Monday, April 07, 2008

Assets & Liabilities & Myths About Write-downs

When the issue of bank losses is discussed, I frequently read statements which indicate ignorance about basic principles of corporate accounting. Such as the assertion that write-downs of bad debt will reduce the money supply or that write-downs is the explanation for the low level of bank reserves rather than the explanation I mentioned the other day. Both of these assertions are false, for reasons I will explain. But in order to explain it I must explain some of the most basic principles of corporate accounting, or more specifically the balance sheet of corporations.

A corporate balance sheet consists of two sides: assets and liabilities. The liabilities side includes owner's equity, which can be viewed as a liability towards the shareholders. Assets and liabilities must in accordance with the principle of double entry book-keeping always be equally large. This is essentially true by definition as owner's equity is defined as the residual left after subtracting external liabilities (debts) from assets. Any increase or decrease in the value of assets must be matched by a equally large increase in the value of the liability side of the balance sheet, whether through external liabilities or owner's equity or a combination of them.

So, returning to the issue of write-downs, if there is a write-down in the value of certain bank assets, such as mortgages, this means that there must be a similarly large decrease in the liabilities side of the balance sheet. Which liabilities will be written down then? Since people depositing money in banks or in other ways lending to the bank have usually not assumed the credit risks for the loans banks makes, this must mean that owner's equity is what will take the hit. This has relevance for the issue of the effect from write-downs on the money supply. Owner's equity is not part of the money supply. The only bank liabilities that are part of the money supply is customer deposits. But as long as the banks do not collapse, the value of customer deposits is unaffected. And bank collapses are not something which the Fed is going to accept. This means that although write-downs will lower the value of bank credit, it will have no direct effect whatsoever on the money supply (It might have indirect effect though, if it makes banks more cautious to issue new loans).

What about the effect on bank reserves? There will be no effect on bank reserves either. The reason is that bank reserves just like bank credit are a form of asset. Bank reserves consist of physical cash held in bank offices and ATMs as well as bank deposits at the central bank, i.e. Fed in the United States. If the value of bank loans is written down this will only affect the liability side of the bank balance sheet, i.e. owner's equity as previously stated. It will however have no effect on either the value of the physical cash the bank have or the value of its deposits at the Fed. And for that reason, it won't have any effect on the level of bank reserves.


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