Wednesday, January 26, 2011

Spain appears to confuse positive bank capital ratios with solvency

Since the beginning of the credit crisis and the Lehman bankruptcy, governments and regulators have been confusing positive bank capital ratios with solvency.  Bank capital ratios are a function of accounting.  Solvency is a function of the market value of what a bank owns and what it owes.  The only time bank capital ratios and solvency overlap is when banks apply mark to market accounting.

A simple example demonstrates this point.

Day 1:  Bank balance sheet

  • Assets - Cash                    = $100
  • Liabilities - Bank Deposits = $ 80
  • Equity - Common Stock    = $ 20
The bank has a Tier 1 capital ratio of 20% and is solvent on a mark to market basis.

Day 2:  Bank buys security for $100 and announces purchase of this type of security to market
Day 3:  Market value for this type of security drops and value of the bank's security drops to $50

What does the bank's balance sheet look like at the end of Day 3?  The are two basic ways to account for the bank balance sheet:  historic cost or mark to market.

Day 3:  Bank balance sheet
                                                    Historic Cost             Mark to Market
  • Assets - Security               = $100                                 $50         
  • Liabilities - Bank Deposits = $ 80                                  $80
  • Equity - Common Stock    = $ 20                                 ($30)
  • Bank Tier 1 Capital Ratio  =  20%                             less than 0
Under historic cost accounting, the bank is well capitalized and has a positive bank capital ratio.  Under mark-to-market accounting, the bank is insolvent just like Lehman Brothers was.

Clearly, a bank can be insolvent on a mark to market basis and still have a positive bank capital ratio under historic cost accounting.  Since the banking industry primarily uses historic cost accounting, their capital ratios are meaningless as an indicator of solvency.

The previous paragraph makes a very important point.

In the absence of mark to market accounting or the disclosure of asset-level detail so that investors can mark the assets to market for themselves, all discussions of bank capital are meaningless.

If a bank is insolvent on a mark to market basis, it is irrelevant if it is in compliance with Basel III on a historic cost accounting basis.  If a bank is insolvent on a mark to market basis, it is irrelevant if it has a high capital ratio on a historic cost accounting basis.

However, this is not the end of the example because it does not address how governments and regulators confuse positive bank capital ratios with solvency.

Day 4:  A bank examiner shows up and looks at the bank's financial performance under both historic cost and mark to market accounting.

Now the regulators have a problem.  Clearly, regulators are going to want this bank to raise additional equity.  However, the regulators know that if investors see the mark to market accounting results, they will not invest unless they are protected from the losses currently on the bank's books.  The regulator also knows that if investors do not put money into the bank the government has to put in the capital and this will contribute to a sovereign debt crisis.

If the regulator does not want to protect investors from the losses currently on the bank's books or put up the capital, what does it do?  The solution championed by the regulators and the bank is to stop accounting for the bank on a mark to market basis and look to bolster the market's perception of the bank's solvency.

Day 5:  Regulator announces that bank has passed a rigorous stress test on its solvency and need a modest amount of additional equity.

Day 6:  Bank announces that it is raising capital.

The question for investors is should they invest.  The case for investing is the regulator says the bank is solvent.  The case against investing is the investor knows the bank has an asset that has declined in value on its balance sheet that could threaten the solvency of the bank.

With this example in mind, let us turn to Spain and the report of its adoption of a policy of having their savings banks, cajas, increase their capital ratios.
Spain will impose a core capital requirement of as much as 10 percent on lenders that don’t have private investors and depend on wholesale funding, Finance Minister Elena Salgado said.
... Listed banks will need to boost their core capital, a measure of financial strength, to the 8 percent level by the end of September, while those that “aren’t listed, that depend on wholesale markets and don’t have private investors,” will have to reach 9 percent to 10 percent, she said in an interview in Madrid with broadcaster TVE today.
Salgado also said the Bank of Spain’s forecast that lenders need additional capital of as much as 20 billion euros ($27 billion) is only an “estimate,” and the figure won’t be written into law. The bill on overhauling the banking system, to be passed next month, will only refer to the “necessary amount,” and the final total “will be that which allows them to reach those capital ratios,” she said.
... Spain said lenders that fail to bolster their capital from private sources will have to seek funds from the bank-rescue facility in return for shares with voting rights. The higher level for unlisted lenders, which includes savings banks, known as cajas, is a further incentive for the regional lenders to seek private shareholders.
How did investors and other market participants react to the estimated size of the capital injections needed to produce higher positive bank capital ratios and the appearance of solvency on a historic cost accounting basis?
Fitch Ratings said ... there’s no “clear stimulus” for private investors to put money into the lenders as the government wants them to. There are still doubts about “the depth of potential asset quality problems,” the company said in an e-mailed statement today.
While more capital for the Spanish banking system is welcome, more stress tests are needed to help investors assess the true value of assets and what the final capital shortfall might be, said Inigo Lecubarri, who helps manage about $200 million at Abaco Financials Fund in London.
“It is a necessary condition to have more capital but another condition is to make sure the assets and liabilities of the industry are adequately priced,” said Lecubarri in a telephone interview. “That’s not happening yet in Spain and it’s another side of the coin that is also important.”
Investors want to see for themselves that the savings banks are solvent when the assets and liabilities are adequately priced (this is the equivalent of marked to market) before they are willing to invest.  This is not surprising because otherwise they are buying the losses on the balance sheet of the savings banks.

Your humble blogger only knows of one way to make sure the assets and liabilities of the industry are adequately priced.  That way has been discussed many times on this blog and is accomplished through disclosure of asset-level data. This disclosure allows the investors to value the assets and liabilities for themselves and determine if the savings banks are solvent or attractive investment opportunities.

Can banks that have a positive capital ratio on a historic basis, but are insolvent on a mark to market basis make loans?

Yes.  Remember that financial institutions can continue to make loans until they are a) closed by regulators or b) market participants come to understand that they are insolvent and effectively close it by engaging in classic run on the bank behavior.

How does mark to market decrease lending capacity?

It does not decrease lending capacity.  What mark to market decreases is the capacity for a bank to hold loans on its balance sheet.

Banks are required to hold capital against their assets.  The idea being that the capital is there to support any losses that are incurred on its assets.  The capital requirement is typically specified as a percentage of the assets.  The capacity to hold loans or any other type of asset decreases on a mark to market basis when the market value of a security or loan held on the balance sheet declines.  This loss in value reduces the bank's capital that could otherwise be used to support holding a loan on the balance sheet.

During the recent credit crisis, bankers and many regulators argued that mark to market accounting should be discontinued because the market was not properly valuing the structured finance securities they were holding and, as a result, the reduction in each bank's capital base constrained its capacity to make loans while continuing to meet regulatory capital requirements.

Actually, the reduction in each bank's capital base constrained its capacity to hold loans on its balance sheet.  Banks were not restricted in the how many loans they could originate.  Once they filled up their balance sheet, they would have had to distribute any additional loans they originated.  This is something that banks have done for years through loan syndications and later securitizations.

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