Financial instability and banks’ balance sheets: A note

H Abraham

doi:10.4102/sajbm.v43i3.477

Abstract

Following the recent financial crisis, it is sometimes argued that financial institutions should be regulated to a greater extent than before in order to prevent a recurrence of global financial crises. It is argued here that since banks create liquidity ex nihilo in exchange for financial collaterals whose nominal values are subject to market fluctuations, in general, banks’ regulation can have only a limited effect on the stability of the financial system. Monetary policy of central banks (i.e., setting short term interest rate) is essential to monitor asset prices and thereby create a stable financial environment.

Highlights

It is the norm in the banking system that loans make deposits (e.g., Allais, 1987)
The creation of loans, and thereby liquidity, by banks is not restricted by demand deposits; the creation of liquidity is an internal decision of the bank and is not dictated by the volume of the bank’s demand deposits. (The creation of liquidity is an internal decision of the bank because the bank itself decides which IOUs are sufficiently credible for the provision of loans.) it is argued here that based on the fact that (i) loans make demand deposits, and (ii) banks make loans in exchange for collaterals, in the form of IOUs, whose nominal values depend on the state of the economy the stability of the banking sector depends on economic stability
Financial crises, and in particular banking crises, are symptoms of economic crises, where economic booms are reversed by economic downturns. This scenario contrasts the current literature (e.g., Diamond & Dybvig, 1983; Green & Lin, 2000) where it is claimed that short term deposits make long term loans and mistrust amongst depositors is to blame for bank runs and financial instability

Summary

Introduction

It is the norm in the banking system that loans make deposits (e.g., Allais, 1987). For any IOU from a borrower maturing at a certain date in the future the bank issues a loan for payment on call. Financial crises, and in particular banking crises, are symptoms of economic crises, where economic booms are reversed by economic downturns This scenario contrasts the current literature (e.g., Diamond & Dybvig, 1983; Green & Lin, 2000) where it is claimed that short term deposits make long term loans and mistrust amongst depositors is to blame for bank runs and financial instability. The lack of sufficient liquidity (should all depositors require their deposits simultaneously), which is inherent in the maximization process of the bank acting as a central planner, forces all long term depositors to be suspicious of each other This leads to the impossibility of the bank’s existence.

Loans make deposits

The market of mortgages

Policy implications