Friday, October 28, 2011

What does 'recapitalizing banks' really mean?

In an excellent Economix column in the NY Times, Princeton Professor Ewe Reinhardt defines what he means by recapitalizing banks.

Regular readers will recognize his definition as it is the one that your humble blogger uses.  This definition of recapitalization looks at the market value of the bank's assets and subtracting from it the book value of the bank's liabilities.  If the market value of the assets is less than the book value of the liabilities, then the bank needs additional equity .... this is the amount needed to recapitalize the bank.

Unfortunately, Professor Reinhardt's and my definition of bank recapitalization is not the same one used by global financial regulators and policymakers.

They use the book value of the bank's assets and the book value of the bank's Tier 1 capital (primarily equity).

In the recent European agreement to deal with the sovereign debt and bank solvency crisis, the Eurozone policymakers and financial regulators said that all Eurozone banks must reach a 9% Tier 1 capital ratio or raise equity.

This 9% ratio is calculated by dividing the book value of the bank's Tier 1 capital by the book value of the bank's assets.

Regular readers know this is a meaningless ratio for showing whether a bank is solvent or not.  Solvency is defined as the market value of the bank's assets minus the book value of the bank's liabilities.  If the result is greater than zero, the bank is solvent.  If less than zero, the bank is insolvent.

Regular readers also know that the reason global policymakers and financial regulators do not use Professor Reinhardt's and my definition of bank recapitalization is because banks do not disclose their current asset, liability and off-balance sheet detailed data so that market participants can determine what the market value of the bank's assets is.

It is this lack of disclosure that effectively blocks Eurozone banks from raising new equity from the capital markets.  After all, what investor is going to want to buy stock in an insolvent bank with great book Tier 1 capital ratios if that bank could end up like Dexia and be nationalize shortly after their investment.


Please note that there is an important distinction between determining how much is needed to recapitalize a bank and when this capital is needed.

In a modern banking system with deposit insurance and access to central bank funding, banks do not need to be recapitalized today.  Rather, they can rebuild their capital through retention of future earnings.

Citizens of any country have reasons to smell a rat when the country’s elite speaks to them of “recapitalizing” banks. In this regard, for example, theUnited States bailout of its troubled banks, and Ireland’s bailout of its banks, are hardly reassuring. The Occupy Wall Street movement appears to be fed in part by this suspicion. 
Recapitalization is a generic term. It can be done in different ways, some more unseemly than others. My inquiry among a nonrandom sample of educated adults suggests that many people do not actually know exactly what recapitalization means. Can we blame them, given that financial experts speak mainly to one another in opaque jargon, and government shuns transparency in these matters? 
To see clearly what is involved, it is helpful to start with a simple accounting identity that describes a business company’s financial position, at market values, at any moment in time as “t.” It is 
At – Lt = Et 
Here At denotes the total, realistically realizable dollar value of assets to which the firm has legal title; Lt denotes the total dollar value of the company’s liabilities, if it paid off all of that debt at time t; and Et denotes the company’s net worth or “owners’ equity” – all as of the point in time t. 
A business is solvent as long as the realizable value of its assets exceeds its debt (At > Lt).
It bears repeating that global policymakers and financial regulators do not use this definition when they are talking about recapitalizing a bank.  They are strictly looking at the book value of the bank's assets and the book value of the bank's equity.

This blog, however, uses Professor Reinhardt's definition.
Even such a company, however, may find itself illiquid if it does not have on hand enough cash or liquid assets that can quickly be converted to cash to meet short-term debt coming due within the next month or year. An illiquid but solvent business can easily be helped through a short-term bridge loan secured by other assets or an open credit line at a commercial bank that can be tapped in such cases. For solvent banks the central bank is a short-term lender of last resort. 
Prudent executives manage the balance sheet of their enterprises so that, at any time t, the realizable dollar value of the company’s assets are enough, under most foreseeable future contingencies, to repay all of the company’s debts and, it is to be hoped, leave some positive net worth for the owners.... 
These assets consist mainly of the right to cash flows inscribed in financial contracts – Treasury and corporate bonds, short-term commercial loans to businesses. In the United States, the banks’ assets also included so-called “structured loans” secured by mortgages (increasingly subprime mortgages) and other derivative securities, including rights to cash flows implied by in bond-insurance contracts (credit default swaps).
European bankers, too, invested in such risky securities – often sold to them by their American colleagues. In addition, they loaded up on loans to governments living way beyond their means (Greece) or loans to real estate developers thriving in a real-estate bubble (Ireland, Spain).... 
By mid-2007, news had penetrated all the way to the banks’ executive suites that a good many of the structured securities on the asset side of their balance sheets were secured by dodgy mom-and- pop mortgages that had been extended to people unlikely ever to earn enough to be able to make their monthly mortgage payments on time. The market value of these securities began to shrink. 
In Europe, on the other hand, it became clear that some governments – especially that of Greece — would not be able to pay debt service on the sovereign bonds they had sold as investments to European bankers. 
Eventually, then, it dawned on everyone, even bankers, that, realistically, the ... banks were not just illiquid, which could easily have been fixed by central banks. Many of the banks were effectively insolvent, if all assets were realistically marked to realizable values.

We can think of the generic term “recapitalizing the banks” simply as “restoring the balance sheets of the banks to financial health.” It requires that somehow the banks’ debt-to-asset ratio Lt/At be reduced to more prudent levels, which is the same thing as saying that its complement, the equity-to-asset ratio, Et/At, also known as the “capital ratio,” provide a robust enough cushion for possible future declines in asset values (Lt/At and Et/At add up to 1, of course).

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