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Worth the Risk
September 2009

Banking is full of paradoxes. Governments and regulators around the world are on a drive to make banks safe, so that the current crisis can never happen again. The catchphrases are that assets should be "de-risked" and balance sheets "de-leveraged", while President Obama has openly applauded the "shrinking" of the financial sector. But nothing is more certain than that further shrinkage of bank balance sheets would intensify the most severe global downturn since the 1930s. 

The paradox of excess banking regulation — that the removal of risk from bank balance sheets aggravates deflationary pressures — arises from an accounting identity. Come hell or high water, assets and liabilities must always be equal. In banking, this means the sum of cash, loans and securities the banks own must be equal to the capital, bonds and liabilities which banks owe to their shareholders and customers. 

In most countries, roughly 90 per cent of banks' liabilities are to depositors. As far as depositors are concerned, their claims on the banks have an important advantage over other types of wealth. Bank deposits can be used to make payments. It follows that — to the extent that programmes of "de-risking" and "de-leveraging" reduce bank assets, to the extent that they eliminate "toxic assets" and lead to the calling-in of bad loans — they also lower banks' liabilities and destroy money. Thus, the greater the regulators' zeal in eliminating risk, the more rapid is the destruction of money balances. 

Economics may be a controversial subject, but almost everyone accepts that the rapid destruction of money balances is madness. Ultimately, a good relationship holds between the quantity of money and nominal national income. In the medium term, the relationship may be less reliable, but a reasonable rule of thumb is that a sharp drop in money will lead to recession. In time spans of a few months, a big fall in bank deposits may not prompt much public comment, but in private it will cause companies and investors to notice a cash squeeze and to consider remedial budget cuts.

In America's Great Depression of the 1930s, the quantity of money tumbled by 40 per cent in four years. In today's Great Recession, a recurrent pattern across the top economies is that money growth has fallen and companies are strapped for cash. Fortunately, the money slowdown is generally less severe than it was in the horror of almost 80 years ago. For example, in the Eurozone, the M3 money measure has now been flat since last October, but it has not gone down. 

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