Thursday, March 28, 2013

Walter Bagehot and the math behind why banks designed to absorb losses without needing bailouts

Regular readers know that your humble blogger has been saying that a modern banking system is designed to absorb the losses on the excess debt in the financial system without requiring a sovereign bailout of the banks.

Today, one of the pre-eminent financial columnists in the world said to me:  prove it using numbers my readers can understand.  So here goes.

The following shows the current condition of a bank if it were not hiding its non-performing loans through 'extend and pretend' or its underwater securities.

                                                       Bank with Bailout                   Bank absorbs losses
 Assets before losses recognized
         Cash                                                         0                                                 0
         Performing Assets                                  60                                               60
         Non-performing Assets                          40                                               40
                 Total assets                                   100                                             100

 Liabilities plus Equity
        Borrowing from Central Bank                   0                                                 0
        Insured Deposits                                      75                                               75
        Purchased funds                                      20                                               20
        Equity                                                        5                                                 5
                Total Liabilities and Equity           100                                             100

Under both scenarios, the losses on the non-performing assets need to be realized.  These losses equal the amount the non-performing assets need to be written down by so that the borrower can afford to service the remaining debt.  For simplicity, we will assume a 50% write-down [40 of non-performing assets becomes 20 of performing assets].

In the bailout scenario, the taxpayer absorbs the loss by injecting enough capital into the bank to cover the losses on the non-performing assets [the injected capital is added to both cash (20) and equity (beginning balance of 5 minus 20 for loss on non-performing assets plus 20 for taxpayer capital injection)].

The following shows the condition of the bank after loss recognition and, in the bailout scenario, the injection of funds by the taxpayer.

                                                       Bank with Bailout                   Bank absorbs losses
 Assets after losses recognized
         Cash                                                       20                                                0
         Performing Assets                                  80                                               80
         Non-performing Assets                            0                                                0
                 Total assets                                   100                                              80

 Liabilities plus Equity
        Borrowing from Central Bank                   0                                                 0
        Insured Deposits                                      75                                               75
        Purchased funds                                      20                                                20
        Equity                                                       5                                              (15)
                Total Liabilities and Equity           100                                               80

Let me make a couple of observations.

First, whether the bank is bailed out or it absorbs the losses, the bank has the same amount of assets that are performing and generating income.

Second, under either scenario, the bank has the same liabilities and the interest expense on these liabilities is unchanged.


  • We can determine before a sovereign bailout whether the bank has a viable franchise or not.  After restructuring the non-performing assets, either the bank's interest income on all its performing assets (including loans and investment securities) exceeds its interest expense or it does not.  If it does, then the bank is viable as it can generate earnings to rebuild its book capital level.  If it does not, then the bank is not viable and should be closed.
  • If a bank has a viable franchise after restructuring its non-performing assets and its interest income exceeds its interest expense, it does not need a sovereign bailout.  Why inject funds into a bank that is capable of rebuilding its book capital without assistance?

Given that we have the same interest income and interest expense under both scenarios, why do bankers prefer a bailout over recognizing their losses?

Because with a bailout, the losses are socialized and it is the taxpayer who pays.  When banks absorb the losses, it is the banks and the bankers that pay.

Bankers understand this and therefore will try to paint a picture of why a bailout is necessary.

For examples, bankers assert that banks need a bailout otherwise they won't be profitable.  With or without a bailout, banks have the same interest income and interest expense.

Another reason that bankers give for needing a bailout is to stop a potential run on the bank.

By definition, the insured depositors don't care about the bank's book capital level because their money is guaranteed by the government.  Depositors learned to trust the government guarantee from their parents.  When they opened up their first bank account as a child and were worried about getting their money back, their parents assured them the government would get their money back for them.  So the depositors aren't going to run.

This leaves the purchased funds from the wholesale funding markets.  With a bailout, the purchased money can run and take the bank's cash with it (see below).

With the bank absorbing losses, the purchased money can also run.  This is where Walter Bagehot and his concept of the central bank as the lender of last resort comes in.  The central bank lends the bank the money so it can pay out the departing purchased funds.  The central bank borrowing and repayment of the purchased funds is shown below.

                                                      Bank with Bailout                   Bank absorbs losses
 Assets after losses recognized
         Cash                                                   0                                                 0
         Performing Assets                            80                                               80
         Non-performing Assets                      0                                                0
                 Total assets                               80                                              80

 Liabilities plus Equity
        Borrowing from Central Bank           0                                                20
        Insured Deposits                               75                                               75
        Purchased funds                                 0                                                 0
        Equity                                                5                                              (15)
                Total Liabilities and Equity      80                                               80

In this example, the central bank has access to performing collateral worth 4 times what it lends to the bank.  So the central bank's loan is very safe.  In fact, there is plenty of capacity for additional central bank loans to satisfy any demand from the insured depositors.

Exchanging the central bank loan for purchased funds only has a negative impact on banks if the central bank follows Mr. Bagehot's advice and lends at high rates of interest that exceed the cost of the purchased funds.

Yet another reason that bankers give as to why banks need to be bailed out is that without a bailout they would have to stop lending and supporting the real economy.

Clearly, with the bailout, assuming that the purchased funds don't run, bankers have cash on their balance sheet that they can lend.

However, not having cash available on its balance sheet, doesn't stop the bank that absorbed the losses from lending.  What it stops is the bank from holding the loan on its balance sheet.

In this case, the bank with no capacity to hold the loan on its balance sheet has to sell the loan on to someone who would like to hold the loan like a pension fund, insurance company, hedge fund or a bank with capacity on its balance sheet.  This is something that goes on everyday for decades even when a bank has capacity to hold a loan on its balance sheet.

I could go on and debunk the rest of the bankers' reasons for needing a bailout.  However, that is unnecessary as the real reason that bankers prefer bailouts over having the banks absorb losses is that with a bailout there is no interruption in the bonuses that the bankers receive.

What we have witnessed since the beginning of the financial crisis is that bankers have paid themselves at or close to record levels.  They could not have done so if the banks had absorb their losses and had to rebuild their book capital levels.

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