There is a very common misconception that when a bank writes down the value of its asset (e.g. due to bad debts), money supply will shrink. To be honest, we had this misconception ourselves before and we are writing this article to address this issue. The reality is that when bank assets are written down, there is no direct contraction in money supply. The contraction in money supply will be an indirect effect.
To see why, a basic understanding of corporate accounting is required. Therefore, we will recommend that you read Introduction to banking corporate accounting and Effect of write-down on bank balance sheet before continuing. As you read these two articles, what do you notice when a bank writes down an asset? You will notice that bank deposits are untouched when that happens. Since bank deposits make up part of the supply of money, there is no direct contraction of it as a result.
But money supply can contract as an indirect effect when banks becomes much more cautious in issuing loans or stop re-issuing loans when they get repaid. This can happen as their minimum capital and reserve requirements are breached, which means they have to either sell their assets or raise more equity.
Since a severe and sudden contraction of money and credit supply can have a devastating effect on the economy, the central banks and government will do anything to help banks to continue issue more loans. This may mean changing the laws to reduce the minimum capital and reserve requirements, swapping suspect assets for government bonds and so on.
Tags: assets, corporate accounting, deposits, money supply
