This is the idea that if a bank agrees to loan the office parlour palm to the next door bank for a million dollars, and in return to rent their aspidistra for a million dollars, they both can update their asset sheets accordingly!
Now that's magic. But it was also the basis of the B for Bubble that brought down most of the world's banking system in 2008!
Of course, banks don't do silly stuff like buy each others' pot plants. But they do buy each others' packaged securities. And for many years, these packages became more and more complex, and thus more and more about buyer and seller agreeing on what mysterious qualities made the deal realistic. We know where that ended up: with thousands of dodgy loans to people who had no income or maybe had even died being bundled up and sold as top quality assets. Banks are plagued by problems with so-called ‘ghost’ collateral that disappears or is pledged to several lenders at the same time! After the crisis, the European Central Bank looked at the use of such devices and in a discussion paper wrote:
"the use of collateral is neither a sufficient nor a necessary condition for financial stability."*
The logicians could not have put it better!
https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2107.en.pdf
