We saw in part 9 how banks go bankrupt due to normal insolvency — when assets become less than liabilities.
We will now look at cash flow insolvency, which is caused by a credit squeeze or credit crunch.
We will go back to our banks and sets of accounts at the end of part 12
(rather than part 13 since they will be simpler to deal with),
and look at the situation where 1st Bank does not have enough
reserves to settle with 2nd Bank.
We can see this in action by "over lending" at 1st Bank,
transferring the funds to 2nd Bank and attempting to settle.
For the loan, we will create two new accounts, Loan Account #2
and Deposit Account #5.
We will assume a loan of £60,000 is made as shown in Figure 14.1.
Figure 14.1 Loan creation.
Next we will transfer the funds from Deposit Account #5 to Deposit Account #4 at 2nd Bank
as shown in Figure 14.2.
Figure 14.2 Deposit Transfer to Deposit Account #4.
And being an interbank transfer, we will defer settlement, as shown in Figure 14.3.
Figure 14.3 deferred settlement double entry.
Before settling, lets assume 1st Bank exchanges its remaining mortgage-backed securty
for reserves from the central bank. This will give 1st Bank extra reserves it can use to settle.
The transfer of the security is shown in Figure 14.4.
Figure 14.4 Transfer of the security.
And the complementary interbank double entry for the reserves transfer is shown in Figure 14.5.
Figure 14.5 Transfer of the reserves.
The balance sheets now look as shown in Figure 14.6,
with the blue arrow showing the balance outstanding between banks.
Figure 14.6 Balance sheets after the transfer of reserves.
Now we will settle using the same steps we used in part 12.
First we transfer £60,000 from 2nd Bank's Deposit Account to 1st Bank's Deposit Account, as shown in Figure 14.7.
Figure 14.7 Transfer from 2nd Bank's Deposit Account to 1st Bank's Deposit Account
To transfer reserves we need to again carry out two double entries with Central Bank.
The first is to reduce 1st Bank's reserves by £60,000 as shown in Figure 14.8.
Figure 14.8 Double entry to reduce 1st Bank's reserves
And the second is to increase 2nd Bank's reserves as is shown in Figure 14.9.
Figure 14.9 Double entry to increase reserves at 2nd Bank.
And finally we transfer the balance from 1st Bank's Deposit Account to 1st Bank's Loan Account to clear balances, as shown in Figure 14.10.
Figure 14.10 Transfer of the balance from 1st Bank's Deposit Account to 1st Bank's Loan Account.
And the balance sheets are shown in Figure 14.11.
Figure 14.11 Balance sheets after the transfer of reserves.
The red arrows indicate we have a problem with 1st Bank's reserve account.
It has actually gone overdrawn (as indicated by the brackets around the numbers).
The settlement just carried out would not clear.
In fact, 1st Bank would not attempt to carry out this transaction as it would fail
since, in general, banks are not allowed to have a negative balance or go overdrawn on their reserve account.
Generally, there is a minmum reserve requirement, although this has been zero during times of stress in the banking system.
This is a cash-flow problem, and is what happens when banks do not have sufficient funds to settle obligations.
Even though the bank's assets are not less that its liabilities, it does not have sufficient
reserves or other liquid assets it can use to settle, or collateral to borrow against,
and so is now technically insolvent.
You may be thinking 1st bank has a mortgage and loan account that can be securitised and used as
collateral, and you'd be correct.
However, during a credit squeeze or credit crunch, like in the
2007 – 2008 Financial Crisis,
lending between banks seized up and banks like Northern Rock and Bradford & Bingley in the UK,
and Lehman Brothers in the US, went bankrupt as a result.
We will look at how central banks can intervene in these situations in Parts 18 and 19,
but before we can do that we need to introduce government bonds.
back to Part 13