A profitable supermarket versus a profitable bank

This post just follows up from the last where I compared a bank to a supermarket which retains it's earnings. There is an important difference between the two, which helps to clarify the point that has been made.

As far as I can see, the difference between an earnings retained Sainsburys (if excess profit-as-cash isn't given back to shareholders but retained, say in a vault) and the desert-island bank - is that Sainsburys sucks in cash; whereas the desert island bank has an outstanding /obligation to receive cash/ which may or not be covered by any 'real' cash existing in the system (it is conceivable that there is not enough cash & deposits in the system to substitute for cash). Bank deposits /can /substitute for cash (until all the deposits are used up) but in this thought-experiment world, there can be a retained obligation for the guy to supply something (cash) which he can't get from anywhere since it does not exist outside the banks and the central banks. In that case there will be large amount of unrequited demand for cash (the debt obligation).

There appears to be only a few ways that cash can be got into the non-bank system, to supply the outstanding obligation. The main options are if the cash in the bank or central bank is used to buy up real assets. Presumably if the bank(-owners) have market power then they would be able to enforce as low cash-price for the assets in exchange for the outstanding debts (in other words there will be a fall in asset prices). In other words, the removal of the outstanding debt obligation /does not have to be /in the form of a default; it could be that the bank invests in property directly; or that the earnings are distributed to shareholders, who themselves invest in property. However, the bankruptcy choice is /more likely/ if asset values fall (and if the decision rest primarily with the debtor) because bankruptcy transforms the obligation to hand over the now-low-value asset rather than a costly cash-obligation.

Thus deleveraging will cause a fall in asset values and either
a) a settlement of the outstanding debt due to the banks or the shareholders of the bank physically buying real assets in exchange for cash
b) default and the exact same process taking place, except that the banks get less for their money

in the same way that in an upturn the reverse is true (leveraging is accompanied by increasing asset prices and low default rates).

I'm not sure of the real world relevance of this primordial example but it does perhaps emphasize that giving banks cash in exchange for assets will not solve the problem, because the key is the cash shortage in the real economy and not within the banks.


TheClimatePhilosopher said...

Just to be crystal clear:
The remaining debt obligation by the guy to the bank can of course be settled with cash or deposits, if the guy can get hold of any. The guy (who in the desert island example is the entire non-bank economy) can get cash or deposits by selling assets (perhaps indirectly) to those who have cash (ie the bank). Therefore so long as the bank doesn't sit on it's cash assets but instead invests them in real physical assets (holds non-financial assets on it's balance sheet for it's retained earnings). Unless there are barriers (institutional?) for investing in physical non-financial assets there is no cash shortage. (* Of course there may be other problems with the banks investing in non-financial assets (volatility) or distributing earnings to employees or shareholders (lack of capital); probably the best option might be for the banks to hold their net assets in gold or equity, rather than cash).

TheClimatePhilosopher said...

Government bonds (e.g. UK gilts) are probably the best place for the banks to store their retained earnings.

Imagine the government wants to borrow from the public. It then sells a bond to the guy in the earlier story.

Later when the guy doesn't have enough cash to pay the bank, he instead sells the bank the government bond in exchange for cash. He can then pay off his remaining debt obligation for cash. Net result. The bank is a bond richer. It now has £100 in cash and £50-worth of bonds. The guy is £50-worth of bonds poorer.

What this suggests is that the capital that banks hold perhaps could increase over time: but that the capital should neither be held in cash nor distributed to shareholders; it should be held in non-cash assets on the balance sheet. Rather than requiring a certain amount of capital, perhaps, the government should charge banks a premium for bankruptcy protection, the more retained capital you have, the lower the charge!

Robin Smith said...

Oops.. forgot to mention. Am I correct in suggesting that government bonds are closer to an official ponzi scheme? As far as I understand it they issue bonds with a lifetime and when they expire, they do not pay back from the balance created by the bond holders. They just issue more newly created bonds and use the proceeds from that to settle with the holders. Is this correct. If so it sounds just like a ponzi scheme? Apologies if its nonsense.