Monday, July 9, 2012

This is why you cannot get a loan.

Good morning economists. Today we will discuss the lack of liquidity in the banking sector and why it has become difficult to secure loans from financial institutions. Did you know that every time a bank gives a loan, it essentially creates money?

Let's review a simple example. Suppose Andrew walks in a newly established bank and deposits 100 Euros. He walks away with a deposit slip and assumes that his money is safe in the bank. Now suppose that Mary walks in and requests for a loan of 90 Euros. In order for the bank to make a profit on the transaction it needs to lend money to Mary at a higher interest rate than it is paying Andrew. So it will approve Mary for a loan and Mary's account now has 90 Euros.

So out of the initial 100 Euros deposited by Andrew, the bank has created an additional 90 Euros in loans to Mary. Both Mary and Andrew can in principal spend 190 Euros. The problem arises when both Mary and Andrew show up at the bank asking for cash. Remember, there is only 100 Euros available as physical cash. The remaining 90 Euros is virtual money arising from the loan. We call this problem "a run at the bank".

This is exactly the problem faced by many financial institutions, namely the lack of liquidity to satisfy both depositors and borrowers. The problem was caused by the inability of central banks all over the world to control the lending patterns of the financial institutions. As a result, a lot of people will default on their loan payments and this will in turn decrease the amount of virtual money in the economy. The liquidity problem will subside only when the amount of virtual money has decreased enough so that existing cash is able to sustain the economy.

Have a nice day!

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