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Part 18. How banks are bailed out

We will look at both bank bailouts and bail-ins, starting with bailouts. Let's continue with the banks and sets of accounts from part 17, and let's assume that 1st Bank has to write down its mortgage loan account (Mortgage Loan Account #1) by £10,000. This will leave the bank with negative equity. This transaction is shown in Figure 18.1.

Mortgage Loan Account #1 1st Bank Description Debits Credits Balance Starting balance £100,000 (DR) Mortgage write down £10,000 £90,000 (DR) Equity Capital 1st Bank Description Debits Credits Balance Starting balance £0 Mortgage write down £10,000 £10,000 (DR)

Figure 18.1 Write down of Mortgage Loan Account #1.

As this loan was securitised, we will also need to write down the security. For simplicity, let's assume 1st Bank takes the full write down on its security. The transaction for this is shown in Figure 18.2.

Mortgage Loan Account #1 Security 1st Bank Description Debits Credits Balance Previous balance £100,000 (CR) Security write down £10,000 £90,000 (CR) Mortgage-backed Securities 1st Bank Description Debits Credits Balance Previous balance £50,000 (DR) Security write down £10,000 £40,000 (DR)

Figure 18.2 Write down of Mortgage-backed security.

The balance sheet of 1st Bank is shown in Figure 18.3 (2nd Bank and Central Bank remain unchanged).

1st Bank's Assets Mortgage Loan Account #1 £90,000 Mortgage-backed Securities £40,000 Digital Reserves £45,000 Total assets £175,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £90,000 Deposit Account #3 £10,000 Government's Deposit Account £40,000 Total liabilities £185,000 1st Bank's Equity Equity Capital (£10,000) Total equity (£10,000) brackets around the number indicates it is negative.

Figure 18.3 1st Bank's balance sheet after the mortgage loan write down.

Now, 1st Bank is in trouble because it has negative equity of £10,000. It has assets of £175,000 and liabilities of £185,000. Assets minus liabilities is negative.

The government may decide it is going to rescue 1st Bank from imminent bankrupcy. It can do this by purchasing share equity in the bank using the funds in its deposit account. Let's assume the government purchases £20,000 worth of new shares. A share is simply an ownership stake in a bank or other business. The transaction for this is shown in Figure 18.4.

Government's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £40,000 (CR) Share Equity Purchased £20,000 £20,000 (CR) Equity Capital 1st Bank Description Debits Credits Balance Previous balance £10,000 (DR) Share Equity Sold £20,000 £10,000 (CR)

Figure 18.4 Purchase of share equity by the government.

And the balance sheet of 1st Bank is now shown in Figure 18.5.

1st Bank's Assets Mortgage Loan Account #1 £90,000 Mortgage-backed Securities £40,000 Digital Reserves £45,000 Total assets £175,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £90,000 Deposit Account #3 £10,000 Government's Deposit Account £20,000 Total liabilities £165,000 1st Bank's Equity Equity Capital £10,000 Total equity £10,000

Figure 18.5 Balance sheet of 1st Bank after the government bailout.

After the bailout, 1st Bank now has positive equity and is no longer bankrupt. There is £20,000 less in deposits at 1st Bank since £20,000 of the government's deposit was used to purchase shares in the bank; so, government bailouts reduce the money supply. The government is able to sell the shares at a later date to recover the amount spent. However, most likely the government would have paid considerably more than the shares would sell for now, and the bank would have to recover its share value first.

back to Part 17

Continue to Part 19:
How banks are bailed in