Thursday, July 30, 2009

the commercial loan theory, or Real Bills Doctrine

A bank has a problem that is best described as the liquidity-earnings dilemma.If a bank desired to be a totally safe haven for all its depositor‘S funds. It would simply hold all those funds in its vault (i.e., as a perfectly liquid asset). Then, whenever a depositor requested cash from his or her bank, the banker would merely let down the drawbridge. cross the moat to the vault, and return to place the cash in the customer‘s hand. The problem is that no earnings would be generated for the bank if it were only a storehouse of cash.
Bankers could take a position at the other extreme. They could employ all the funds deposited with them to make a loan to finance a high-risk venture by company seeking to find a cure for the common cold virus. Such a loan might have a high earnings potential for the bank, but the loan probably will not be liquid. It would be difficult to liquidate (sell) the assets to obtain cash when depositors wanted to make withdrawals.
To resolve the liquidity-earnings problems, bankers long ago recognized the advantage of making self-liquidating loons (otherwise Known as real bills, or claims on real resources). A loan was considered self-liquidating if it was secured by goods in the process of production or by finished goods in transit to their final destination for resale. When the goods were sold, the loan could be repaid. loans of this type could ensure the banks continuous liquidity and earn profits. Thus, liquidity and earnings were simultaneously gained. (note, however, that no loan is truly automatically self-liquidating, because there may not be a market for the goods produced.) Banks that limit themselves to making self-liquidating loans subscribe to the commercial loan theory of bank management (or the real bills doctrine).
the commercial loan philosophy, however, suffers from the fallacy of composition:
Such a system can keep one bank liquid, but if all banks follow this procedure, overall liquidity needs will not be met during times of crisis. thus, a loan secured by goods cannot be repaid if the goods can‘t be sold.Or if the customer borrowers the funds to purchase the goods,the banking system is no more liquid or less liquid than before the transaction. In the absence of central bank that stands ready to supply needed liquidity to the system as a whole, the commercial loan theory is incomplete.
Although commercial loans continue to be an important component of banks‘ asset portfolios, the development of other uses of their funds has caused the operating methods of modern banks to change considerably.

No comments: