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Part 14. How banks fail

We saw in Part 9 how banks go bankrupt due to normal insolvency — when assets become less than liabilities. We will now look at cash flow insolvency, which is caused by a credit squeeze or credit crunch.

We will go back to our banks and sets of accounts at the end of Part 12 (rather than Part 13 since they will be simpler to deal with), and look at the situation where 1st Bank does not have enough reserves to settle with 2nd Bank. We can see this in action by "overlending" at 1st Bank, transferring the funds to 2nd Bank and attempting to settle.

For the loan, we will create two new accounts, Loan Account #2 and Deposit Account #5. We will assume a loan of £60,000 is made as shown in Figure 14.1.

Loan Account #2 1st Bank Description Debits Credits Balance Starting balance £0 Loan debited £60,000 £60,000 (DR) Deposit Account #5 1st Bank Description Debits Credits Balance Starting balance £0 Loan credited £60,000 £60,000 (CR)

Figure 14.1 Loan creation.

Next we will transfer the funds from Deposit Account #5 to Deposit Account #4 at 2nd Bank as shown in Figure 14.2.

Deposit Account #5 1st Bank Description Debits Credits Balance Starting balance £0 Loan credited £60,000 £60,000 (CR) Transferred to Deposit Account #4 £60,000 £0 Deposit Account #4 2nd Bank Description Debits Credits Balance Previous balance £5,000 (CR) Received from Deposit Account #5 £60,000 £65,000 (CR)

Figure 14.2 Deposit Transfer to Deposit Account #4.

And being an interbank transfer, we will defer settlement, as shown in Figure 14.3.

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £60,000 £60,000 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £60,000 £60,000 (CR)

Figure 14.3 deferred settlement double entry.

Before settling, lets assume 1st Bank exchanges its remaining mortgage-backed securty for reserves from the central bank. This will give 1st Bank extra reserves it can use to settle. The transfer of the security is shown in Figure 14.4.

Mortgage-backed Securities 1st Bank Description Debits Credits Balance Previous balance £50,000 (DR) Received from 1st Bank £50,000 £0 Mortgage-backed Securities Central Bank Description Debits Credits Balance Previous balance £50,000 (DR) Transferred to Central Bank £50,000 £100,000 (DR)

Figure 14.4 Transfer of the security.

And the complementary interbank double entry for the reserves transfer is shown in Figure 14.5.

1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £5,000 (CR) Transferred to 2nd Bank £50,000 £55,000 (CR) Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £5,000 (DR) Received from Central Bank £50,000 £55,000 (DR)

Figure 14.5 Transfer of the reserves.

The balance sheets now look as shown in Figure 14.6, with the blue arrow showing the balance outstanding between banks.

Central Bank's Assets Mortgage-backed Securities £100,000 Total assets £100,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £55,000 Total liabilities £100,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Digital Reserves £55,000 Loan Account #2 £60,000 Total assets £215,000 1st Bank's Liabilities 2nd Bank's Deposit Account £60,000 Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £215,000 2nd Bank's Assets 1st Bank's Loan Account £60,000 Equity Release Loan Account £50,000 Digital Reserves £45,000 Total assets £155,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 Deposit Account #4 £65,000 Total liabilities £155,000

Figure 14.6 Balance sheets after the transfer of reserves.

Now we will settle using the same steps we used in Part 12. First we transfer £60,000 from 2nd Bank's Deposit Account to 1st Bank's Deposit Account, as shown in Figure 14.7.

2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £60,000 £60,000 (CR) Transferred to 1st Bank £60,000 £0 1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Received from 2nd Bank £60,000 £60,000 (CR)

Figure 14.7 Transfer from 2nd Bank's Deposit Account to 1st Bank's Deposit Account

To transfer reserves we need to again carry out two double entries with Central Bank. The first is to reduce 1st Bank's reserves by £60,000 as shown in Figure 14.8.

Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £55,000 (DR) Transfer reserves £60,000 £5,000 (CR) 1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £55,000 (CR) Transfer reserves £60,000 £5,000 (DR)

Figure 14.8 Double entry to reduce 1st Bank's reserves

And the second is to increase 2nd Bank's reserves as is shown in Figure 14.9.

2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £45,000 (CR) Transfer reserves £60,000 £105,000 (CR) Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £45,000 (DR) Transfer reserves £60,000 £105,000 (DR)

Figure 14.9 Double entry to increase reserves at 2nd Bank.

And finally we transfer the balance from 1st Bank's Deposit Account to 1st Bank's Loan Account to clear balances, as shown in Figure 14.10.

1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Received from 2nd Bank £60,000 £60,000 (CR) Transferred to loan account £60,000 £0 1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £60,000 £60,000 (DR) Received from deposit account £60,000 £0

Figure 14.10 Transfer of the balance from 1st Bank's Deposit Account to 1st Bank's Loan Account.

And the balance sheets are shown in Figure 14.11.

Central Bank's Assets Mortgage-backed Securities £100,000 Total assets £100,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £105,000 1st Bank's Digital Reserves (£5,000) Total liabilities £100,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Digital Reserves (£5,000) Loan Account #2 £60,000 Total assets £155,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £155,000 2nd Bank's Assets 1st Bank's Loan Account £60,000 Equity Release Loan Account £50,000 Digital Reserves £105,000 Total assets £215,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 1st Bank's Deposit Account £60,000 Deposit Account #4 £65,000 Total liabilities £215,000

Figure 14.11 Balance sheets after the transfer of reserves.

The red arrows indicate we have a problem with 1st Bank's reserve account. It has actually gone overdrawn (as indicated by the brackets around the numbers). The settlement just carried out would not clear. In fact, 1st Bank would probably not attempt to carry out this transaction but instead approach Central Bank to try to borrow additional reserves.

This is a cashflow problem, and is what happens when banks do not have sufficient reserves to settle obligations. Even though the bank's assets are not less that its liabilities, it does not have sufficient reserves or other liquid assets it can use to settle, and so is now technically insolvent.

This type of situation is what is referred to as a credit squeeze — or credit crunch when multiple banks suffer from the same situation. We will look at how central banks can intervene in these situations in Parts 18 and 19, but before we can do that we need to introduce government bonds.

back to Part 13