Capitalism 2 and Capitalism Lab Forum

I stumbled upon this article recently that hints at the "core" mechanics of the banking business.
Obviously it points to just one (core) aspect, but worth reading for it´s a very easy read.

https://themacrotourist.com/endogenous- ... est-of-us/

Just wanted to add my one quarter of a cent to the developement of the dlc.

Warning: The first two paragraphs below are a description of how commercial banking works. The last paragraph are my suggestions for the game.

Essentially, from an individual bank's perspective, every time someone deposits $1, they can make $9 of loans (putting aside capital requirements and all that for a second). Since they don't actually have $9, they can't do this instantaneously. First, they can loan out the $1 to someone else who would initially deposit it in their bank. Now they have $2 of deposits, $1 of loans on their books, and $1 of reserves. Next, they loan the $2 to a new customer who deposits them back into the bank. The bank now has $4 of deposits, $3 of loans, and $1 of reserves. This process can continue until they have loaned out $9 for the original $1 that was deposited at which point they have $10 of deposits, $1 of reserves, and $9 of loans. Suppose that $5 they loaned out were actually immediately transferred to be deposited in another bank (Bank B). Now they have a problem because they have $9 of loans, $5 of deposits, and $0.50 of reserves, but they need a whole $1. Accordingly, they need to borrow $0.50 in reserves from another bank. The reserves are available in the system given that someone just deposited $5 in Bank B, so Bank B can loan them to Bank A to cover their requirement. If Bank B and all of the other banks don't want to lend the reserves to Bank A because they would rather use them to create their own loans, Bank A can pledge some of its assets (not typically loans, but I don't want to overcomplicate this example) to borrow them from the central bank.

This all assumes a 10% reserve requirement for the purposes of illustration ($1 of reserves for $9 in loans/$10 in deposits). This reserve requirement theoretically ensures that banks have enough cash on hand to cover withdrawals. In practice, I don't think it actually matters in the U.S. and banks typically hold excess reserves. The real determinant of loan growth is not the reserve requirement, but the rate of interest at which the Federal Reserve is willing to lend or borrow reserves. This determines the risk free rate at which banks can borrow money (from each other or the Fed). The lower this rate is, the more loans banks generally can make because they can offer lower rates on their loans to the real economy. Demand for loans is a function of economic conditions, investment opportunities, optimism about future household income, etc. as well as price (i.e., interest rate), which is where the Federal Reserve comes in. Banks don't make new loans (and create new deposits as a consequence) if the risk adjusted net interest margin on such a loan is inadequate to warrant holding equity capital against. Recall that banks need to hold fund some portion of their balance sheet with equity and other long term capital for risk and regulatory reasons.

***

I think the point here is that banks are really driven more by lending than by deposits in some sense because lending creates deposits. Now, the reality is that lending creates deposits for the system instead of deposits that go directly back to the lender. Recall that if Bank A loans a business money, the customer can deposit the money in Bank B in many cases. The implication for the game is that you can still lend money without having any deposits at all because you can just borrow the cash to fund the loan from another bank! It doesn't make sense really that the amount of deposits is what drives the amount of loans you can make. That should be dictated by your target capital ratio and perhaps whatever cash you want to set aside to invest in other stuff (bonds maybe). The benefit of deposits is that they are cheaper financing than loans from other banks. The more deposits you gather up to the amount of loans you want to make, the better your net interest margin should be. I think the implication is pretty simple.

Loan origination in the game should not be restrained by the amount of deposits. Loans and other bank investments should be automatically financed by wholesale funding at a rate above the deposit rate. The more deposits you have to offset, the lower your overall cost of funding should be. The amount of loans should be limited by the equity capital rate (no new loans can be originated if your equity capital ratio is below the minimum). Loan origination should also be made more interesting. We could have separate types of loans each with the same ratings tranches we currently have in the game. Instead of just generic branches, we could have mortgage banks, commercial banks, and retail banks. Each could collect generic deposits as they currently do, but also have a loan origination function. Mortgages would be long term loans with low interest rates but lower loss rates. Commercial banks would be medium term loans with medium interest rates and loss rates. Retail banks would be short term loans with high interest rates and loss rates. The volatility of loss rate as a % of the average loss rate for each type of bank would be (1) high for mortgages, (2) medium for businesses, and (3) low for retail/credit cards.

Hello Buells, and thanks for the comments.

It seems you didn´t read the paper attached. It´s dated 2014, from the Bank of England (Bank of England Quarterly Bulletin).
I just posted it because there MIGHT BE some folks around that might enjoy knowing the real stuff (like me).
I recommend you do as you got most of it wrong and you seem to be someone that would do enjoy it.

For your convenience:
https://www.bankofengland.co.uk/-/media ... rn-economy

Haha, that was a very kind way of telling me I am clueless on this, which may very well be true! I tried to recapitulate what I learned in my college macroeconomics class... that was a long time ago, so I may have gotten that wrong. The other possibility is that what I learned was a simplified example. I did read the original article you posted, which I thought was interesting.

Would you be so kind as to explain where you think I am off? I will read the BoE article you posted as well. My understanding is the U.K. doesn't have reserve requirements, so the mechanics might be a bit different.

What I (think I) do know is that the reserve requirement in the U.S. has no material impact on lending. I thought this was because the system always has excess reserves, and the Fed can control the price of reserves regardless of the quantities by essentially offering to borrow or lend an unlimited amount of reserves at a set price (the Fed Funds target rate). Accordingly, the supply of reserves wouldn't really matter. The reason why I provide the example in my first paragraph is to show that every bank needs to lend or borrow reserves, so deposits in a given bank do NOT limit its lending. Also, I think it is important to note that finding borrowers at a given credit risk adjusted interest rate IS a constraint and having deposits coming in does not magically allow the bank to lend them all out instantly in a remotely prudent way.

Is that understanding essentially correct?

buells wrote: Sun Dec 29, 2019 4:14 am Haha, that was a very kind way of telling me I am clueless on this, which may very well be true! I tried to recapitulate what I learned in my college macroeconomics class... that was a long time ago, so I may have gotten that wrong. The other possibility is that what I learned was a simplified example. I did read the original article you posted, which I thought was interesting.

Would you be so kind as to explain where you think I am off? I will read the BoE article you posted as well. My understanding is the U.K. doesn't have reserve requirements, so the mechanics might be a bit different.

What I (think I) do know is that the reserve requirement in the U.S. has no material impact on lending. I thought this was because the system always has excess reserves, and the Fed can control the price of reserves regardless of the quantities by essentially offering to borrow or lend an unlimited amount of reserves at a set price (the Fed Funds target rate). Accordingly, the supply of reserves wouldn't really matter. The reason why I provide the example in my first paragraph is to show that every bank needs to lend or borrow reserves, so deposits in a given bank do NOT limit its lending. Also, I think it is important to note that finding borrowers at a given credit risk adjusted interest rate IS a constraint and having deposits coming in does not magically allow the bank to lend them all out instantly in a remotely prudent way.

Is that understanding essentially correct?

First I have to say that I believe the paper does a fair enough job of telling "how", but not "why".
Second: Anyone with a properly furnished head will realize the information provided is a game-changer.

I can try to super-condense the scheme I have in my head with the fewest possible words.
So this will be the set-up of the game and process:

A-Players.
A1 There are four (systems):
governments, non-banks, banks and central banks.

B-Policy:
B1 Is created by system 4.
B2 Systems 3&4 MONETIZE ASSETS from systems 1,2&3.
B3 Systems 1&2 don´t monetize.

C-Assets:
C1 Can be present or future.
C2 Can be material or abstract.
C3 Can be domestic or international.

C.1-Valuation:
C.1.1 By proximity or by guess.
C.1.2 Measured in currency units.

C.2-Monetization:
C.2.1 Means here to create money, equal to the value of the asset.

D-Business:
D1 Fixed fees.
D2 Variable fees.

NOTES.
B Policy, meaning politics, meaning power.
b1 System 1 delegates policy to 4 (Basel III)
b2 System 4 is outlying.
b3 System 2 includes all producers.

C noun, it has qualities of:
c1 time
c2 substance
c3 space

C.1 Verb, acting upon C (First step)
c1.1 noun (established), or verb (to establish).

c.2 Verb, acting upon C (Second step)
c2.1 NO LOANS!

D how banks make money.
D1 fees on valuation
D2 fees on monetization (interest).

Now, anyone is free to add, substract or correct this scheme, just tell me. I could add stuff but then it will be just condensed instead of super-condensed.
Where I believe you are wrong is by assuming banks lend, and then lend deposits. The paper says they lend, but they create the money "first" before lending. Obviously you cannot lend something you don´t have, so monetizing is a verb I personally find more convenient to explain the process. Lending is just misleading.
As for "depositing", it also sounds misleading. It will be better to talk about buying and selling securities (aka. collateral, go figure!)
So a deposit will be your collateral, bought by system 3. Remember you don´t monetize being a producer (system 2), so this collateral of yours came from another member which owes it to system 3, (plus fees!)
This has interesting consequences to the whole system if you think on it.
Does the scheme above makes any sense? I´d like to tweak it here and there if neccessary.