The Paradoxical Equation of Bank Debt | When a Liability Morphs into an Asset

Is it possible to lend someone money that you do not possess? In reality, the answer is probably no. The banking system, however, makes this unimaginable transaction possible through many complex mathematical mechanisms. On the flip side, it is perfectly possible for many of us to magically possess money–usually in terms of assets and goods–that we have not earned… and cannot even afford.

Banks have traditionally and generally been treated as financial intermediaries: the role of which is to connect borrowers with savers by facilitating their requirements and acting as credible middlemen. Individuals who possess more than their immediate consumption needs would deposit their surplus funds in a bank, thereby creating a large reservoir of funds that is cumulatively bigger than the sum of its individual deposits.

The bank then draws on those funds to loan out to those whose incomes fall below their consumption needs. While some bank lending is short-term in nature (i.e. an overdraft), most of it is long-term and ongoing. From the bank’s perspective, the loan is an asset while the deposit is a liability.

Commercial banks, in essence, create money in the form of bank deposits by making new loans. For instance, when a bank makes a loan to someone who is taking out a mortgage to buy a house, it credits their bank account with a bank deposit in the size of the loan. At that moment, new money is created. The exact mechanism behind the creation of commercial bank money has always been a controversial issue.

The amount of money that is ‘created’ when a loan is issued is equal to the principal sum of the loan. Nevertheless, the money needed for paying the compound interest of the loan has not been created and is entirely contingent on the future probability of repayment. As a consequence of this process, the amount of debt in the world exceeds the total money supply.

In consumerist societies, an array of fancy credit cards have become status symbols of wealth–signifying the bank’s willingness to lend. A premium credit card is associated with high social status and higher fees, but recent research suggests that people choose them because it signifies higher income.

Since the 2008 Financial Crisis, many have claimed and asserted that banks create money out of thin air. From an economic viewpoint, however, commercial banks create money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one. The fact remains that a bank’s ability to create money through lending is constrained by many factors–rendering the concept of unlimited money creation implausible. When banks create money, they do so–not out of thin air–but rather, they create money out of assets. Assets which are either very valuable or assets that will become valuable in the future.

Without an asset–whether a tangible one or an illiquid one–it is not possible to continuously create money. Problems in the banking sector played a critical role in triggering and prolonging the two greatest economic crises of the past 100 years: the Great Depression of 1929 and the 2008 Great Financial Crisis. In both cases, insufficient regulation of the banking system was cited to have contributed to the crisis.

The fault, however, is many fold. If we borrow beyond our means and are allowed to borrow beyond our means–and if this happens on a large scale–it can, and does, send a shockwave through the entire banking system. If banks misjudge the ability of their borrowers to repay, it magnifies the ability of banks to create financial boom-bust cycles. It also permanently ties the creation of money to debt creation, which becomes problematic when ballooning debt levels trigger financial crises.

While it is possible for banks to loan out money that they do not possess, it is simply not possible for banks to do that without a sound backing and basis for the transaction.

On the flip side, while it is perfectly possible for many of us to magically possess money–usually in terms of assets and goods–that we have not earned… It should still serve as a reminder of the many days when we will be called to repay.