Sunday, November 27, 2011

savings bank making loans

Edward,

(New thoughts below. We were distracted by "fractional reserve banking" concept, which doesn't apply to Thomas, OrangeUnion or KS. For a real example, I actually deposited $1600 in Citibank but I know I can't take out $5000.)

Suppose Thomas is a small venture fund with $2 million of real cash. Thomas likes a start-up called Prism so he invests $2m in Prism. Now Thomas has $0 balance. Thomas likes another start-up CakeHealth, so he invests $1m in CakeHealth.  Both cases, Thomas gives a check from his CapitalOne corporate account. Both start-ups have bank accounts in Chase. When CakeHealth cashes in the $1m check, it bounces.

In theory, CapitalOne may implicitly give Thomas a credit line of $1m when CakeHealth cashes the CapitalOne check drawn against Thomas's depleted account. Question is how much credit. In fact, since there's no collateral, I doubt CapitalOne will give the $1m unsecured loan. If CapitalOne were so generous, then many Thomas's would queue up to take advantage of it -- deposit $100k and take out $200k to buy gold. Bank would soon collapse. I know that in reality a commercial bank like CapitalOne looks at each application when handing out loans -- not implicitly or automatically approved.

That's story 1. Now Story 2. Orange bank is a tiny private (unregulated) savings union not registered with Fed or FDIC. It can't even print checks. OrangeUnion takes deposits from local residents totalling $20m. Depositors mostly use CD's. Then a McDonald's franchise shows up to borrow $20m so OrangeUnion lent her. Then KFC wants to borrow $10m and OrangeUnion lent him. Both loans mature in a month and get repaid. Then McDonald's borrows $22m and KFC $11m, but for 10 years. Now OrangeUnion must be careful because it can't get the money back quickly. 

But let's analyze the first OrangeUnion 2 loans. Suppose the $20m deposit is maintained in a Citibank account owned by OrangeUnion. McDonald's gets the loan amount in a $20m Citibank check. McDonald's owner deposits that in her corporate account in Citibank (Citi just transfers the $20m from one account into the other.) Then she writes a check of $20m to pay her supplier. No problem. Orange's Citibank account and McDonald's bank account both become $0. Now KFC gets the $10m loan from OrangeUnion in a Citibank check and tries to deposit it into KFC's account with Wachovia. Check Bounce? In that case, this OrangeUnion has absolutely no leverage as a lender. It can only lend out $20m if it has $20m deposit.
I now think OrangeUnion (or Thomas) has no leverage.

Story3 is a regular savings bank -- say AppleBank. Somehow AppleBank does have leverage. If it has $20b deposit, it CAN lend out more than that. What's the real difference between AppleBank and OrangeUnion? I guess answer is the regulation. The central bank gives AppleBank its leverage and central bank has some kind of control over its lending practice.

Story 4 is an investment bank KS. No Fed no FDIC. KS __borrows__ $3b from short term money market, but how can it lend $2b to Shell and then $4b to BP in investment banking deals? Say KS checks are issued from BofA, when both Oil companies take money out of the checks, they will more than deplete the $3b cash KS puts into its account with BofA! The BP check will bounce?

Note KS has to _borrow_ from money market because it can't freely borrow from central bank -- no fractional reserve banking for KS.

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