Arnold Kling  

Determining Bank Solvency

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John Hempton has a must-read post in which he says that determining bank solvency is difficult. I think he understates the difficulty, because he does not get into the issue of valuing short put options that once were way out of the money and now are close to being in the money (if that language confuses you, think of trying to value a property insurance company with a lot of policies written in Gulf states when a huge hurricane threatens. Maybe the insurance company will be solvent after the hurricane makes landfall--and maybe it won't). Hempton suggests moderate forbearance.


My view - and it is open to debate - is that a reasonable sort of regulatory buffer is that a bank - properly provisioned when the disaster happens - should be forced to have about a third required regulatory capital - and should be restricted from reducing that capital (dividends, buybacks etc) until the buffers are fully restored. Forbearance is right at this point of the cycle - unlimited forbearance is not.

Since this has been my position since September, I am sympathetic to this view now. I want to see triage. A healthy bank, that meets required regulatory capital standards, gets as much freedom as it has always had. A bank that has negative capital gets put through a rapid-bankruptcy or FDIC receivership process. A bank with positive but inadequate capital gets put under close supervision to make sure that it does nothing to detract from or risk from its capital adequacy.


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COMMENTS (11 to date)
Mike Moore writes:

Very illuminating read. Thank you for posting.

One thing that keeps getting hammered on in the article, and something that was bothering me yesterday from Prof. Henderson's post, was how assets that are marked to market are often marked below their yield to maturity. I know that it's not a large enough portion of their books for them to reach regulatory solvency, but I will point out that it makes a big difference in restoring some kind of normalcy to their balance sheets. At least give banks the option of assets generated for sale to remove those from consideration and take the loan to maturity.

malavel writes:

I'm not an economist, so this question might be really stupid. But why does it matter if a lot of banks are insolvent? One reason, if I remember correctly, is that they wont lend out more money since they have to satisfy capital requirements. If there are credit worthy individuals or companies who want to borrow money but no bank who can lend them that money, why wont this drive up interest rates and thus attract more capital to either old or new banks?

El Presidente writes:

malavel,

. . . [W]hy does it matter if a lot of banks are insolvent?

It matters for two reasons (at least). First, because it dampens lending of domestic capital, which is presently necessary to maintain the proper functioning of input markets. Second, if they are insolvent, but do not disclose this, it places a black cloud of suspicion over the vast majority of financing activities. The foreign capital that would flow in, if it exists, would be very hesitant because the risk of moving it into our market is unknown and presumed to be too high. This places an even higher premium on borrowed funds, which saps growth. Eventually the premium eats up expected profits at potential output for many businesses, which makes financing falter and slows or stops a great deal of production. Some would say this is happening right now.

Arnold has been talking about the need to stoke profits in order to pull out of our death spiral. Without profits after borrowing costs, business have no long-term incentive to invest, and will trim their variable costs and output in preparation for reduced scale or eventual shutdown. We disagree mightily about the best way to increase profitability, but we agree whole-heartedly that businesses need more profits relative to borrowing costs. Arnold's triage idea and bold stance on shutting down insolvenet banks is the right posture if we want to reduce borrowing costs, thereby helping the other side of the ledger and restoring vibrancy to input markets. We would still have to do something about output markets though.

Sierra Tango writes:

Arnold - some bozo at the NY Fed states that tax cuts will heighten deflation. See

http://www.reuters.com/article/newIssuesNews/idUSN1845479520090218

Would you,Bryan,and Dave please put him back in his cage. Thanks

malavel writes:

El Presidente,

Thank you for your answer. However, I still don't quite understand why foreign capital couldn't create a new bank while stating that they wont lend any money to the old banks. Is this not possible?

Sergei writes:

Question: Are regulators required to always enforce Basel II capital requirements? If a bank's capital falls below requirements and the bank isn't able to issue tier 3 capital, but is otherwise okay, is it shut down? The article implies that regulators are presently ignoring requirements. If that is indeed the case, is it done on an ad hoc basis?

Strictly enforcing capital requirements seems counterproductive; if a bank is never able to actually use its capital cushion, it's as if that money doesn't actually exist and the mandated capital is the new $0.

As an alternative, how about requiring an *average* capital ratio over a period of time, allowing the cushion to grow and contract fluidly as needed?

Graeme Bird writes:

Determining bank solvency is not difficult. Currently they are all basically insolvent and this would be evident if their special privileges and subsidies, direct and indirect were withdrawn.

Last year if the central bank had not have stepped in every last bank would have collapsed. So in this way we see that they are all insolvent.

There is no need to nuance the raw facts of this matter when the situation is so stark. If the writer is claiming there are degrees of hopelessness and insolvency well so be it. But all known banks are insolvent as far as anyone knows. To be solvent they would have to carry on-call reserves of at least about 40% and still be able to make a profit. No bank is in this situation today as far as I know. Does anyone know differently?

Graeme Bird writes:

"Since this has been my position since September, I am sympathetic to this view now. I want to see triage. A healthy bank, that meets required regulatory capital standards, gets as much freedom as it has always had."

Capital standards are unacceptable cronyism and they will not prevent a crisis. So why advocate this sort of regulation? It just ensures poor resource allocation and an uncompetitive market.

Fundamentally banks create their own new capital when they are on a money creation spree, since this revalues everyones balance sheet. And also since new money creation is an incredibly profitable rort.

Thus capital requirements are useless for the prevention of a crisis. When the crisis comes the asset values collapse. These are just cartelisation regulations and are really poxy. Because what we are doing here is creating a barrier to entry and a closed shop for what amounts to a counterfeiters den. "How much money do you have already? Well ok then. You get to do so much money creation?" This is like OPEC for counterfeiters.

This is a totally corrupt state of affairs. What it ought to be is freedom of entry but a reserve asset ratio of at least 40%. But since the only reasons not to make that RAR 100% are reasons of special interest and reasons to do with quasi-religious macromancy...... then there exists no reason why the RAR ought not slowly be brought up to 100%. The closer to 100% the RAR is the more spending patterns reflect authentic preferences in the economy and not some random wave motion generator superimposed on the real economy.

Bill Woolsey writes:

It is important to remember that either the "shadow" banking system must be rebuilt or else the conventional banking system needs to expand.

If "investors" want to hold bank deposits (perhaps because they are government insured) rather than holding securitized loans at first, second, or third remove, then the banks need to be holding the loans either directly or in securitzed form.

Much goverment policy seems to have be about propping up the shadow banking system. The guarantees to those investing in money market mutual funds (who held commerical paper that financed securitized loans) would be an example. The Fed's commercial paper facility would be another--financial commercial paper and asset backed commercial paper having been directly used to finance securitzed loans.

The alternative policy would be "let" those who had invested into the shadow banking system move their fund to deposits in the conventional banking system. But this requires that the conventional banking system hold onto their loans. Most of their 13 trillion in assets are loans directly held, but that would need to expand. Clearly, there are some conventional banks and bankers who have seen their business as making and then selling loans, but banks do have lots of loans on their balance sheets. Some one must be holding loans.

Anyway, the needed expansion of conventional banks (if a contraction of the shadow banking system is accepted,) will require more capital. I think allowing any sound banks to expand lending and lower their capital ratios may well be a good idea. A lower capital requirement for "safe" commercial lending? Later, they can build up their capital. Of course, this is risky.

I also agree that capital should be a cushion that can actually be used. If a bank had sufficent capital to cover losses, requiring the bank to stop making new good loans is a mistake. Similiary, having many banks simultaneously try to raise new capital is probably a bad idea as well. Why keep capital in good times if it doesn't provide a cushion for the bad times?

But I also believe that Citibank should get the FDIC overnight reoganization. Some of the long term debt holders should become the new owners. They should get shares in a good bank, that is very sound, and then, shares in all the junk held by a bad bank. Citibank needs the Zingale treatment.

This would be punishment for the SIV's. They would have been OK if the investors in the off balance sheet entities had taken the loss, but putting them back on the balance sheet...well, actually, I think it was a fraudulent effort to avoid capital requirements and if Rubin knew, maybe some jail time would be appropriate.

Citibank alone has 15% of the conventional banking system's assets. This would be a systemic event. But, by definition, long term bond holders cannot run.

Of course, this would make it more difficult for banks to borrow money through long term debt compared to a system where the governent always protects those holding long term bank debt. So what?

I have acutally read otherwise sensible people point out that wiping out shareholders will make it more difficult for banks to raise private capital. Well, of course, compared to a system where goverment bails out stockholders.

I don't think it is desirable for banks to raise equity from people who make the investment because if the business model failes they will be bailed out by the government.

Bank of America, another 15% of the conventional banking system, is troubled too, but much of that is because they took over Merril Lynch at the behest of the govenrment. Perhaps it is too late, but letting them back out of that deal might be best.

Anyway, banks are allowed to borrow using insured deposits. That means that there is no reason for a bank to default. The theory that an FDIC insured bank is still paying its bills, so what is the problem, fails to understand the nature of depsosit insurance. There has to be another way of declaring an insured bank insolvent than it being so reckless that they cannot broker enough insured deposits to pay its current bills.

El Presidente writes:

malavel,

Thank you for your answer. However, I still don't quite understand why foreign capital couldn't create a new bank while stating that they wont lend any money to the old banks. Is this not possible?

(Disclaimer: I'm not an expert in baking) It could, and it might not be a bad idea, especially since it would be untainted. However, they would likely need to participate in interbank lending to be viable and competitive for any extended period of time. They would also have to contend with our currency problems. Bernanke made a comment yesterday about the added value of private sector banking being closely attached to a brand; a reputation and the expectations of depositors and partners that the bank will be around for a long time to come. That might be a hard sell for a new bank right now.

Graeme Bird writes:

"It is important to remember that either the "shadow" banking system must be rebuilt or else the conventional banking system needs to expand."

Not true at all. Consider the implications of Milton Friedmans concept of the "optimal supply of money." What this implies is that if we get used to falling prices all the time we would barely need the banks at all.

We don't need to reintroduce the horribly financialised economy. Thats a scenario where almost 20% of the workforce is misallocated running an ineffectual financial system. We want a shake-out and all these people to go get proper jobs.

SPENDING NOT LENDING.

The key to how to go forward is to realise that we are not in any way dependent on bank lending if we understand monetary-economics. Its not bank-lending that we need to recover or maintain. Rather its BUSINESS SPENDING.

Note: Not consumer spending, Not government spending, Not NET business investment, and not GDP. These are unworthy metrics for the task.

We have to stabilise business-to-business spending at its formerly highest level or something prudently close to that. But getting gross business spending to recover has nothing to do with getting banks to start another lending spree.

This is the case so long as you can use a combination of direct cash injection and a reserve asset ratio, to hit the desired level of spending you are aiming at.

Its about time we got out from under this tyranny of the banks. Its an embarrassment to be having these welfare queens getting around and gobbling up all our resources like some new clandestine constellation of shadow government bureaucracies.

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