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Bank Nationalisation must follow failure to meet stress test for solvency

Bank Nationalisation is finally the topic de jour.  It is an undercurrent in many discussions, and strangely has the Democrats and Republicans in some kind of opposite land debates.

I favour the view of Nouriel Roubini who speaks of the current procress as being death by a thousand cuts in this worth watching video.  The governments in UK and US are dribbling money into banks and the auto sector, with no end in sight, and little apparent contrition from management.  A strategy is needed for both those sectors and decisive action taken. However it has to be based on principle not emotion.

Martin Wolf outlines the debate here in the FT.  I would add that a clear process exists today for insolvent banks and is managed by the FDIC (US).  Each month several banks are taken over by the FDIC or arrangements made for other banks to take over – those are small local banks, but the process is clear.  However the distinction with the top banks.

It is not necessarily feasible or acceptable to have them taken over by each other.  We get into the too big to exist problem that could forsee further crises in the future.  There are 19 banks undergoing stress tests in America.  This from the FT piece.

The US Treasury’s response is its “stress-testing” exercise. All 19 banks with assets of more than $100bn are included. They are asked to estimate losses under two scenarios, the worse of which assumes, quite optimistically, that the biggest fall in gross domestic product will be a 4 per cent year-on-year decline in the second and third quarters of 2009 (see chart). Supervisors will decide whether additional capital is needed. Institutions needing more capital will issue a convertible preferred security to the Treasury in a sufficient amount and will have up to six months to raise private capital. If they fail, convertible securities will be turned into equity on an “as-needed basis”.

Martin points to this fascinating paper from Douglas J. Elliot at Brookings.  (pdf here)

I support Elliot’s views that he wraps up succinctly in his conclusion.

However, if it becomes clear through the stress test that a bank is already insolvent or is at high risk of becoming insolvent, then it would be better to go directly to the step of full nationalization. Mid-sized and smaller banks should generally be treated in a similar manner. The main difference is that the traditional approach of forcing weak banks to sell  out to stronger ones is a viable option for smaller banks, which is no longer true for the largest banks.

The issue remains solvency.  Banks cannot be insolvent.

In finance, or business solvency is the ability of an entity to pay its debts with available cash. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth.

The stress tests must address solvency.  This graph indicates the variances possible in the stress tests that are possible depending on degrees of optimism or realism.  Note that write downs of this magnitude would place some banks in negative capital territory, inability to meet Basel tests, inability to raise capital, and the associated lack of confidence would result in loss of deposits exacerbating the situation.  This is the connection between capital and solvency for banks.


Roubini is infrequently wrong so I lean to his view.  I also read most political in the left, and least on the right which further supports Roubini.  We all feel the emotional raction against the point in continuing to throw good money at the biggest banks with those kind of losses in their balance sheets.  However the stress tests if done right should provide clear guidanc and objective answers.  With clear re-valuation of assets based on realistic views of the future the answers will be clear.  Note that link goes to a CIBC World Markets report which suggests US has 25 million too many cards on the road based on economic capacity.  It forecasts a reduction in auto ownership.  That type of realistic assessment of the future will determine the value of banks assets (loans and mortgages) which will ultimately determine solvency.

Written by Colin Henderson

March 4, 2009 at 03:54

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