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Part 9. How banks go bankrupt

We showed in Part 8 how banks can lose money on bad loans, and clearly enough bad loans could wipe out a bank's equity and bankrupt the bank. This type of bankruptcy is referred to as normal insolvency, where assets are less than liabilities. Another type of insolvency, called cash-flow insolvency — which is caused by a credit squeeze or credit crunch — is looked at in Part 14.

To see normal insolvency in action, let's go back to Part 8, and this time consider the situation where the house is re-sold for £85,000 instead of £95,000. The loan creation is shown in Figure 9.1.

2nd House Buyer's Mortgage Account Description Debits Credits Balance Starting balance £0 Mortgage loan debited £85,000 £85,000 (DR) 2nd House Buyer's Deposit Account Description Debits Credits Balance Starting balance £0 Mortgage loan credited £85,000 £85,000 (CR)

Figure 9.1. The mortgage loan transaction.

And the house purchase transaction is shown in Figure 9.2.

2nd House Buyer's Deposit Account Description Debits Credits Balance Starting balance £0 Mortgage loan credited £85,000 £85,000 (CR) Paid for house purchase £85,000 £0 House Buyer's Deposit Account Description Debits Credits Balance Previous balance £100 (CR) Received for house sale £85,000 £85,100 (CR)

Figure 9.2. House purchase transaction.

Again the money created from the loan is immediately used to pay off the loan outstanding on the 1st house buyer's mortgage account. This transaction is shown in Figure 9.3.

House Buyer's Deposit Account Description Debits Credits Balance Previous balance £100 (CR) Received for house sale £85,000 £85,100 (CR) Mortgage repayment £85,100 £0 House Buyer's Mortgage Account Description Debits Credits Balance Previous balance £96,242 (DR) Payment received £85,100 £11,142 (DR)

Figure 9.3. 1st house buyer's mortgage repayment.

After the 1st house buyer has transferred all funds to the mortgage account there is still a balance of £11,142 owing to the bank. As the 1st house buyer has no more funds, this is the amount the bank needs to write off. Again, it does this by transferring money from its earnings account to the 1st house buyer's mortgage account, as shown in Figure 9.4.

Bank's Earnings Description Debits Credits Balance Previous balance £6,142 (CR) Mortgage write off £11,142 £5,000 (DR) House Buyer's Mortgage Account Description Debits Credits Balance Previous balance £96,242 (DR) Payment received £85,100 £11,142 (DR) Mortgage write off £11,142 £0

Figure 9.4. After the 1st house buyer's remaining mortgage is written off.

And the bank's balance sheet after the 1st house buyer's remaining mortgage is written off is shown in Figure 9.5.

Bank's Assets 2nd House Buyer's Mortgage Account £85,000 Total assets £85,000 Bank's Liabilities House Seller's Deposit Account £90,000 Total liabilities £90,000 Bank's Equity Bank's Earnings (£5,000) Total equity (£5,000) brackets around the number indicates it is negative.

Figure 9.5. Bank's balance sheet after the 1st house buyer's remaining mortgage is written off.

This time, the loss of £11,142 has resulted in the bank having negative equity of £5,000, and negative equity means the bank is now bankrupt. We look at what happens to bankrupt banks in parts 18 and 19. Before we can do that, we need to look at debt securities, government bonds, and introduce central banks.

back to Part 8