Effects of Nonperforming Loans on Endogenous Banking Money Creation and Banking Sector Fragility in Iran

In recent years, a gap between banks’ deposits and loans has been emerging and rather continuously growing. Also, loans to liabilities ratio and liquidity multiplier have been decreased and increased, respectively. Furthermore, a kind of stickiness has been observed in interbank interest rate. The objective of this paper is to explain the mentioned behaviors by investigating the effects of nonperforming loans on banks’ balance sheets by taking account of creative accounting practices done by banks to hide losses. It will be argued that applying such practices by banks has led to disruption in banking money destruction as well as a rise in banking money creation through revenue detection on fictitious assets. These factors exacerbate banking sector fragility. For this purpose, a model is developed to explain the effects of fictitious assets on banks’ balance sheet. Based on this model, a method for estimation of the banking money creation is developed, as a proxy variable for fictitious assets, which is not through lending. Then, some evidences for exacerbation of banking sector fragility in recent years have been provided by investigation of this proxy variable using least squares model with breakpoints as well as another set of indicators during September 2004 - May 2019.