Commentary to an article “Loan to deposit ratio and banks liquidity”

An article "Loan to deposit ratio and banks liquidity" shows inter alia:

- why control over liquidity was lost at all levels (individual banks, regulator, The Treasury) and the crisis and its scale came as a surprise

- why the scale of liquidity depth is very difficult to assess (based on traditionally reliable parameters like total loans to total deposits ratio and money multiplier)

- why banks are not lending and it is rather irresponsible to expect them to do so (this is a statement valid under the current circumstances; if the government took certain appropriate actions then the banks could be in position to start lending on a greater scale again).

As many politicians complain that banks are not lending to good businesses it seems not to be understood that a reason why lending remains severely restricted is not really creditworthiness of borrowers. Any lending deteriorates already fragile banks’ liquidity. Banks look like a rabbit caught in the headlights: if they start lending they deteriorate further their existing fragile liquidity position, and, if they do not, the economy goes down resulting in increased credit defaults and further deterioration of the liquidity position. A classic Catch 22.

Additional problem is that certain market players, who bought default swaps, possibly many times over the underlying credits, have an interest in defaults occurring as it is their way of making profit. This adds to the point expressed that short selling of shares is perverse in free market economy. If this happens on a small scale it does not matter and may be regarded as some kind of economic freedom. However on a macro scale this creates a perverse situation whereby there are huge and influential market players in whose interest is NOT the growth but deterioration of the economy. It appears that the government still did not get a grasp on the complexity of the current crisis.

ADDITIONAL COMMENT:

The banks' management lost control over liquidity under the following scenario. Liquidity is a direct function of money multiplier: i.e. how many liabilities on banks balance sheets a real £1 cash has to cover. Traditionally loan to deposit ratio (LTD) was the basis for calculating money multiplier (on a macro level). It is MM = 1/(1 – LTD) (LTD expressed decimally). But it only works if, at every deposit – loan cycle, LTD is below 1 (i.e. below 100%). Once LTD is above 1, at any deposit – loan cycle (even if it later goes down below 1, this macro control is lost. Money multiplier (MM) cannot be reliably calculated based on total loans to total deposits on a bank's balance sheet.

Calculating Money multiplier using straight reserve ratio is flawed. (It appears that this method was used by the banks.) It comes from the original notion, that with loan to deposit ratio below 1 (below 100%) reserve ratio R equalled 1 – LTD. So MM = 1/R.

However if loan to deposit ratio is equal or more than 1 (100%), and you use a formula MM = 1/R, it means that you consider your reserves (which are not strictly cash), as good as cash. As you keep lending with LTD above 1, you push cash on the market inflating assets prices and artificially improving your reserves. However each £1 cash has to serve more and more (at exponential pace) pounds on the balance sheets. So whilst your real money multiplier goes up extremely fast (£1 cash has to serve ever growing number of pounds on the balance sheets), you seem to maintain healthy balance sheets (in terms of R and, based on it, calculated MM = 1/R). However when a pyramid collapses, R goes down to the floor, and MM, as banks calculated, becomes astronomic. This leads to the banks losing liquidity and becoming insolvent.

The above shows the mechanics of the collapse of a pyramid that caused the current crisis.