Gearing Ratios: Trading Company vs Bank

[Snoopy]

No bank CEO knowingly makes a loan that he/she knows will be difficult to repay in a timely manner. Yet we do know that often the first step in a bank loan going bad is a problem with liquidity. Liquidity issues are often resolved by bringing in new capital from somewhere else. This is what I call a 'sideways solution', because bringing in new capital does not necessarily solve the underlying liquidity problem. Rather, the new capital usurps the original problem so the original underlying liquidity issue becomes redundant.

Here then is the enigma for investors concerned with bank liquidity. If the most common way to fix an emergency 'liquidity issue' has nothing to do with manipulating the timing of cashflows of depositors and lenders, does it make sense to study liquidity at all?

Improving the bank gearing ratio by recapitalisation is a 'big picture solution' to liquidity questions. Recapitalisation under these circumstances though, often means that those existing holders of bank equity are disadvantaged, because any new capital must be issued at a greatly discounted price. So although a bank liquidity event is very unusual, the fact that the consequences are extremely severe means I think bank liquidity is worth studying.

From a bank perspective, New Zealand was largely insulated from GFC wash down effects because of the well capitalised Australian parent banks that dominate the NZ banking market. The second tier NZ finance industry, by contrast, was almost wiped out. But just because the NZ Banks survived the last GFC, this should not lead to a complacency that they will automatically survive the next.

The 'headline worry' is that bank customers will lose access to their bank deposits for a while, and even take a 'haircut' on their bank investments. In fact, this is exactly what happened with NZ investors trying to recover their capital from debenture investments in finance companies that went bad. So the idea that this could happen between a customer and their bank while incredible (to those who were around before the GFC) is at least on the horizon as an unwelcome possibility. But is there another loosely connected worry that no-one speaks about and which hides behind a cloud because no-one in the last twenty years has experienced it?

SNOOPY

[Snoopy]

But is there another loosely connected worry that no-one speaks about and which hides behind a cloud because no-one in the last twenty years has experienced it?

My oblique reference above, comes from the idea that:
"the amount of money a bank has on deposit, or can borrow from a 'parent bank', does not affect the size of that individual bank's loan book."

Now I admit that statement sounds a bit wacky. And the internet is full of wacky economic theories that do not increase their credibility by people reading them. But the above 'wacky theory' is the theory promoted by the 'Bank of England', which follows a model very similar to our own 'Reserve Bank of New Zealand'. A forum member has sent me a 'reference link' that explains this idea in great detail.

http://www.bankofengland.co.uk/publi...ion.pdf#page=1

The idea that a 'loan book' is the creator of deposits, not the saving behaviour of bank customers, will be too much of a shock to many and will bring comprehension of this post to a full stop. So I will leave it at that.

SNOOPY

[Snoopy]

The idea that a 'loan book' is the creator of deposits, not the saving behaviour of bank customers, will be too much of a shock to many and will bring comprehension of this post to a full stop. So I will leave it at that.

Now to carry on, for those that have got over the shock....

From a shareholder perspective in a single bank, I am not sure that 'loan books create the bank deposits' is the most useful way of looking at things. I have long been of the view that 'bank customers create their own deposits.' However, I can't dismiss the explanations of the 'Reserve Bank of England' either. After reading that bank of England article I came to the conclusion that:

1/ 'loan books create the bank deposits' AND
2/ 'bank customers create their own deposits.'

could amount to two different ways of looking at what turns out in the end to be the same thing. However, this thinking does challenge my long held view that, to run a bank, it is the quality and quantity of customer deposits (and money borrowed from 'parent banks') that matters most. Maybe it is equally valid to think of the quality and maturity of bank receivables as the primary driver of any individual banking business?

If you follow the 'receivables matter most' perspective, that means the substantive liquidity risk for banks is not: "Bank depositors may have a problem getting their loan money back.".

Instead the primary bank liquidity risk is that "Banks will not be able to get enough loan customers to fully cover the payout of their broad spectrum of depositors." Effectively the banks would become 'undergeared' due to a collapse in market demand for their loans.

To be honest, this still seems like a weird consequence to me. I can't recall a bank ever being in this position. But just because I can't recall it though, doesn't mean it didn't happen, or it couldn't happen.

SNOOPY

[Snoopy]

If you follow the 'receivables matter most' perspective, that means the substantive liquidity risk for banks is not: "Bank depositors may have a problem getting their loan money back.".

Instead the primary bank liquidity risk is that "Banks will not be able to get enough loan customers to fully cover the payout of their broad spectrum of depositors."

To take this further, I think it is useful to look at a specific example. I am tempted to call our hypothetical example "Bank A". But to be slightly less predictable, I will call it "Bank H".

The 'contracted position' for "Bank H's" receivables verses deposits, is significantly altered when the 'human factor' is added in on top. I have already talked about the 'human factor' of depositors leaving money in "Bank H" for longer than they signed up to do so.

The "human factor" that is less discussed is that those who take out loans, have an 'historical statistical tendency' to repay some loans early. How early? In the case of "Bank H', take the current term loans due as one figure, and add to that figure 32% of that short term loan total. More loans being 'cashed in early' is an indicator that there is more pressure to create extra new loans than many shareholders in "Bank H" realise.

Before the GFC, I could scarcely imagine a bank customer's deposit not being repaid in full.

Yet even now I find it hard to imagine that a reverse mortgage customer (for example) would not want to take out a new loan at any price. I suppose if house prices went into a profound slump, a houseowner might suffer the combined effect of a compounding interest reverse mortgage bill aggressively eating away the value of the family home asset that is simultaneously falling in value. A double whammy!

In another example, one might imagine a sharemilker with a herd of cows that has slumped in value, with no means to buy any more cows at any price.

In both these examples, the worst thing the owner of these assets could do is to rush to "sell at the bottom of the market". If I was such an owner, I would attempt to 'hang on' until house/cow prices recovered a bit before voluntarily exiting my loan. So I can now imagine a situation where demand for 'new loans' dries up. Reducing the corresponding 'on call' deposit interest rate might be a way for "Bank H" to lose some 'on deposit' funds quickly. "Bank H" would not want to be in a position of paying interest on deposited funds, while having no customer on the other side to "on loan" these funds to.

When a loan customer enquires about repaying their loan early, a bank can be proactive in seeking new loans to replace those being repaid early. In the short term some 'borrowing headroom' in the parent bank facility can be used to accelerate the new loan process, until the loan to be repaid early is 'actually repaid', or new offsetting debenture deposits come on board. What I have described here is a very short term fix. But this example nevertheless shows that "Bank H"'s 'borrowing headroom' can assist as a bridge in both:

1/ 'paying out depositors' AND
2/ 'setting up new finance receivables'.

SNOOPY

[macduffy]

I'm not sure where you're going with this, Snoopy, but the "primary bank liquidity risk" is surely that the subject bank loses the confidence of the financial "world"; depositors withdraw funds; liquid assets are insufficient to cover further withdrawals; other banks refuse to lend to it; borrowers, naturally enough, don't rush to repay their loans. Unless the central bank/govt comes to the party either with temporary funding or an arranged sale, subject bank folds. Consequences ensue for the rest of the financial system.............

[Snoopy]

I'm not sure where you're going with this, Snoopy, but the "primary bank liquidity risk" is surely that the subject bank loses the confidence of the financial "world"; depositors withdraw funds; liquid assets are insufficient to cover further withdrawals; other banks refuse to lend to it; borrowers, naturally enough, don't rush to repay their loans. Unless the central bank/govt comes to the party either with temporary funding or an arranged sale, subject bank folds. Consequences ensue for the rest of the financial system.............

Macduffy, your explanation of a liquidity crisis corresponds more or less to how I thought the financial system worked, before I read the "Bank of England" explanation that I have previously referenced. Except your explanation is more succinct and clear than I could have managed! The first thing you mention in your chain of events is that 'depositors withdraw funds'. The Bank of England seems to have a different take on all of this though, even if The Bank of England document was talking about the economy in general, whereas this thread is based around what happens from a 'single bank perspective'.

Yet the Bank of England states that it is the 'loans of individual banks' that create external deposits in the accounts of bank customers. And it is these new external to the bank deposits that cause the growth in money supply of a country. From the sole perspective of "Retail Bank H" though, "Bank H" needs to attract some of the already existing money sloshing around in the economy to be 'new' deposits in "Bank H" (even though the money in those 'new' deposits is not new to the country's economy in total). If "Bank H" did not attract a 'new deposit' of 'old money', then Bank H's balance sheet could not support the "finance receivable' that it is creating as part of the process of creating 'genuinely new money' outside of the bank's walls.

The Bank of England seems quite adamant that a potential collapse in the demand for loans is the real threat to the liquidity of the economy, not 'depositors withdrawing funds'. From the perspective of "Bank H" though, 'Bank H' must still manage that balance between 'finance receivables' and 'customer term deposits'. Yet from an overall perspective, the economy does not care if "Bank H" has those term deposits, or if those same term deposits are deposited in another bank that I will call "Bank J". This goes to the heart of looking at the same problem from different angles.

Is a liquidity problem for "Bank H" 'caused' by:

1/ a reduction in people willing to put deposits in "Bank H", (as you assert Macduffy). OR
2/ Does "Bank H" and "Bank J" not loaning people money, so not creating new money in the borrowers account, mean that eventually and indirectly there is no new money for depositors to put more money on deposit in "Bank H".

OR do 1/ and 2/ really amount to the same thing for "Bank H", but from different perspectives? That is the conclusion I came to.

So, if you then accept there is more than one way to explain the same money flows (or lack of) then I think you also must accept that you can explain any liquidity crisis from at least two perspectives. And seeing something like this from both perspectives is actually a really hard thing to do if you were only brought up with one of the explanations.

This in turn explains why I am having difficulty completing my post 24. Time to lie down again as my head is hurting.

SNOOPY

[Baa_Baa]

It is confusing and takes a while to get ones head around it. The Reserve Bank of England report is also tough reading, which doesn't help.

These people http://www.positivemoney.org.nz are NZ's arm of a worldwide movement that are opposed to the practices that enable banks to literally create money out of thin air, ergo create liquidity in the economy (which many/most think that only the country's Reserve Bank can do), all by creative accounting.

It's a consequence of fractional reserve banking and is endemic worldwide. It is also extremely profitable for banks. It is seen by some to be a root cause of many financial issues.

They put the problem quite succinctly: http://www.positivemoney.org.nz/Site...m/default.aspx

And because they think it is a terrible system that has caused no end of trouble, they also have ideas as to a solution: http://www.positivemoney.org.nz/Site...w/default.aspx which they go into a great more detail if one wishes to understand the finer points.

But here are some easy to understand and very informative other sources here: http://positivemoney.org/our-proposals/

I'm inclined to believe all this is correct. As long as it is not illegal it is not in the interests of the banks to disclose precisely how 'money is created' and how they profit from it, or how it affects liquidity in the economy and indebtedness.

Frankly I'm less interested in how it affects the banks' liquidity. They seem to have it figured out any which way.

[Snoopy]

They put the problem quite succinctly: http://www.positivemoney.org.nz/Site...m/default.aspx

And because they think it is a terrible system that has caused no end of trouble, they also have ideas as to a solution: http://www.positivemoney.org.nz/Site...w/default.aspx which they go into a great more detail if one wishes to understand the finer points.

I didn't expect to propose a solution many of the ills of financial system when I started this thread This thread has exceeded my expectations.

Frankly I'm less interested in how it affects the banks' liquidity. They seem to have it figured out any which way.

Call me small minded Baa-Baa, but I still think liquidity within individual banks is very much a live issue. There haven't been any recent bank collapses in Oceania (don't mention NZ's post GFC finance company sector though). But post GFC there are many overseas banks that only exist now because of the support of their respective countries' government's bail outs. Liquidity issues were only fixed by massive capital injections from those governments.

SNOOPY

[Baa_Baa]

I didn't expect to propose a solution many of the ills of financial system when I started this thread This thread has exceeded my expectations.

Call me small minded Baa-Baa, but I still think liquidity within individual banks is very much a live issue. There haven't been any recent bank collapses in Oceania (don't mention NZ's post GFC finance company sector though). But post GFC there are many overseas banks that only exist now because of the support of their respective countries' government's bail outs. Liquidity issues were only fixed by massive capital injections from those governments.

SNOOPY

Certainly wouldn't call you anything of the sort, apologies if I have shifted a bit off topic bringing up the notion of banks being a source of new money in the economy. No doubt the banks need liquidity to survive, it's how they create money out of thin air and their accounting practices that enable that, which subverts the role of the reserve bank that most think is the sole source of money:

http://www.positivemoney.org.nz/Site...letter_72.aspx

BAA