The Bankwatch

Tracking the consumer evolution of financial services

Posts Tagged ‘solvency

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.

projected-losses-summary

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

Enter the Zombie banks: Liquidity fixes for banks will not solve their solvency problem


James Baker of all people sums up precisely why the current government approaches to fixing banks’ problems is flawed.  As you will have gathered I fall in the Niall Ferguson/ Martin Wolf camp that says this situation is not just worse than we think but more importantly it is different than the prevailing wisdom.   We risk fixing the wrong problem in other words.

‘How Washington can prevent ‘zombie banks’ | Financial Times

Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.

A period of feeble economic performance called Japan’s “lost decade” resulted.

Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.

To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.

Baker suggests quick and decisive action, and I agree.

This is a crisis of debt and bubble asset values.  The asset values are being re-stated in the equity markets and housing markets as we see evey day.  That horse has left the barn, as they say.  The result is a set of debt around the world on the balance sheets of companies and consumers that is too high relative to the asset base.

The prevailing theme of government and therefore consumer belief is that government stimulus plans will address the economic shortfalls, and return us to growth later in 2009.  But what does that mean, even if successful?

The key is to define “growth” and what that means.  That would mean GDP, that mix of consumer, government and businesss expenditures and investments is no longer dropping.  There are two key points that have to be said here.  Even if growth in GDP returns, that does not mean asset values will return to 2007 levels – no-one can believe that now.  Despite a return to normal patterns of consumer, business and government expenditures sometime in the next 2 years, house prices will not rise by the 25 – 50% that would be required to attain 2007 levels, nor is it likely that the stock markets will grow the 100% + that will be required to return to 2007 levels.  Those things are possible, but we have to believe unlikely in the near term (5 – 7 years)

As Baker states clearly above, this is a crisis of solvency.  A liquidity crisis merely means value is tied up in assets that are not quickly useable as cash.  Solvency means debt exceeds asset values.  The banks have a solvency crisis.  That brings be back to Niall’s point.  This is a crisis of debt.

The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do. (Niall Ferguson/ LA Times Feb 6th, 2009)

A crisis of solvency has requires help for debtors and there is some relief coming on that for US people mortgages, although the plans are not yet completed.

But the worry is the banks.  As Baker says above, and Wolf said yesterday on the Fareed interview on CNN banks are frozen in a state of inaction by virtue of potential asset value losses that exceed their capital base.  They also cannot generate new assets, ie lend, because they do not have an adequate capital base to support.  Enter, what I have been calling financial utilities, and Baker calls zombie banks.  Banks that are moribund and merely exist to provide very basic functions under the guidance and auspices of their bureaucrat overseers.  This does not bode well for innovation, nor new and better services.

Relevance to Bankwatch:

The good news is that the opportunity remains for those that choose to accept it.  This timing of this economic mess is not co-incidence and although few predicted the precise date, many knew a day of reckoning was to come [link to The Upside of Down].  When Thomas Homer-Dixon wrote that book in 2005 the characterisations of stress in the world he saw were these.

Homer-Dixon contends that five “tectonic stresses” are accumulating deep underneath the surface of today’s global order:

  • energy stress, especially from increasing scarcity of conventional oil;
  • economic stress from greater global economic instability and widening income gaps between rich and poor;
  • demographic stress from differentials in population growth rates between rich and poor societies and from expansion of megacities in poor societies;
  • environmental stress from worsening damage to land, water forests, and fisheries; and,
  • climate stress from changes in the composition of Earth’s atmosphere.

With the benefit of hindsight it is easy to see he was correct in the assessment.  More imporantly though these stresses point to a systemic shift in the world that requires different and better solutions, if we are to mitigate future crises, economic and otherwise.  For example it is all very well to point to the Keynesian approach of replacing consumer spending with government spending to address the problem, but what ought the government spend its money on, if the target is a different and better system than we have today?

Going back to the banks’ – the information we have just summarised strongly suggests they are not going back to the way things were before.  What better opportunity to rethink strategy.  We are now in a period of an experential economy, powered by customer empowerment.  Internet has seen to that and that change is also systemic.

If a big bank can really, and I mean really, grasp the power of internet, and the associated cost benefits associated with customer empowerment, ie, customers willingly doing the work for them, in return for better value, and banking on their terms. just perhaps a bank could join in the disruption for banking that is surely upon us.

Written by Colin Henderson

March 2, 2009 at 14:09

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