Friday, June 04, 2010

Accounting for Loans, deposits, and equity

winterspeak reader TH asks:
There's just one part of introductory MMT that I can't quite figure out: why, if loans create deposits, can a banking system have a loans-to-deposits ratio other than 1? Do some loans somehow not
create deposits in equivalent amounts?
Bank loans, of course, are not the only thing that creates deposits. Deficit spending creates deposits with their being no private sector loan associated with that.

Non-bank elements of the private sector can also, of course, extend credit -- for example, by issuing bonds. Here, the borrower expands its balance sheet just like before, but the non-bank borrower does not, he just changes the composition of his assets.

Here are some related threads that happened to be going on elsewhere. First, from Mosler:
“He seems correct to me — can you take us through t-tables to show how deposits increase when private credit is extended in this way?how deposits increase when private credit is extended in this way?”

Deposits don’t need to increase as a result of this. That’s orthogonal, unless you are defining “credit” to be solely deposits, in which case you need another word for equity, bonds, money market mutual funds, and commercial paper. As well as repos and other credit-market instruments I must have missed. :P It’s good to stick to standard usage, as all of these are considered to be “credit market instruments”, and an increase in any of these corresponds to an increase in “credit”.

I think, if you want to only talk about deposits, then say “deposits”, or “bank credit”, if you prefer.

Just as with bank loans, the supply of credit market issues expands and contracts as return prospects change, and as a result, the quantity of deficit spending increases and decreases, causing the quantity of cash-flow surpluses to increase and decrease (which helps or hurts the thirsts of savers for more and more and more financial assets :P)

Any liquid IOU takes on the characteristics of money or “credit-money”, and the stock of these IOUs contribute to the stock of financial assets held by households. If the issuer of the credit market instrument is outside the household sector — say in the business sector, which would be typical for corporate bonds or equities, then an increase in these assets causes an increase in household net financial assets.

“So, the firm has a larger balance sheet, but the household has a balance sheet the same size.”

Yup. The borrower’s balance sheet is key. The borrower incurs a liability — to repay the loan, or to repay a bond — as well as an asset — a deposit, or money market fund, however he decides to park his short term assets while he goes about deficit spending.

But the point is that the borrower does not hang onto his asset. The loan is used to buy a house or car, and the bond is sold to expand industrial production. So the borrower then turns around and spends the asset (technically, he sells it for cash, pays the cash to someone else, and that person buys some financial asset with the cash — maybe a deposit, maybe a money market fund, maybe a bond — who knows?).

The bank borrower pays the homebuilder or the car maker, who in turn supplies wages and capital income to *someone* in the household sector, increasing that person’s financial assets. In the same way, the bond-seller turns around and invests in productive capacity by paying employees and parts suppliers, etc, and that ends up also increasing the wages and capital income of some households.

In both cases, investment is self-funding, and the “savings” of the fortunate workers or capital owners whose financial assets increased as a result of the deficit spending ends up being the accounting record of borrowing — whether that borrowing takes the form of selling bonds or borrowing from a bank.

As an aside, you can look at the various forms of credit market borrowing in table F.4 in Z.1. Hope that helps
Also, an oldy but goodie from JKH regarding equity (comment 188):
This is a response to Mahaish’s questions # 134 and # 151. It is a macro accounting explanation of the concept and measurement of household net worth, in the context of the Chartalist accounting model. It is not intended to address issues beyond that.

The top-down Chartalist sector balance sheet decomposition is that of government and non-government sectors. Although this breakdown could be applied globally, one typically would choose a particular national balance sheet to model, and then anchor the model with the corresponding government sector.

So let’s take the United States and the US government.

The entire United States balance sheet can then be modelled according to government and non government sectors.

The non government sector decomposes further into the private sector and the foreign sector. We can alternatively refer to the private sector as the domestic private sector, or the domestic non government sector.

The private sector decomposes further into the household sector and the non household sector. The non household sector is mostly incorporated and unincorporated business, including financial institutions.

The US household sector balance sheet as at June 30, 2009:

(Numbers rounded)

Total assets $ 67 trillion
Tangible assets 25 trillion
Financial assets 42 trillion

Liabilities 14 trillion
Mortgages 10.5 trillion
Consumer Credit/other 3.5 trillion

Net Worth $ 53 trillion

Household tangible assets of $ 25 trillion include about $ 20 trillion in real estate and $ 5 trillion in consumer durable goods.

Against financial assets of $ 42 trillion we net $ 14 trillion of liabilities (which are of course financial) to arrive at:

Household Net Financial Assets $ 28 trillion

This household net financial asset total is significantly larger than the total level of non government net financial assets for all sectors. The conceptual and numerical difference is explained below.

Any household financial asset that is not a direct obligation of the government must by definition be the obligation of another non government entity.

E.g. a corporate bond held by the household sector is the liability of the corporate sector.

Therefore, although the corporate bond contributes to both the gross and the net financial asset position of the household, it does not contribute to the net financial asset position of the entire non government sector, due to cancellation of the household asset against its corresponding representation as a non government liability.

This relationship holds for all financial claims of non government entities on other non government entities.

Importantly, this includes equity financial claims. This can seem a bit counterintuitive. Equity claims represented in the usual way on a balance sheet are not categorized as liabilities. However, the essential double entry book keeping characteristic is that they are on the right hand side of the balance sheet. The right hand equity entry directly offsets the corresponding asset entry on the balance sheet of the equity claim holder.

E.g. common stock held by the household sector is that sector’s financial asset. It is not technically a liability of the corporate sector. Nevertheless, it is a financial claim issued by the corporate sector in the sense that the owner of the stock has the right to benefit from all cash flows and valuation effects that accrue directly to the stock (dividends and marked to market stock price changes). This benefit reflects a comprehensive valuation of the operation of the issuer, including its deployment of real assets, its use of liabilities, and its ability to generate profits, etc. The point is that even though common stock is not categorized as a balance sheet liability, it is a financial claim issued by the corporate sector and a financial asset held in this case by the household sector. Common stock and equity claims in general are treated as a financial asset of the holder and a financial obligation of the issuer (cash flow and marked to market evaluated), and because of that essentially net to zero when consolidating the net financial asset position of the non government sector. The residual as a result of this equity netting includes the real assets of the issuer that are instrumental to the generation of such gross equity value. Depending on the objective of a given measurement exercise, those real assets obviously can also be valued separately from their representation as value embedded in the liability and equity structure of the issuer’s balance sheet. They are excluded from direct representation in the measure of net household worth because their implicit valuation has already been transmitted via the direct debt and equity valuation of the enterprise.

The household sector, in addition to holding direct financial claims in such forms as bonds and stocks, also holds financial assets in the form of mutual funds, pension funds, life insurance, and unincorporated business equity. Again, these positions are all represented as obligations of the issuer, and therefore all net out on consolidation with the household sector’s corresponding assets in the calculation of non government net financial assets. From the asset perspective alone, they constitute a large component in the gross financial asset position of the household sector.

One could similarly work through the balance sheets of the non household domestic private sector (incorporated and unincorporated business, including financial institutions) and the foreign sector. The business sector has a substantial net negative financial asset position, reflecting the corresponding net tangible or real asset position referred to above. The foreign sector has a positive net financial asset position, reflecting the result of a cumulative US current account deficit, with certain balance sheet items valued on a marked to market basis.

If one then nets the net financial asset positions of all these sectors against each other, the result will be an aggregate net financial asset position equal to the government net liability position, as per the Chartalist overview. Financial claims between non government entities net to zero. But government to non government financial claims don’t. The primary reason for this is that governments tend to issue more claims to non government than vice versa. The latter direction is quite possible of course. That is what has happened to a limited degree in the case of the US Federal Reserve accumulating private sector credit assets, and in the case of the US Treasury injecting TARP capital into the banking system. But such unusual US government financial asset activity has been mostly offset at the same time by the issuance of additional excess reserve base money by the Fed and additional bonds by the US Treasury. Beyond that is the aspect of outstanding and expanding US Treasury debt that reflects the more typical creation of net government liabilities due to government deficit spending. It is this latter net mismatch that results in the corresponding vertical net financial asset accumulation of the non government sector.

Two concluding points:

First, the net worth of US households was calculated at $ 53 trillion as at June 30, 2009. This includes “real” assets of $25 trillion and net financial assets of $ 28 trillion.

This net financial asset measure of $ 28 trillion is one of deceptively wide scope.

One may ask where the real assets of business can be found in this calculation. Where is the measure of plant and equipment investment value in the United States? Where is the left hand side of the business balance sheet?

The answer already alluded to above is that the real assets of businesses are reflected implicitly in the value of their financial obligations, which are included comprehensively in the value of household and foreign sector gross financial assets. This includes as well business liabilities and issued equity claims that are held indirectly through such household financial assets as mutual funds and pension. All business assets are reflected in this way. This is double entry book keeping hard at work.

Second, although this describes the connection between non government net financial assets and household net financial assets, one must delve deep into the various sector gross positions in order to extract the exact location of government issued liabilities held as assets by the non government sector. It’s there. You just have to look for where the government bonds are, as well as Federal Reserve currency, and finally central bank reserve balances.

(BTW, those who are interested in the consolidated treasury/central bank government position can find expert commentary from the various Chartalist oriented economist bloggers, including Scott Fullwiler, Randall Wray, Warren Mosler, and of course Bill Mitchell. But in summary, the net balance between government and non government includes the gross effect of central bank reserve balances issued to the banking system, central bank currency issued to the non government sector, and treasury debt issued to the non government sector.)

The bonds in particular are all over the place. For example, foreign central banks own trillions of US treasury bonds and bills, most prominently in China and Japan. Those central bank bond holdings are part of the gross US financial assets held by the foreign sector. In turn, the foreign sector in total has a net positive financial asset position with the US as counterparty (again the result of the cumulative US current account deficit).

The foreign sector thus includes a net asset position with the US government sector, embedded within its larger gross financial asset position with the US, and in conjunction with its total net financial asset position with the US. When one recognizes that the net horizontal asset position of the non government sector must sum to zero, one can then attempt to identity the location of the net vertical asset positions embedded in each defined horizontal sector. The foreign sector clearly has a net positive vertical position according to its bond holdings and some currency. The household sector actually has a modest vertical position relative to its size, consisting of bonds and currency. The rest of the vertical position exists in the non household private sector. Ironically, although this sector has a large net negative financial asset position, most of the net positive vertical position can be found in the gross assets of financial institutions and pension/life insurance investment funds. Against this would be netted the effect of Fed Reserve private sector credit and Treasury TARP funds. Thus, one may decompose sectors according to their positions in net financial assets, as well as their positions in net government assets. The sum in both cases will be the same, according to the overarching Chartalist axiom of aggregate net financial asset equivalence, with the government deficit equal to the non government surplus.

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7 Comments:

Blogger Ramanan said...

Winter,

There are many questions one can ask. I believe the reader TH may be asking this from an individual bank's viewpoint. For for him/her, the simplest answer is that deposits may move out and be replaced with interbank liabilities.

In case TH is looking from the perspective of a banking system:

Government deficits do create deposits but in the US, banks hold less Treasuries so bond sales would drain most of the deposits created by spending, so less likely the explanation.

There is another way deposits are drained. Issue of equities/bonds by banks drains deposits.

To complicate things, there is a lot of securitization done in the US, and the outstanding I believe could be anywhere between $7T to $10T. Issue of securitized products also drains deposits because the banking system attracts the deposit holders to buy to these products.

Apart from wages paid by banks, there is another way deposits can increase/change: purchase/sale of FX and/or real assets by banks increases deposits because they pay by increasing liabilities.

1:53 AM  
Blogger winterspeak said...

Ramanan:

TH was talking from the perspective of the banking system.

Good point about Treasury purchases draining deposits. That's true whether it's a household or a bank doing the purchasing, of course.

And yes, since all bank spending is done by balance sheet expansion, that create/reduce deposits without the corresponding asset being a loan.

I'm not sure about securitization. If I buy a MBS, my deposit account is debited, and some other deposit account is credited. Isn't that just an asset swap?

6:27 AM  
Blogger STF said...

The other thing to note is that deposits don't always stay deposits. I can use my deposit at my bank to purchase a CD at my bank, or transfer it into a MM account, or a savings account both at the same bank. Or I can transfer my deposit into any of these sorts of liabilities at any other bank. Any of those transactions result in a decrease in deposits and an increase in the other type of bank liabilities.

Scott Fullwiler

8:58 AM  
Blogger Ramanan said...

Winter,

Yes secondary market purchase will be the way you described.

At the point of creation of these securitized products things happen differently. Let us assume that the economy has the sectors households, production firms, banks, central bank and the government. Household purchase financial securities directly. When a pool of loans is securitized and sold, the following happens:

Initially the pool of loans made increase the deposits of the banking system. Then,

1. An SPE is formed.

2. The bank pools these loans and "sells" it to the SPE

3. The SPE creates ABSs and sells it to the bank.

Steps 1, 2 & 3 happen simultaneously.

3. The bank sells it to households and debits the deposits and issues the Asset backed securities.

Later when the ABS is traded, the total deposits do not change. At the creation they do.

Its a liability management trick. The SPE has loans as assets and ABSs as liabilities. However, the SPE belongs to the bank itself and the ABSs are the bank's liabilities, though off balance sheet.

Its really tricky. The bank makes a gain because it sells the loans at a price above the book value and since the loans go off balance sheet, it makes a regulatory arbitrage - its capital adequacy ratios improve!

I had intentionally combined the household sector and the financial sector to simplify. Else it is difficult to see. The financial sector usually purchases these ABSs and MBSs - but then one runs into complications about the financial sector selling some other security to purchase the ABS and one loses track of the whole chain.

11:03 AM  
Blogger Ramanan said...

There is another way to look at this.

Consolidate the banks' and SPEs' balance sheets. The loans appear back in the combined entity's balance sheet. In the liabilities, however one has MBSs' instead of deposits.

However, since they report on-balance-sheet numbers, banks may have loans and deposits of similar size. However if you count it via other sectors such as households, businesses etc., the loan numbers may be different i.e, the total loans may be much higher than what banks' balance sheet may show.

12:49 PM  
Blogger winterspeak said...

Excellent points, thank you!

3:30 PM  
Blogger VJK said...

W:

I wonder what MMT'er balance sheet/accounting treatment of the profit paradox might be, i.e. more or less detailed SFC description of monetizing profits.

Here's what I posted on http://bilbo.economicoutlook.net/blog:


---------------------
Speaking of profits and looting.

How does MMT treat the paradox of profits ?

[In a closed system without external exchange, with money created by banks through loans, the private sector financed by such loans can hope to recover only the original loans by selling the totality of their products. When the principal was repaid, there is nothing left for either profits or even interest (see the circuitist theory, e.g. Graziani)].

Steve Keene approached the problem with some unorthodox accounting, but some mmt’er (I do not recall who exactly) commented that (s)he was puzzled by the paradox without elaborating much.

Since the private sector consolidated sheet balances to zero, how do mmt’ers ‘monetize’ profits in the accounting sense ? Where does money come from (my hunch is that the CB has to be involved to generate new money)? Could an mmt’er in the know describe a more or less detailed sequence of money flow through balance sheets that leads monetizing profits ?

I am familiar with various circuitist attempts to solve the paradox, however, I could not find any SFC MMT treatment of the problem.

Thanks.

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9:53 AM  

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