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Cooking the Books: Southsea bubble

On 17 June the papers reported the failure of a bank. It was only a small bank in Hampshire with a single branch. But it was a bank, subject to the same regulations and basic practices as any high street bank. It took in deposits and loaned out money.
Called the Southsea Mortgage and Investment Company, it had 267 depositors whose deposits totalled £7.4 million (Daily Express, 17 June) and lent money to people, mainly to buy a house, or to finance property developments. It was the failure of one of its property investments that led to its assets becoming less than its liabilities. In short, to becoming insolvent, to it not having enough assets to cover the value of its liabilities, in particular what it owed its depositors.
The Southsea bank was set up fifty years ago. At that time all UK banks were required to keep a “cash ratio” of 8 percent, which meant they had to retain 8 percent of all money deposited with them as cash. The other 92 percent they could lend out at interest. Interest is of course the main source of any bank’s income, its profit coming from charging a higher rate of interest to lenders than it pays to its depositors.
This is still how banks operate today, even though there is no longer any formal requirement for a bank to keep 8 percent of deposits as cash. It’s now up to their own business judgement to decide how much or how little money they can safely retain as cash (or assets quickly convertible into cash) to meet withdrawals.
Some people think that a cash ratio of 8 percent means that, when someone deposits £100 in a bank, that bank can then immediately lend out an amount of which £100 is 8 percent, i.e. £1250. There is in fact a whole school of currency cranks who do argue this and claim that banks can “create money” (make loans) “out of thin air”. They are obviously wrong. What an 8 percent cash ratio means is that if someone deposits £100, the bank can lend out £92.
The “thin air” school of banking is based on a misunderstanding of something that is in economics textbooks about what the whole banking system can do over a period of time. The textbooks set out a scenario of what happens to the £92. They assume that it will be spent and will eventually be redeposited in some bank. That bank now has a new deposit of £92 and so can lend out 92 percent of it, or £84.64. The same will happen to this, and 92 percent of it (£77.87) can be loaned out. In the end loans totalling £1250 will have been made, which is 12.5 times the original deposit of £100.
The loans have not been made out of thin air, but out of successive deposits totalling £1250. Certainly, the same sum of money has been used to make these loans, but that money circulates and can be used to make more than one transaction is one of its features. So nothing remarkable there either.
The proof – or rather the disproof – of the pudding is in the eating. If the view that a bank on receipt of £100 can then, depending on the cash ratio, immediately lend out many times that amount were true, why would a bank ever go bankrupt from making a bad loan? With deposits of £7.4 million why didn’t the Southsea bank simply write off the bad investment in property development and “recreate” a loan of the same amount for something else?