Part 9. How banks go bankrupt
We showed in part 8 how banks can lose money on bad loans. Clearly enough bad loans could wipe out a bank's equity and bankrupt the bank. This type of bankruptcy is referred to as normal insolvency where assets are less than liabilities. A different type of insolvency, called cash-flow insolvency — which is caused by a credit squeeze or credit crunch — is looked at in part 14.
To see normal insolvency in action, let's go back to part 8, and this time consider the situation where the house is re-sold for £85,000 instead of £95,000. The loan creation is shown in Figure 9.1.
Figure 9.1. The mortgage loan transaction.
And the house purchase transaction is shown in Figure 9.2.
Figure 9.2. House purchase transaction.
Again the money created from the loan is immediately used to pay off the loan outstanding on the 1st house buyer's mortgage account. This transaction is shown in Figure 9.3.
Figure 9.3. 1st house buyer's mortgage repayment.
After the 1st house buyer has transferred all funds to the mortgage account there is still a balance of £11,142 owing to the bank. As the 1st house buyer has no more funds, this is the amount the bank needs to write off. Again, it does this by transferring money from its earnings account to the 1st house buyer's mortgage account, as shown in Figure 9.4.
Figure 9.4. After the 1st house buyer's remaining mortgage is written off.
And the bank's balance sheet after the 1st house buyer's remaining mortgage is written off is shown in Figure 9.5.
Figure 9.5. Bank's balance sheet after the 1st house buyer's remaining mortgage is written off.
This time, the loss of £11,142 has resulted in the bank having negative equity of £5,000, and negative equity means the bank is now bankrupt. We look at what happens to bankrupt banks in parts 18 and 19. Before we can do that, we need to look at debt securities, government bonds, and introduce central banks.
back to Part 8