Delevering Part I

Delevering is a term which we are hearing a lot these days. Liquidity crunch, an offshoot of the delivering process, is another most often heard term.  I have tried to explain the process of delivering can be explained in the following example,

Assume a simple economy which contains the following key players, B, C and I.B is a bank, C is a common man and I is an industry.  All the three players are interlinked, C lends to banks in form of deposits, B lends to I in form of loans and I lends to C and gets services of C in return. In the actual world the arrows are bi-directional, but let us assume that in this case the arrows are uni directional. This is simplistic view of the economy but the basic idea that everything is interlinked in a circular manner is captured by this m

odel. As long as the money keeps moving from one arm to another, this model works fine. Increasing speed of movement gives a feeling of increasing wealth. The model has an in build feedback mechanism, which if not checked (regulator’s role, who failed miserably in the current world ) can lead to high levels of leverage. Ultimately one of the parties might get suspicious about the ability of the entity to which it has lent to pay back. If B stops lending to I or if C thinks that B may not be able to repay him back, then the entire model comes to a sudden halt. B does not lend to I and wants I to return the money he lent so far, I will not take any services from C (As he wants to pay back B) and C stops lending to B as he is not sure of his services to I getting him money. Thus everything is in a gridlock.Thus, everyone wants their money back, thus leading to a liquidity crunch. This is the current scenario being 

faced by most of the economies worldwide.  

The only way to break this gridlock is to bring back the confidence that each of the players would pay back its lenders. The outsider to this system is the Government (G), which is trying to pump in money into the banks and try to restart the system and slowly bring down the leverage levels in the system.

The next topic of my blog would be how the government gets the money to fund this process and the consequences of such infusion.