation is more complicated than in this example, for the sake of example, I have used a single capital requirement percentage applied to all categories of risk assets. For First Bank, with $100,000 of capital, it can own up to $1.25 million in risk assets, primarily held in the form of notes. (That amounts to $100,000 divided by 8%.)

Jim Berger, February, 2014

Known as the Basel Accords. The capital ratio I have used here serve only as an example. The details of the accords do not matter for understanding the relationship described here.

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Bank Limitations & Losses

Interactive Limitations

As you have probably already figured out, these limitations on deposits and risk assets operate interactively. In the last two slides I have demonstrated how: 1. the amount of reserves held by the bank limits its ability to create deposit liabilities, and 2. the amount of capital held by the bank limits the quantity of risk assets (or notes) that the bank can own. Bank reserves have no direct influence on the amount of loans that a bank can make, and bank capital has no direct influence on the level of deposits a bank can hold. But, bank capital and bank reserves create interactive limitations on both note acquisition and deposit creation. First, when a bank has no excess reserves (when its actual reserves equal its required reserves), it can no longer create deposit liabilities with which to acquire notes. Second, when the amount of bank capital drops to a ratio of risk assets equal to its required capital ratio, that bank has reached the limit of its note acquisition capabilities. The bank can no longer acquire new notes regardless of the amount of excess reserves it holds. The interactive relationship between bank reserves and bank capital means that the limiting factor with the least "slack" determines the limit of deposit creation (monetary expansion) and note acquisition. In Jim Berger, February, 2014 Page 9

Bank Limitations & Losses other words, when First Bank has no Excess Reserves but plenty of capital it cannot create deposits liabilities with which to buy notes. And, when the capital of First Bank amounts to only 8% of its risk assets it cannot acquire new notes even if it has plenty of excess reserves.

Summary of Limitations
The amount of First Banks reserves limits its ability to create new deposit liabilities; and the amount of First Banks capital limits its ability to acquire notes. Since First Bank uses deposit liabilities to acquire notes, these limitations become interactive. Thus, the amount of First Banks excess reserves can limit its note acquisitions and the amount of First Banks capital can limit its deposit liability creation. This interactive relationship has become significantly important with the recent extreme expansion of bank reserves. Based solely on their high level of excess reserves banks have an almost unlimited capability of creating new deposit liabilities. It would seem from this that they would also have the capability of acquiring an almost unlimited volume of notes. So, why dont banks make more loans? The relatively slim current capital ratios, however, severely limit the amount of notes banks can acquire. That coupled with potential risk from existing loans makes banks highly reluctant to make new loans particularly risker loans. This provides an answer to that often asked question of, "Why don't banks make more loans?" Even though banks have massive amounts of bank reserves, they do not have massive amounts of capital to support note acquisition. Note: It is my contention that with the reduction of bank reserve requirements and the immediate access to time deposits making them virtually indistinguishable from demand deposits the reserve requirements have lost their ability to limit deposit expansion and thereby monetary expansion. As a result, the interactive limitation resulting from the levels of bank capital has provided the primary limitation on deposit liability growth. Over the last couple of decades monetary expansion (MZM) has progressed at roughly 7 1/2% per annum, which I suspect parallels the expansion of bank capital through earnings. Monetary expansion of that same period has a relatively low correlation to the growth in bank reserves.

Losses
The question now remains, "What happens when "loans" go bad?"

Jim Berger, February, 2014

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Bank Limitations & Losses

What Happens When Loans Go Bad?

If First Bank owned a note on which the signer defaulted, who would bear that loss? Would the depositors suffer a loss? Would some sort of adjustment be made to the bank reserves? (You may have heard the term loan loss reserves and confused it with the reserve balance at of the Federal Reserve.) Or, do the owners of First Bank have to absorb any loss in their capital account? Lets first look at the effect of a moderate loss

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Bank Limitations & Losses

Moderate Loss

If First Bank suffered a loss of $35,000 as a result of note default, that would amount to only 4.375% of the banks risk assets (of $800,000) significant, but not terrible. That loss, however, would come entirely from the capital of the bank 35% of the $100,000 of capital. The capital structure of the bank (a ratio of 8.50% of risk assets) would fall to near the threshold of the capital requirements. The bank officers would become much more cautious about their future loan criteria. But, would the holders of deposit accounts have any risk? As a practical matter taxpayers guarantee the bank deposit accounts. Technically the Federal Deposit Insurance Corporation (FDIC) guarantees the banks deposit accounts (with a few minor exceptions). In the long-run, because of the limited financial capacity of the FDIC, the government must guarantee those deposit accounts. What effect does this have on the banks ability to create more deposits and buy more notes?

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Effect of Capital Losses

This capital loss does not directly affect the banks ability to increase deposit liabilities. They still have $100,000 in excess reserves, which means they could hypotheticallyincrease deposit liabilities by $2 Million, but indirectly it does create a limitation. Because of the deterioration of their capital, First Bank can add only $47,794 to their note portfolio. Since they cannot create deposit liabilities for which they get nothing in return, they will limit additional deposit liabilities to $47,794 to match the assets they can buy. Thus, capital limitations can limit deposit liabilities (money) creation. So, what happens if the losses grow?

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Bank Limitations & Losses

Bank Capital Absorbs Even Greater Losses

First Bank has already lost $35,000 of notes but now it loses another $65,000. The total amount of the loan losses $80,000 would be absorbed entirely by the capital of the bank. Some or all of this loss might be absorbed by the bank's loan-loss reserve, which represents part of the bank's capital. Banks are allowed to accumulate a certain amount of loan-loss reserves on an annual basis to protect against the possibility you of large losses. It still amounts to a loss of capital. Capital Ratio Inadequate You can see by the capital ratio after the loan-loss that First Bank can no longer meet its capital requirement. The bank regulators would consider this bank as insolvent. The FDIC would shut this bank down. But, rather than just closing the bank and absorbing the loss, the FDIC would, more than likely, prenegotiate a sale of the bank's assets to another bank with stronger capital. As a part of that deal the FDIC would get an agreement that the new bank would take over the deposit liabilities. This transaction would happen Friday afternoon and Monday morning the new bank would open for business. The poor condition of First Bank might, however, cause prospective buyers to decline that offer

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Bank Limitations & Losses

No Bank Buyer
In rare cases the FDIC cannot find a buyer for an insolvent bank and might have to liquidate its assets (i.e. sell the assets). When that scenario occurs, the depositors would not risk losing any of their money. The deposit liabilities of the bank have the guarantee of the FDIC and ultimately the backing and guarantee of the US taxpayers. Although the government has no obligation to protect shareholders or the makers of notes owned by this bank, they have a very real and important obligation to protect the deposit liabilities of the bank. Those deposit liabilities make up a significant portion of the nations money supply.

Summary of Losses
To summarize the points we have made about loan losses: All loan losses, large and small, come directly out of bank capital (i.e. the shareholders suffer the loss). Moderate loan losses have the effect of restricting the amount of risk assets the bank can acquire. Large loan losses can cause the bank's capital ratio to fall below required the required minimum. As a result, regulators would classify the bank as insolvent and take one of the following two actions: Negotiate the sale of the failed bank's assets to another sound bank in exchange for the assumption of deposit liabilities and possibly other consideration. If the FDIC cannot find a buyer for the bank, they might have to sell off the assets piecemeal and pay off depositors from their insurance reserve. Excessively large losses, from one or many banks, could potentially shift the liability to taxpayers.

Summary of Limitations & Losses

In order to pull everything together, let me first summarize the information I have provided so far related to transactions, limitations on some bank activities, and the effect of loan losses.

Transactions
We have discussed three types of bank transactions two of which affect deposit liabilities and one of which does not. Those transactions consist of: Increase of deposit liabilities and bank reserves by a transfer into the bank. Increase of deposit liabilities for the purpose of acquiring notes for investment. The purchase (or sale) of securities with the Federal Reserve affects only the reserve account and not deposit liabilities.

Limitation
We discussed two types of limitations on bank activity: limitations on the expansion of deposit liabilities and limitations on risk asset acquisition. The devices used for limiting these activities can also play interactive roles: Jim Berger, February, 2014 Page 15

Bank Limitations & Losses Bank reserve totals limit the deposit-making capabilities of a bank. Capital amounts limit the quantity of risk assets that a bank can acquire. The interactive limits resulting from reserve balances and capital accounts cause two ways to limit deposit growth.

Losses
Loan losses can have an effect not only on the bank and its owners but on larger segments of the economy: Loan losses come directly out of bank capital. Reduced bank capital causes a reduction in the capability of banks to acquire risk assets. Large losses of capital can cause regulators to either sell or liquidate a bank. Bank failures potentially shift deposit liabilities to taxpayers.

Conclusions
The Effects of Bank Limitations
Banking regulations set limits on the level of deposits that banks can carry and the amount of risk assets they can own. There are separate limitations for each of these; however, it remains important to understand the interaction of these limiting regulations.

Limitation on Deposits
Traditionally people have thought that the expansion of bank reserves drives the expansion of deposit liabilities and therefore the expansion of the money supply. In fact bank reserves act as a limitation on the expansion of deposit liabilities and the money supply. In other words the Federal Reserve cannot create money without the help of banks.

Limitation on Assets
People frequently asked the question, "Why don't banks make more loans?" The answer to that question frequently exists in the bank's capital ratio. When a bank is at or near its minimum capital ratio it will be far more reluctant to make new loans or it may be prohibited from making new loans.

Interaction of Limitations
Understanding the interaction of the limitations set by reserve requirements and capital requirements helps us to understand why banks react to the pressure to make new loans in the manner in which they do. It seems that people more commonly recognized the ability of banks to make more loans because of excess reserves, but they don't fully understand the limitation caused by the capital requirements. I would argue that the reason banks don't make loans (and that the risk of hyperinflation remains low) results from the influence of bank capital requirements. When the current level of capital in banks restricts the amount of risk assets the bank can hold, the bank will not expand deposit liabilities (thereby expanding money) more than they are willing to (or capable of) taking on new risk assets.

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The Impact of Losses

Loan losses have a much wider impact than just on the owners of bank capital. If the owners run a shoddy operation, they should lose some or all of their money. But the collapse of banks affects all of the bank's customers as well as the many people who rely on a sound banking system.

Deposits & Money Supply

First, all banks teeter on a very small capital base. As I hope you've seen from this example, it takes a relatively small loss in the banks note portfolio to put it at risk of failure. In the large scheme of things the deposits of each and every bank represent an important part of the nations money supply. To allow depositors to suffer any loss at all creates the very real possibility of people losing confidence in the US money supply. To have this happen could have catastrophic effects on the economy at large.

Confidence in Money
The confidence that people have in their banking system is a widespread influence on the stability of the monetary system. When one bank goes out of business, people frequently fear that other banks will do likewise. For this reason bank regulators try to make the closing of insolvent banks as invisible as possible. When widespread bank failures occur they have the potential of leading to "bank runs." These sudden and widespread withdrawals can topple a banking industry balanced on a very limited amount of capital.

Government Underwrites Deposit Liabilities

Second, it takes the sizable acquisition of risk assets in order for the inflation machine of the US banking system to distribute the vast amount of money produced for nothing. Without the support of the FDIC and the federal government they could not afford to take the huge risk they do with a large amount of deposit liabilities that they accumulate. In chartering banks under a reserve banking system the government has allowed banks to be the creators of the bulk of our money supply. Because of the important role that money supply plays in the stability of our economy, the government has taken steps to ensure the reliability of bank deposit liabilities. The FDIC amounts to simply a smokescreen to assure bank depositors of the soundness of banks. In reality the FDIC does not have the resources to cover large-scale bank losses. By default, to protect its own money supply, the federal government has underwritten the deposit liabilities of banks. If the FDIC cannot cover losses, the taxpayers most assuredly will.

Bailing Banks Bails Money Supply

The reason the FDIC and the federal government cannot let large banks fail is not to protect the assets of the bank nor its shareholders. The government cannot let them fail in order to protect the veil that hides the basic insolvency of the banking system as a whole. In order to get another bank to take on the deposit liabilities the federal banking regulators must do something to protect the assets acquired by the new bank. Jim Berger, February, 2014 Page 17

Bank Limitations & Losses A number of people make big talk about allowing banks that make bad loans to fail, but this position cannot be defended within the current structure of our banking system. Allowing banks to fail could create potential risks to the entire nations money supply and the economy as a whole. Employing the free-market concept of "too big to fail" in our non-free-market system would represent an act of irresponsibility.

My Solution
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.

Jim Berger, February, 2014

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