The Theory of Money, Part 18

Image credit: iastate.edu

Well I guess it wasn’t the “same bat time” this week because this post is a little late. If you recall, I left you with some suspense at the end of Part 17 when Indie Bank was on the verge of collapse due to a bank run getting triggered. But I’m sorry to say that that suspense is not going to be resolved in this post because, in reading through last week’s post, I realized I need to spend more time clarifying some of the details surrounding the whole Indie Bank financial situation.

So let’s look at a bunch of different details of the finances of these banks, which hopefully will come together by the end of this post to make my point.

Bank revenue. These banks in our fictitious society are simplified, so they only have one revenue stream, which is the interest they earn on the money they create through fractional reserve banking. If you’ll recall, Pepper Bank originally charged fees, but (something I never mentioned at the time) those fees mostly went away when it shifted to fractional reserve banking.

How can banks earn more from their one revenue stream? There are two ways: (1) they can push their reserve ratios even lower to lend out even more money, and (2) they can find a way to charge higher interest rates. The way to charge higher interest rates is by making riskier loans.

Bank costs. These banks also have costs. They have building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.

Bank profitability. Hopefully the income they earn (interest on their loans) is more than their costs. If so, then they have a profit, which either gets reinvested into growing the business or distributed to the owners of the bank.

Money the bank receives. Regardless of whether the debtors are paying their monthly loan payments in specie or receipt money, it’s all the same to Indie Bank. If someone gives them a Goldnote from Pepper Bank, they can simply go down the road to Pepper Bank and exchange it for a gold coin. Or maybe Pepper Bank has received some of Indie Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in our fictitious society, it’s all the same. Every bank’s Goldnotes are equal in value to one gold coin.

Breakdown of the payments banks receive. Each time a debtor makes a monthly loan payment, some portion of the payment goes to paying interest, and the rest goes to paying down the principal. Let’s pretend each bank actually takes each payment and stores the interest portion in the Revenue section of their vault, and the principal portion will be put in the Money to Lend section of their vault.

What is this money in the Money to Lend section? It’s the extra Goldnotes they printed for the sake of lending and have now gotten back. Picture it as a big pile of Goldnotes. They could keep them in their vault (out of circulation) or even burn them, and it would be like they’d never printed them in the first place–their reserve ratio would go back up to where it was before, prices would drift back to what they were before, etc. The only lingering evidence that they had existed at all would be (1) the nice pile of money in the Revenue section of their vault, (2) whatever benefits accrued to society as a result of someone being able to borrow that money and do something with it, and (3) the aftermath of all the costs to society that that money induced (discussed thoroughly in Part 15).

Did I just suggest the banker could burn that money he got back? Let’s not be crazy. No self-respecting banker would burn perfectly good money when it could be used again to lend out and start earning interest for him and his investors again! This is why this section of the vault is called the Money to Lend section. The banker is just waiting for enough Goldnotes to accrue in there so he can lend it to a new debtor.

All right, I think those are all the details about bank finances that are needed to better understand the predicament Indie Bank got itself into, so let’s jump into Indie Bank’s situation directly.

Let’s say Indie Bank, in an effort to be particularly profitable, was pushing its reserve ratio extra low so it could lend out as much money as possible. And let’s say that it was also making fairly risky loans so that the interest it was charging on that loaned-out money was fairly high.

Then the bad crop happened, and a lot of people lost some or all of their annual income. Suddenly a lot of people were defaulting on their loans. And since Indie Bank was making the riskiest loans, it found itself with a higher default rate than its competitors.

This meant that its Money to Lend pile wasn’t growing as fast, which was not immediately a big problem (they just have to wait a little longer before making another loan), but it also meant that its Revenue section was also not accumulating money as fast as it normally does. But its costs are mostly fixed costs, so the bank was still having to spend a lot of money from its Revenue section. This was a big problem!

Soon enough, Indie Bank’s Revenue section ran dry, and its leaders had three choices. They could (1) default on their payments to suppliers and employees, (2) print more Goldnotes and pay them with those, or (3) pay them directly with specie from the vault. Options 2 and 3 are basically the same–either way, the reserve ratio goes down and the vault gets further depleted of specie.

The leaders of Indie Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to some of those Goldnotes being exchanged for specie, and the vault’s piles of gold coins became progressively smaller. This is what led the employee to conclude that they were about to run out of specie altogether, which is why he ran home to tell his family to exchange all their Indie Bank Goldnotes for specie before they become worthless.

Ok, I hope this clarifies how a bad crop (or any other financial shock) can lead to a bank’s reserves getting low and eventually trigger a bank run. Next week we’ll talk about how the bankers respond.

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