Economics Lesson: The Difference Between Bank Liquidity and Capital

For the past year, and especially for the past few weeks, U.S Treasury and Federal Reserve officials have cautioned that a credit crunch (significant reductions in normal bank lending to companies and household that regularly depend on such credit for normal business activities and investment) threatened to turn a mild economic slow down into a more serious recession. Sometimes they pointed to a lack of liquidity as the problem and at other times to the lack of capital. What is the difference?

Banks and firms, like households, experience a mismatch of receipts and expenditures day by day, which they manage by investing temporary surpluses in liquid assets (those that can be sold and turned into cash quickly and easily) or by borrowing to cover temporary shortfalls. Problems can arise when normally liquid assets become hard to sell or usual sources of funds become hard or expensive to obtain. Its like maxing out your credit card. If depositors withdraw their funds or investors/lenders fail to renew their investments in a bank, the bank must find other depositors/investors, liquidate assets, or reduce lending. If their assets become hard to sell, requiring a discount, or if new depositors/investors become expensive (require higher interest rates) to attract, banks will reduce lending. If secondary markets for their normally liquid assets (e.g. Mortgage Backed Securities—MBSs) become thin, expensive, and unreliable, banks will tend to shift to more liquid assets such as treasury securities and reserve deposits with the Federal Reserve. In short, they will try to build up (horde) “liquidity” as a precaution. When all banks are trying to build up their liquidity at once, their reluctance to roll-over or extend loans squeezes businesses and households who then must cut back on inventories, employees, investments or purchases. Such credit crunches can cause or worsen recessions. Rather than force a bank to sell assets at a steep discount in an illiquid market to cover deposit withdraws, central banks traditionally accept such assets as collateral for loans to banks to satisfy their need for liquidity.

Normally banks borrow and lend from each other in an interbank money market as part of their day to day liquidity management. The interest rate for three month interbank credits (London Interbank Offer Rate—LIBOR) is normally about 0.1 or so percentage points above the Federal Reserve’s target for the interest rate on overnight interbank lending (the Fed funds rate). In the second half of September this spread (mark up over the Fed funds rate) jumped to 2.4 percentage points. This does not represent a liquidity shortage as banks can borrow large amounts from the Federal Reserve at 25 basis points about the Fed funds rate. Rather it is a risk premium for the risk banks see in lending to other banks (counterparty risk). This focuses attention on bank capital.

Capital means somewhat different things in different contexts. For economists, capital is net worth, the difference between the value of a bank’s (or anyone else’s) assets and its liabilities. There is a closely related but somewhat different concept of “regulatory capital” for banks. Capital absorbs limited losses in the value of assets so that banks are still able to honor all of their deposit and other liabilities. Prudential regulations limit the amount a bank can lend in relation to its capital. Thus even if a bank has all of the liquidity it wants, it can not lend if it does not have sufficient capital.

If a borrower defaults on its mortgage from a bank, the bank reduces the value of that loan on its books (it still expects to recover much of the value of the loan by foreclosing and selling the collateral) and its capital falls by that amount. If losses are larger than its capital it becomes insolvent and cannot pay off all of its liabilities. U.S. banking law requires the FDIC to take over banks when their capital reaches very low levels and to sell off the bank or its assets and operations in whatever manner maximizes their value to pay off the depositors and other creditors.

Before introducing deposit insurance (and sometimes still) when depositors suspected that their bank did not have the money to cover and return their deposits, depositors would run the bank (line up to withdraw their money). However, a bank might be solvent (have positive capital) but not be able at the moment to return deposits because it is temporarily illiquid (not enough cash in the faults). This is exactly when central banks are supposed to provide such liquidity by lending to banks. However, the bank might be insolvent as well as illiquid, in which case the central bank should not provide liquidity and the banks should be “closed” (taken over and resolved by the FDIC). A major challenge is that the ultimate value of assets (e.g., loans and mortgages) is not known and can be difficult to estimate. The value of a mortgage cannot be known for sure until it is fully paid off (or defaulted). Thus a bank’s capital can only be estimated. Experience suggests that when banks are seriously illiquid they are almost always also insolvent (negative capital) as well.

Treasury Secretary Paulson and Federal Reserve Board Chairman Bernanke asked for and got the Emergency Economic Stabilization Act, which included the $700 billion Troubled Asset Relief Program (TARP), in order to improve bank liquidity and capital. This act also increased the size of deposits covered by the FDIC’s deposit insurance while at the same time Ireland and some other European countries guaranteed all deposits in their banks (100% insurance coverage). Deposit insurance improves bank liquidity by removing the reason for bank runs, but it does nothing to improve bank capital. It has no effect on bank capital because it does not change the value of bank assets. Deposit insurance also reduces the incentive for depositors to monitor the soundness of their banks. The purchase of MBSs by the Treasury under TARP on the other hand can increase bank capital in two ways as well as improve bank liquidity by improving the marketability of MBSs. If the Treasury pays their actual value for the MBSs it buys, it will ultimately receive that value when they are paid off and these purchases will cost tax payers nothing (however, it is impossible to know for sure what the actual value will turn out to be). If as is suspected the market is currently undervaluing these MBSs because of its aversion to the risk and uncertainty about their “true” value, the higher price paid by the Treasury will allow banks holding them to mark up their value on their books. This will increase their capital at no cost to anyone because it comes from reduced uncertainty. Secondly the Treasury might pay more than their true value for the MBSs it buys. This would increase bank capital even more as a result of tax payers picking up the tab for the difference.

An obvious question is why not just let insolvent (or seriously undercapitalized) banks fail and accept the punishment free markets hand out for poor or overly risky behavior. After all, the FDIC has developed quite efficient ways of handling such failures. In systemic crisis like the one we are in the longer run costs to the economy can be far greater than the costs that fall on those in the financial markets who misbehaved and would be born by most of us. That cost can be limited with minimal damage to market discipline of economic actors by increasing bank capital generally until confidence returns to the market and its normal functioning can resume with market determined winners and losers. This would require that some existing losses be shifted to tax payers. A government (tax payer) recapitalization of banks should be offered only to those banks rated as generally sound by the banking supervisors and those that are not should be allowed to fail (using the FDIC’s normal bank resolution tools). Accounting tricks that merely hide losses (by abandoning honest mark to market accounting) will not do and are dangerous (a form of capital forbearance).

TARP is a rather roundabout way of improving bank capital. I have describe two better ways in "The Big Bailout–What Next?", CATO Institute, October 3, 2008 and in "The Subprime Crisis–Plan C".

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About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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