Banks, Equity, Liquidity, and Insolvency

It was my intention to write a number of posts on bank operations and tie them into a narrative of the 2008 financial crisis.  I got no further than explaining the role of capital in protecting banks against losses (Banks and the Importance of Equity) before the exigencies of finishing my classes in the fall semester delayed my plans.  A question by an anonymous reader has placed me back on path.

Brooks,
Thanks for taking a simple example to explain a complex issue such as this. Could you please explain the following for me:

- As loans given out by banks result in profits (e.g., through interest/fees less operating costs), these get added to the equity capital and thus, the equity capital account line grows. However, to me this does not feel like a "real thing" that is available to a bank to absorb losses. It feels like "Cash" is the thing that is ultimately available to the bank to absorb losses. If that is true, then why worry about equity capital at all?

In this post, I attempt to distinguish between insolvency and liquidity.  An institution is insolvent if its liabilities are greater than its assets.  It is illiquid if it does not have sufficient cash to meet its liabilities as they come due.  In the short run, an insolvent institution can be liquid if it has sufficient cash to pay its most immediate liabilities.  Obviously, it will eventually become illiquid as more liabilities become due.  I will also demonstrate that leverage, the number of dollars of liabilities per dollar of equity, magnifies both profits and losses.  
As a quick review, a bank's balance sheet is described by the equation, Assets=Liabilities+Equity.  The owners of a bank have a goal of maximizing profits for a given level of risk.  The risks are the probability that the bank will suffer losses from operations ( expenses exceed revenues) or a decline in asset value.  I will begin with the example provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009.  At the beginning of operations (Year 0), the bank's leverage ratio is $20 of liabilities (deposits) for every $1 of equity. 

Figure 1. Year 0

Assets		Liabilities
Reserves (Cash)	$10	Equity	$5
Loans	$90	Deposits	$95
Total	$100	Total	$100

To keep the math simple, assume that in the first year of operations (Year 1), the bank earns a return of $5.00, or a 100% return on equity.  The bank must decide how to distribute the profit between dividends and retained earnings (I will show retained earnings as an increase in equity.), and if the profit is retained, how it will be invested.  In Figure 2, the bank did not pay dividends, increasing equity by $5.00, and it held all new equity as reserves (cash).  As it begins its second year of operations, it has $9.50 of liabilities for every $1.00 of equity; its leverage has decreased.  

Figure 2. Year 1: The Conservative Option with Profit

Assets		Liabilities
Reserves (Cash)	$15	Equity	$10
Loans	$90	Deposits	$95
Total	$105	Total	$105

If the bank earns a return of 5% ($90*.05=$4.50), the resulting return on equity is ($10/$4.50*100=) 45%.  

Figure 3. Year 1: The Aggressive Option with Profit

Assets		Liabilities
Reserves (Cash)	$2	Equity	$7
Loans	$100	Deposits	$95
Total	$102	Total	$102

Alternatively, if the bank had taken a more aggressive, riskier position as it began is second year of operations, paying $3.00 as dividends, increasing equity by $2.00, and investing the additional $2.00 of equity and $3 of returns in new loans, its balance sheet would be depicted by Figure 3.  Its leverage is $13.57 of liabilities for every $1.00 of equity.  In this case, a 5.0% return on loans ($100*.05=) $5.00, results in a return on equity of ($5/$7*100=) 71.4%.  The additional leverage magnified the return on equity. 

Figure 4: Year 2: The Conservative Option with Losses

Assets		Liabilities
Reserves (Cash)	$9.40	Equity	$4.60
Loans	$90.00	Deposits	$95.00
Total	$99.40	Total	$99.40

Now consider the bank's financial position if it had lost 6% on loans.  Figure 4 adjusts Figure 2 for losses in operations.  The bank's return on equity is (-$5.40/$4.60) -117.4%.  The bank's equity position is weaker, but it is both liquid and solvent.  Compare that outcome to that of the more aggressive investment strategy.  Figure 5 adjusts Figure 3 for a 6% or $6.00 loss on loans after one year of operations. 

Figure 5.  Year 2: The Aggressive Option with Losses from Operations

Assets		Liabilities
Reserves (Cash)	-$4	Equity	$1
Loans	$100	Deposits	$95
Total	$96	Total	$96

The bank is still solvent (Assets-Liabilities>0), but it is illiquid, it does not have cash to meet short term depositor demands.  Its return on equity is (-$6.00/$1.00) -600%.  The higher leverage magnified the losses.  The bank might be able to secure short-term loans to meet its cash demands.  If not, it will be forced to liquidate.

Figure 6.  Year 1: Operating losses

Assets		Liabilities
Reserves (Cash)	$4.60	Equity	-$.40
Loans	$90.00	Deposits	$95.00
Total	$94.60	Total	$94.60

Compare this outcome to a 6% loss on loans ($90*.06=$5.40) in the first year of operations (Figure 6).  If the same level of losses had occurred before implementing an aggressive investment strategy after a profitable year, the bank would have been liquid, but insolvent.  If the losses had occurred after a year of profitable operations, even with the aggressive strategy and illiquid cash position, the increase equity from the first year of operations protected it against insolvency.

My next post on banking will explain maturity mismatching (long-term assets and short-term liabilities), and how it impacts the regulation of banks. 
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Banks and the Importance of Equity

Principles of economics textbooks generally omit equity from the balance sheet equation, Assets=Liabilities+Equity, to focus on money creation. Given the financial crisis that became manifest in September 2008 and its continuing aftermath, this post reinserts equity or capital to focus on the risk of insolvency bankers take in lending. The example is provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009. The article often refers to capital, a richer term than equity, the term used in class. When reading the quote, you can replace capital with equity with no loss of understanding. I added Figure 2 to the quote.

Figure 1

Assets		Liabilities
Cash	$10	Equity	$5
Loans	$90	Deposits	$95
Total	$100	Total	$100

Generally speaking, "capital" is the portion of a bank's assets that does not have to be ultimately repaid to creditors--such as depositors, who are, after all, merely loaning their funds to a bank. To see why capital should offer protection against unexpected losses, consider the following simple example of a bank's balance sheet (Figure 1).

The balance sheet consists of the bank's sources of funds (liabilities) and the uses to which those funds are put (assets). By definition, the two must be equal at all times We can see that our bank has collected $100 of funds: $95 in deposits from retail customers, representing liabilities; and $5 in "capital" which for the moment, we will assume is equity capital: income from issuing shares of common stock in the bank. Such income does not have to be repaid: Shareholders have no legal right to be paid dividends; and common shares have the lowest-priority claim on other assets in case of bankruptcy.

Of the $100 of liabilities (including the $5 in capital), 90 percent is then turned into credit by being loaned out, while 10 percent is held as cash in the bank's vault as cash reserves against potential withdrawals from depositors of a portion of the $95 they have lent to the bank. A bank's loans plus its cash reserves constitute its assets.

Figure 2

Assets		Liabilities
Cash	$10	Equity	$3
Loans	$88	Deposits	$95
Total	$98	Total	$98

Now imagine that some of those to whom the bank has loaned money unexpectedly default, rendering $2 of loaned assets worthless (Figure 2). The bank has to write off these losses, diminishing the total value of assets to $98. But while the value of the bank's assets has declined by $2, the amount that it owes depositors remains exactly the same ($95). Thus, for assets ($98) to continue to equal liabilities, capital must fall to $3. Suppose, by contrast, that the bank didn't initially have any capital, and that its assets ($90 in loans plus $10 in cash) were financed fully by the collection of $100 in deposits. Any unexpected (and unaccounted for) loss would then render the bank immediately insolvent, as the assets--all that the bank has--would not suffice to pay off all that it owes.

It is only due to the fact that a portion of its financing does not have to be repaid (e.g., the portion obtained from issuing stock) that the bank has the capacity to withstand unexpected losses on the investments that it makes with the funds entrusted to it. That is the primary reason that bank regulators believe it necessary to control the amount of capital that financial institutions hold. On the other hand, holding capital constrains risk-taking (and thus, potentially, profitability); that is the point of the capital regulations. To the extent that bank managers view regulatory capital as a tax imposed on them, they will tend to see capital regulations as obstacles to be gotten around.

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Why Do We Need The Credit Cardholders' Bill of Rights (HR 627)?

An old 1992 single frame cartoon shows a man and woman standing in front of a tombstone that reads, "Here Lies a Good Man and a Banker."  The woman asks the man, "When did they start burying two people in one grave?"  As a former banker, I can firmly state that bankers are less popular now they they were then.  It is precisely when a group becomes the target of public and private scorn that we need to be vigilant in guarding their rights.
The White House is pushing legislation that would "protect" consumers from "unfair" credit card lending practices.  The Treasury Department (US Treasury Dept. Supports HR 627-Need For Credit Card Reform) provides a bullet list of the protections that the bill provides as well as a longer explanation of each bullet item.  The bullets are,

• Ban Unfair Rate Increases
• Prevent Unfair Fee & Interest Rate Charges
• Plain Sight / Plain Language Disclosures
• Consumer Right to Know
• Accountability
• Protections for Students and Young People

I have seen two lines of reasoning supporting the legislation.  Some supporters of the bill argue consumers are the easy prey of ruthless bankers who force credit onto naive borrowers.  Once credit is extended and the consumers are hooked, the lenders raise the rates to exorbitant levels based on fine print rules that nobody can read or understand.  Others argue that borrowers have no willpower, and take out credit until they can only meet minimum payments.  These arguments are old and tired and underestimate the intelligence of the average borrower and the competitive nature of consumer credit markets.

Todd Zywicki, in an EconTalk interview with Russ Roberts ("Zywicki on Debt and Bankruptcy", March 2, 2009) describes evolution of consumer credit market.  Fifty years ago, consumers borrowed from friends and family.  Pawnshops also provided credit as did retail lenders who provided installment loans or lay-away plans.  High interest rates of 30 to 40% were hidden in the price of purchases.  Financial innovation separated the purchase from the loan, increasing both transparency of the transaction and consumers' choices. Credit cards offer more flexible payment options and lower interest rates.  I might add that the Internet makes it easy to compare and shop terms and rates.  MSN Money is one of many sites that allow shoppers to compare terms and conditions offered by different lenders.  Consumer credit markets are now national and very competitive.  If a consumer doesn't like terms of your current account, they can switch lenders.  Even when borrowers get in trouble, they have a way out.  Bankruptcy laws in the United States are generous, the most generous in the world.  Finally, current levels of consumer debt are not historically high, Zywicki observes.  Debt appears high because we focus on a relatively new type of debt, credit card debt, that has replaced older forms of debt.   

The rhetoric is certainly aimed at banks, as is the majority of the proposed law's text, but make no mistake, you cannot make it more expensive to lend and not affect the amount of credit offered in markets.  Nor is all of the text aimed at lenders.  Using the section of the bill dealing with students as an example, it is easy to see how less credit will be extended.  A THOMAS (Library of Congress) summary of the bill states,

(Sec. 7) Prohibits extensions of credit to consumers under age 18, unless they are emancipated under state law, or the consumer's parent or legal guardian is designated as the primary account holder.

Prescribes procedures for the issuance of credit cards to full-time, traditional-aged college students. Limits the maximum amount of credit which may be extended to a college student for whom no one else assumes joint liability to the greater of: (1) 20% of the student's annual gross income; or (2) $500. Limits the aggregate credit limits of all such credit cards to 30% of the student's annual gross income in the most recently completed calendar year.

Do you believe consumer credit markets are not competitive, that consumers are abused, stupid, or just lack willpower?  Perhaps I have created a straw man.  Are there other arguments for supporting the Credit Cardholders' Bill of Rights?  Maybe, just maybe, consumers do not need rescuing and government action is not necessary.
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Friedman on Businesses and Markets

Many have noted an apparent paradox of businesses that demand freedom from government taxation, regulation, social engineering are begging for government bailouts. Today, we read that Bank of America will bet an additional $20 billion in taxpayer money on their bold investments (HT Drudge). Does anyone smell a moral hazard? In an episode of porn gone wild, Larry Flynt and Joe Francis are asking for a $5 billion bailout of the porn industry. It seems like the demand for porn is more elastic (responsive to changes in price) than porn executives believed and anti-porn leaders had feared. And who will forget the specter of auto executives driving to DC and eventually winning a $17.4 billion bailout.

In an EconTalk podcast of Milton Friedman hosted by Russ Roberts, Friedman explains that there is no paradox in business behavior. They are doing what's best for them.

[I]t's always been true that business is not a friend of a free market...It's in the self-interest of the business community to get government on its side. It's in the self-interest of a particular business...But the real puzzle—puzzle isn't quite the right word—the real problem here is where do you find the support for free markets? If free markets weren't so damn efficient, they could never have survived because they have so many enemies and so few friends. People think of capitalism or free markets as something that obviously is supported by business. People think that if a business party is a party in politics, it will promote free market. But that's wrong. It will be in the self-interest of individual businesses to promote a tariff here and a tariff there…

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Michael Spence and Root Causes

Michael Spence is a Nobel Prize winner in economics for his analysis of markets with asymmetric information. In a Financial Times Economist Forum titles, "Balance sheets and income statements: breaking the downward spiral" he gives his opinion about the causes of the current financial crisis and recommendations on how to solve it.

I recommend this article. For those who do not wish to read it, here is a quick synopsis. The financial crisis which is international in scope was due to extreme leverage, an underestimation of risk, and the growing correlation of risk between assets. As an example of the correlation of risks between assets, the risk that housing prices in Atlanta would fall at the same time that housing prices in Las Vegas fell increased. The falling housing values were also linked to the default rate on mortgages. Assets and liabilities are found on balance sheets and the correlations were not limited to housing.

Developed economies have to deleverage, lower asset values, and temporarily reduce consumption, but the process may be going too far. Investment, consumption and employment, all part of our national income statement have entered a feedback loop with the balance sheet that is creating a sort of negative bubble. Asset values are being reduced too much, and this in turn results in too great a reduction in investment, consumption and employment. The loop then passes through the loop again.

Spence recommends a large stimulus package, hopefully international in nature, as well as announced in advance. He notes that addressing asset deflation is crucial and very difficult. He also recommends that governments buy assets. He notes that under current conditions, governments will make many mistakes, opening themselves to critics. He ends by noting that it is fortunate that the government's deeds will be done before the critics pens have cooled.

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A Cautionary Tale of Bailing Out Equity

This post is dated; it should have been written in September or early October. On October 1, Paul Krugman made a prescient remark on the government bailout,

My view, which I think is now shared by many economists, is that Paulson grabbed hold of the wrong end of the stick — he should have been seeking to expand bank capital, taking an ownership share in compensation, rather than trying to push up the value of toxic paper. In the end, that’s what we’ll probably do.

Later, Krugman criticized the Bush administration for taking equity but not protecting taxpayers by voting rights or negotiating other concessions from banks and investment banks.

On October 5, Don the swing voter from the Daily Kos succinctly stated his plan,

Nationalize. Then privatize. That is a proven approach.

I am in a fortunate position. I can sit back and criticize without making a decision. I do agree with Don, if you are going to buy equity, nationalizing or partially nationalizing, get in and out as quickly as possible. Long ago, in economic circumstances far, far away, Boarding and Vining studied the performance of private firms, state-owned enterprises, and mixed firms. Mixed firms have both private and government ownership. They found that

The results provide evidence that after controlling for a wide variety of factors, large industrial mixed enterprises and state-owned enterprises perform substantially worse than similar private companies.

While banks, investment banks, and insurance companies are not industrial companies, the incentives faced by private companies, nationalized companies and partially nationalized companies differ. Private companies will try to maximize profits while minimizing costs.

State-owned companies may try to increase employment, increase worker pay, introduce what they consider socially beneficial products, or not introduce innovative products.

Many mixed firms have the worst characteristics of both private firms and state-owned firms. Like Fannie and Freddie, profits may be private and losses paid by taxpayers, or they maintain inefficient social policies to satisfy government overseers.

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Yet Another Reason for the 1937-38 Depression

Tyler Cowen, in a New York Times column, offers yet another explanation for the depression within the depression. (HT to Cafe Hayek)

A study of the 1930s by Christina D. Romer, a professor at the University of California, Berkeley (“What Ended the Great Depression?,” Journal of Economic History, 1992), confirmed that expansionary monetary policy was the key to the partial recovery of the 1930s. The worst years of the New Deal were 1937 and 1938, right after the Fed increased reserve requirements for banks, thereby curbing lending and moving the economy back to dangerous deflationary pressures.

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