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Is it Liquidity or is it Solvency? Risks in Banking

A properly functioning banking system is an essential ingredient for fostering economic growth, as it allows banks to act as efficient intermediaries between scarce savings and profitable investment projects. When the system falters, however, the results can be disastrous. In the worst case, a crisis in the banking system leads to the failure of the system of payments as banks no longer can provide "backstop" liquidity to the economy, thereby compromising the ability of monetary authorities to create money. It is, therefore, important to understand the process by which banks fail so that supervisory can take appropriate and timely preventive measures.

Balance Sheet Basics
The mechanisms leading to bank failures can be seen through the structure of a bank's balance sheet, which reveals much about the specialized financial structure of banking institutions. A bank takes deposits from the public, which are liabilities on its balance sheet. It promises to pay back the full amount of the deposits plus interest at the end of a specific time period (sometimes on demand). These deposits, together with the capital provided by shareholders, are then lent to borrowers and invested in other assets. Loans are riskier and longer term than the deposit base and thus are expected to yield a net return greater than the interest paid on deposits.

Banks must carefully match liabilities with assets and the income generated by them. The bank's capital provides a buffer between the value of assets and liabilities. When asset values exceed liabilities, depositors receive payment in full and shareholders earn a return on capital. Since asset returns are risky, capital must be sufficient to persuade depositors (or regulators/insurers) that deposits will be repaid. Under the current Basle Committee rules, the level of required first-tier capital in the balance sheet is eight percent of the value of risk assets weighted by specific risk factors.

Liquidity and Solvency Scenarios
In an adequately capitalized and liquid bank, when the profile of assets matches that of liabilities, deposits are paid with funds from investment income and loan repayments. Additional liquidity requirements can be met from various sources, such as raising new deposits to match liquidity demands. Where new funds are not readily available, the bank can rely on its more liquid assets, cash reserves or short-term investments. As a final resort, the bank can get a short-term loan from the Central Bank or other private banks in the interbank market. These procedures are used frequently in the daily management of banks and do not necessarily constitute a problem as long as depositor demands are met in an orderly fashion.

Problems arise when a bank is unable to meet its obligations to depositors. In the worst case, the bank is insolvent because the market value of its assets is less than its liabilities. If the bank is solvent but is unable to convert assets to cash fast enough to meet the demands of depositors, it is illiquid. These two scenarios, as well as their possible interactions, are illustrated below.

Scenario A: Liquidity Problems
A mismatch between assets and liabilities-e.g. a move by depositors towards more liquid (shorter-term) instruments or a sudden withdrawal of funds-leaves the bank unable to cover its liquidity requirements. The bank must try to cover the shortfall with available cash, freed up reserve requirements with the central bank, and the sale of short-term investments. However, if these do not cover the shortfall, there is a liquidity problem and the bank may be forced to sell long-term investments or raise funds through borrowings from the Central Bank or in the interbank market.

In this scenario, the composition of deposits shifts to liquid instruments that require more liquid assets (rediscounts/interbank loans). Nonetheless, the bank is still solvent because it maintained its capital and funded itself with non-risk assets. Thus the ratio between capital and risk assets has not changed and the bank still meets capital adequacy requirements.

Scenario B: Solvency Problems
Solvency crises are slightly more complicated. In such a case, the market value of assets drops, for instance, when the quality of the loan portfolio deteriorates owing to factors such as poor credit analysis or economic factors (e.g. drop in aggregate demand, hike in interest rates or changes in relative prices). This means that assets (of which loans tend to be a large portion) are riskier than before and hence the same amount of capital that previously protected the bank against losses is now insufficient. To account for these losses, the bank must make charges against the loan portfolio (loan loss provisions) that are paid for from retained profits. As long as profits are sufficient to cover these provisions, the risk-weighted capital-asset ratio is unchanged; when profits do not cover provisions, shareholders must provide the additional capital to restore the ratio to the required level.

Since the downside risk to shareholders is limited to the losses already suffered, banks may attempt to recover losses through higher interest rates on loans and/or lending to riskier borrowers. In the end, "good" clients may pay higher rates because of bad credit decisions by the bank, or the depositor (or government, when there is deposit insurance) bears the additional losses.

Scenario C: Liquidity-Induced Solvency Problems
Liquidity problems may often turn into solvency problems. For example, a continuous liquidity shortage could lead a bank to tighten credit by not renewing short-term revolving lines of credit for working capital. This would force debtors to repay their loans earlier than expected; those unable to do so will default on the debt payments. In turn, the quality of the loan portfolio will suffer, requiring additional loan loss provisions. As outlined in Scenario B above, this leads to insolvency.

A Lender of Last Resort?
It is important to recognize the real nature of the problem-liquidity or solvency -since the remedies are very different. Liquidity crises by definition are short-term in nature. In the worst case, a "bank run" reduces liquidity and may compromise a bank's ability to sell its longer-term assets at full value. In such a case, the Central Bank can act as a lender of last resort, lending money against the banks' collateral of illiquid loans and investments. Once confidence is restored, the bank continues business as usual because it is solvent.

When there is a solvency problem, shareholders must provide funds from profits or additional capital to restore the capital-asset ratio. In practice, bankers will often assume their problems are short-term and borrow from the central bank or other banks. It is common to mistake a solvency problem for one of liquidity and continue to pump money into a bank. Conventional wisdom holds that frequent requests for such loans and/or the refusal by another bank to grant interbank loans is a "warning sign" of potential solvency problems.

As a rule, the steeper the drop in the capital-asset ratio, the stronger should be the actions taken by the financial supervisory authority. For example, if the ratio drops to 6% to 8%, the bank is required to undertake a restructuring and recapitalization plan (usually pre-approved by the supervisory entity); if the ratio drops to 4% to 6%, the bank is intervened (which includes replacing shareholders and management); and if the ratio is below 4%, the bank is declared "technically insolvent" and liquidated. These thresholds may vary among countries, but the categorization within ranges is common to many systems.

Systemic Risk
The prescriptions for dealing with a liquidity or solvency problem at a single institution are clear. Matters are more complicated when an entire banking system is threatened. The risk of systemic problems is greater in developing economies, where financial markets are not as deep and the economies are subject to greater fluctuations. While there is no one recipe, it is dear that the ingredients should include clear rules, swift interventions when necessary, and when the entire banking system is at risk, firm controls on excessive risk taking.

Conclusion
Since risk is a fact of life in financial markets, it is not possible to eliminate liquidity or solvency problems altogether. Even in the best run banking system, the optimal rate of bank failures is not zero, since there is always risk inherent in banking. Nevertheless, by taking prompt, well-thought out and consistent actions, regulatory authorities can minimize the chance of disruption. In banking, where one centavo of prevention is worth a peso of cure, constant surveillance of markets, improved and timely information, and a well-trained regulatory authority are essential. Early warning signs must be closely monitored. Experience has shown that countries with professional, well-managed regulatory authorities have considerably fewer problems than those that are forced to improvise and react after the losses have already taken place.

-Roberto Vellutini, Office of the Executive Vice-President
-Kim Staking, Infrastructure and Financial Markets Division

Last updated: 01/16/07