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Where did all the money go?

Posted By on December 24, 2008

When banks “lose” money, where does it go?

Does it disappear? Or does it just change hands?

I’ve heard this question before, but I’ve never heard a good answer.

Here’s my go at it.

To figure out where the money goes, you have to consider bank accounting.

A bank’s balance sheet is a list of all its assets (money lent out to others), and liabilities (money owed to others).

The difference between the two is a bank’s net worth, or equity.

A simple version might look like this:

Assets					        Liabilities

Mortgages:	         $1 billion		Deposits:		$1 billion
Consumer loans: 	 $1 billion		Short term finance:	$1 billion
Business loans:	         $1 billion		Long term finance:	$1 billion
Cash & reserves:	 $150 million		
						Equity: 		$150 million

Equity is critical because it’s what tells you if a bank is solvent.

In this case, the bank is solvent. It’s worth $150 million. That’s what’s left if the bank sells all its assets, and pays off all its debts. It’s what’s owed to the shareholders.

But suppose there’s a recession. The housing market tanks, businesses go out of business, and consumers, some of them, stop paying their bills.

When that happens – when loans go bad – they’re worth less. In some cases, they’re worth nothing at all.

The bank must write down the value of its portfolio of loans. It must estimate how much less they’re worth now than they were before people stopped sending them checks. In some cases, this is pretty straightforward. In others, less so. In this case let’s say everyone agrees only 90% of the loans are going to get paid back, meaning the value of the bank’s assets have declined by 10%.

Now the balance sheet looks like this:

Assets						Liabilities			

Mortgages:               $900 million		Deposits:		$1 billion
Consumer loans:          $900 million		Short term finance:	$1 billion
Business loans:          $900 million		Long term finance:	$1 billion
Cash & reserves:         $150 million		
					        Equity: 		-$150 million

What’s interesting about this is that the bank has lost $300 million without losing a dollar of cash. The only thing that has changed is the accountants’ estimation of what the banks loans are worth.

If they’re correct (and let’s say that they are), this bank is insolvent. If it were closed up today, the shareholders would lose $150 million (they’d lose everything). In addition, somebody would have to take another $150 million loss on top of that. In the race to see who has to take that loss, the loser would be whoever got there last (which is where the ‘run’ in bank run comes in).

The interesting thing is that the accountants did all this with the stroke of a pen.

The other interesting thing is that should the accountants take a more optimistic view, the bank can disguise its insolvency for quite a while. (Eventually, it will show up as a cash flow problem, but that’s another story.)

So the answer to the question, “Where does the money go?” is

When people don’t pay their debts to banks, the losses show up as “write-downs” on the value of the bank’s assets. Those losses come first from shareholders, and next from the bank’s creditors (which means you and me, and everybody who has a checking account).

In the short term, it’s up to the bank’s accountants to decide whether the bank is solvent. But in the long term, the bank’s ability to stay in business(to pay its obligations) depends on cash flow, not accountants. If the bank’s debtors can’t pay pay the bank, then the bank can’t pay you or me.

In the long term, the only way for an insolvent bank to survive is by hoovering up government money.

In which case, the losses are still paid by you and me – in the form of higher taxes.


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