Thursday, November 17, 2011

Bank insolvency may or may not be permanent or fatal

I am always surprised by the amount of confusion that exists surrounding bank solvency.

This blog has preferred to use the definition of bank solvency provided by the Financial Crisis Inquiry Commission.
  • The Commission observed that a bank was solvent if the market value of its assets exceeded the book value of its liabilities.
  • Conversely, a bank was insolvent if the market value of its assets was less than the book value of its liabilities.
Solvency is therefore a snap shot of the bank at one point in time.

In his NY Times column, Professor Simon Johnson observed
In 1982, Citi had a large loan exposure in the emerging markets of the day — Latin America, and the Communist nations of Poland and Romania — and it was saved from insolvency by “regulatory forbearance,” meaning that the Federal Reserve and other regulators did not force it to recognize its losses.
From the definition of solvency, we can see that the Fed and other regulators did not 'save' Citi from insolvency.  Everyone with a phone could call their broker and find out what the value of less developed country debt was and knew that the market value of Citi's assets was less than the book value of its liabilities.

What the Fed and the other regulators did was not to 'close' Citi.  Rather, they let Citi continue to operate in the hopes that it could generate and retain enough earnings to restore itself to solvency.

"Regulatory forbearance" is entirely a different issue.  It is a fundamentally flawed concept that is based on the idea that market participants are too stupid to look at their Bloomberg terminal to determine if a bank is solvent or insolvent.   Instead, they will look at a bank's book equity to tell them if the bank is solvent or not.

In fact, regulatory forbearance led directly to bank bailouts as regulators, operating under the impression that market participants are stupid, are focused on doing whatever they can to maintain positive book equity.  Even at the same time as market participants know that the bank is insolvent.

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