Tuesday, November 20, 2007

Two trillion dollars is a catchy number

Banks make money by taking in deposits and lending them out at higher rates than it pays. They don't lend it all out - what they keep is called the capital ratio and it is typically around 10 percent of what they have lent.

For example, say a bank has $1,000 in outstanding loans. It keeps 10% or $100 in cash. That's $100 it won't lend because to do so would put its capital ratio below 10%.

Now say just 1% of the $1,000 in outstanding loans go bad, which is $10 of bad loans. The bank has to pay the $10 out of cash since the loan has to be repaid by someone. Now the bank only has $90 in cash; the maximum amount it can lend is $900. But it has $990 left in outstanding loans. Ooops, the capital ratio just went down to 9.1%.

The bank would need to reduce its lending another $90 to get back to a 10% capital ratio. That's a total reduction of $100 in lending: $10 for the bad loan and $90 to keep the 10% capital ratio.

The bottom line? A bank needs to reduce its loan balance by $10 for every $1 in losses.

Goldman's chief U.S. economist estimates that because of sub-prime mortgage losses, lending may be reduced by as much as $2 trillion, 7% of US non-financial debt, raising the likelihood of recession.

Now there’s a depressing thought.

2 comments:

JamesD said...

Larry,

Thanks for a fabulous set of posts -- helps make math relavant to all of us!

Just wanted to point out that after paying off the bad loan ($10), the bank only needs to reduce its lending by about $8.18 to bring its capital ratio back to 10% (because every dollar pulled out of the lending pool covers another $10 in current loans). Reducing the loans outstanding has two simultaneous effects---reducing the loan balance while also raising the capital balance (you left out this last bit in the post).

The capital set aside would then be $98.18 and the loans outstanding $981.82.

So, really a bank only needs to reduce its loan balance by about $1.82 for a $1.00 loss. Depressing? Yes, but not nearly as depressing as $10 would be!

Well, hope that's helpful! Thanks again for some great reading here on your blog!

James

Larry Shiller said...

Hi James,

I agree with your comment: assuming the reduction in outstanding loans is returned to capital your answer is correct.

Thank you for your kind words on the blog and for pointing this out in such a gentle manner, of which I'm 98.2% sure I am not deserving.

Larry