Sunday, January 18, 2009

Banks Technically Insolvent?

Analysts working for RBS, one of several British banks to have received emergency funding from the UK Government last year, told the City that "the domestic UK banks are technically insolvent on a fully marked-to-market basis".

The warning does not mean British banks are about to go bust, because the assessment is purely theoretical, and RBS said the position was "not unusual at this stage in the economic cycle".
Exactly what does this mean? If insolvency on a theoretical "mark to market" basis isn't UNUSUAL, then perhaps that theoretical metric isn't useful.

With fractional reserve banking and a reserve to asset ratio of 10%, then once the theoretical M2M of the assets would wipe out capital. Since all assets except treasuries have taken significant haircuts, then how could they not be "technically insolvent" on a theoretical basis?

Look at a simplified, hypothetical balance sheet:

Assets:                                            Liabilities:
Loans   10,000                              Deposits: 9,000
                                                        Capital:     1,000
               ______                                   ______
Total    10,000 10,000

Any asset impairment over about 5% puts this balance sheet under stress. Capital ratios to assets would go from 10% to 5% or less.

But lets assume that people think that the impairment is temporary, the deposits are guaranteed, and the interest rates paid on the demand deposits has declined along with short term rates to, say 4%. Let's also say the loans were made at an interest rate of 7%. Lets also assume that 5% of the loans are delinquent. Finally, assume that various fee income offsets the expenses and the only income items are the interest income and costs. In this case, the interest income is 665 and the interest expense is 400 and the net income is 265 before any provisions for loan losses.

Now, give the 5% delinquency rate, lets assume that we write off all 5% with an expected recovery rate of 50%. that would give us a loan loss provision of 250, making the income net of loan loss provisions 15. Or break even.

This could go on for say 3 years and the bank capital would remain flat as the net interest margin offsets the loan losses.

If you tried to sell the loans in a secondary market under stressed conditions, there is no way that you could get close to the 10,000. If the loan loss provision is supportable, under current US GAAP accounting, the bank ISNT INSOLVENT.

The theoretical balance sheet and discussion of income, etc. may be incomprehensible to people that aren't familiar with basic bookkeeping and hopelessly simplified for those that do. However, it is designed to show the impact of leverage on a typical bank and how they are inherently vulnerable to a "run on the bank" without some sort of liquidity backstop, since the (demand) deposits could be all withdrawn more quickly then the loans could be liquidated.

Remember in the US in the Great Depression years of 1929-1933 price levels fell between 30 and 40%. Roughly half the banks failed and half of them didn't. However, ALL OF THEM would have been technically insolvent if they had capital ratios of less then 40%.

So, if every single US bank was "technically insolvent" on a theoretical mark to market basis during the Depression, then should all of them have failed? I think more then enough of them actually did fail. If we demand accounting standards that would have forced every US bank during the depression into insolvency, then I would say that the standards are fundamentally flawed.

Maybe people need to go back and rethink why they believe accounting rules designed for derivatives traders are superior to traditional rules that allowed the strongest banks to survive the US depression of the 1930's.

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