Part 8. How banks lose money
Like any business, a bank can make a loss for a variety of reasons. Examples are when outlay exceeds revenue, when an investment goes bad, or when a debtor defaults and a debt has to be written off. This part looks at at how banks can lose money on the money they create, since it is often asked how banks can lose money or go bust when they can just create money.
Let's go back to our house purchase example in Part 7 up to month 10, but take a different path from there. This time let's assume the house buyer loses their job with the house seller. The house seller is in no obligation to continue to pay a salary to the house buyer; nor are they responsible for the house buyer's outstanding mortgage.
At month 10, the house buyer has £3,400 of unspent money in their deposit account, and so can continue to pay the mortgage for 5 more months whilst they look for new employment. We will assume that they do not need to spend the money on anything else, for simplicity. The mortgage transactions up to and including month 15 are shown in Figure 8.1.
And the bank's balance sheet is shown in Figure 8.2.
Now suppose that the house buyer was unable to secure new employment, defaulted on the mortgage loan and told the bank they could no longer pay the mortgage. What would the value of the house buyer's mortgage account be to the bank if the house buyer really did never pay a single penny more off of their mortgage debt? Clearly it would be zero rather than £96,242 (less the £100 in the house buyer's deposit account). That is, the bank's only asset would be zero, but the bank would still have a £90,000 liability for the house seller's deposit account, and if the house seller moved their depost to a different bank, the bank would have a £90,000 deferment to settle from assets, and it has none.
Fortunately, the bank has a solution to this problem: repossession. It is able to repossess the house buyer's house and sell it to recover some or all of the outstanding £96,242 mortgage debt owed to it. The right to repossess — in the event of the borrower being unable to pay back the mortgage loan — would have formed part of the contract between the borrower and bank when the mortgage loan was taken out.
To see how this works we will introduce a second house buyer to buy the house. We will need two new accounts for the new buyer we will call 2nd House Buyer's Mortgage Account and 2nd House Buyer's Deposit Account, and we will assume these are with the same bank, as before. However, we will also assume that the second house buyer is only willing to pay £95,000 for the house due to house prices having dropped over the past 15 months. First we create the mortgage loan as shown in Figure 8.3.
Next, we carry out the house purchase transaction as shown in Figure 8.4.
Next, the money in the 1st house buyer's deposit account is used to pay off as much of 1st house buyer's mortgage as possible. This transaction is shown in Figure 8.5.
After the 1st house buyer has transferred all funds to the mortgage account there is still a balance of £1,142 owing to the bank. As the 1st house buyer has no more funds, and no other assets the bank can repossess, the bank needs to write this amount off. It does this by transferring money from its earnings account to the 1st house buyer's mortgage account, as shown in Figure 8.6.
And the bank's balance sheet after the write off is shown in Figure 8.7 (The 1st house buyer's accounts no longer appear in the balance sheet since they are now all empty).
Comparing this balance sheet with the prior one, the bank has taken a loss of £1,142 due to writing off 1st house buyer's remaining mortgage, and this has reduced its equity from £6,142 to £5,000.
You may be thinking why can't the bank just scrub out the £1,142 on its computer system by setting the digits to £0.00? Or why not just scrub out the £96,242 outstanding and let the 1st house buyer keep their house? Not excluding the fact that they would be scrubbing out an asset, scrubbing out the debt would be the equivalent of a credit entry on the account, and every credit is associated with a corresponding debit and vice versa whether its recorded or not. In fact, a bank's equity is defined as its assets minus its liabilities, so the bank would just be stating its equity incorrectly if it didn't subtract the amount scrubbed out or written off.
So as we can see, banks can't just write off outstanding debt without absorbing the loss themselves. This is because when a bank creates money, it creates both a deposit liability and a loan asset. Even if the asset becomes worthless, the liability remains. Any asset written off is a loss to any business, and a bank can go bankrupt as a result of writing off loans, as is demonstrated next.back to Part 7