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Easy Liquidity always the Enemy of Banking Sector Solvency

May 24, 2012

That liquidity does not solve solvency problems is an oft-repeated truism.  What is does not highlight is easy liquidity can a) multiply existing solvency problems and b) create solvency problems where none exist.

The ECB’s LTRO programs are a testimony to the fact that liquidity worsens solvency problems.  Until the LTRO programmes started last year, European banks had some of the worst capitalization metrics (in terms of core Tier I ratios) in the world.   The solution to this problem was a combination of a) asset sales b) raising of fresh equity if the market permitted and c) in case b) was not feasible, recapitalization of banks with sovereign support.  If the sovereign did not have the wherewithal, orderly bank liquidation with some form of deposit guarantee was the way out.  Instead, the banks were provided 3 year funds at 1%, with the understanding that the cheap funds would be used to subscribe to sovereign bonds of troubled countries.  As the sovereign creditworthiness of several countries worsened over the last few months, the spreads on the sovereign bonds widened, causing MTM losses to the banks that thought they had an easy carry trade (investing in higher yielding sovereign debt with 1% funds).  Alas, these MTM losses reduced the Tier I ratios from already parlous levels.  The easy liquidity worsened a solvency problem.  So, it would be idiotic to attempt LTRO3 or some mutation thereof.

Easy liquidity policies of the maestro Alan Greenspan caused the solvency crisis of 2008 for American banks.  When liquidity was easy, going lower and lower down the credit ladder was the only way out for banks to report decent RoEs (and as a corollary, ensure healthy bonuses for bank executives).  This ensured that schemes which never should have been financed (such as second lien home loans, LBOs of private equity rogues etc) secured funding.  There was a massive misallocation of capital.  Karma being a bitch, when the fruits of these lending transactions caught up, a solvency crisis ensued.  American banks do not seem to have learnt their lesson- they are holding on to big US treasury portfolios with cheap financing from the Fed.  Today, the problem is being masked on account of a global “flight to quality” (whatever that means in the context of a deeply indebted US).  When the spreads on US treasuries widen (we don’t know when that will happen, but it is inevitable), US banks will have the same solvency issues of Greek, Spanish and Italian banks that fooled around with sovereign debt with the aid of cheap funds.

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From → Credit Analysis

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