An Asset-Based Framework of Credit Creation (applied to the Global Financial Crisis)

Abstract

Abstract:We develop a conceptual asset-based framework of credit creation based on three leading variables: (i) the amount of assets acceptable as collateral, (ii) the level of leverage and (iii) the level of trust. As credit expands along these dimensions in a non-linear dynamic, the financial system becomes more liquid. At the same time, it becomes more prone to endogenous feedbacks and vulnerable to internally generated instabilities manifested as booms and busts. Applying this framework to the global financial crisis, we show that the subprime crisis was both a signature and only one possible trigger in an increasingly unstable financial system. Using historical data, we demonstrate a significant shift in the components of US bank balance sheets and a decoupling of bank assets from deposits since the mid-1980s, marking the rise of "securitized-fractional reserve banking". The subsequent decades were a period of growing leverage, with debt-securities assuming money-like functions and serving as collateral for further credit creation. As trust began to recede, the high levels of leverage were no more viable, precipitating a reduction of the amount of assets acceptable as collateral, and leading to a contraction in credit and to liquidity spirals. We discuss the potential general applicability of this framework of credit creation and define extensions in future research.

Asset-Based Money Systems in a Global Context: Implications for Social Inclusion and Economic Development

“…Commercial banks deal in different modes of money. One of them is asset-based money, also known as commodity money or intrinsic money, which has specific characteristics that set it apart from fiat money (currency with no intrinsic value) (Fantacci, 2013;Muhammad, 2010;von der Becke & Sornette, 2017).…”

“…Gold, silver, copper, and other precious metals were frequently used in the past as coins, and these are all examples of asset-based money. Fiat money (credit-based) and asset-based money are complex, and each system has advantages and drawbacks (Andolfatto et al, 2016;von der Becke & Sornette, 2017). Fiat money provides greater flexibility in managing the money supply and responding to economic conditions, while asset-based money offers stability and intrinsic value but may have limitations in certain aspects of the modern economy.…”