Liquidity and banks – a primer

Several of the responses to the last post (about bank excess liquidity) seemed to confuse liquidity and solvency.  Indeed several confused “cash reserves” with “loan loss reserves” and the like.

Aaron Krowne – a fairly sophisticated guy and the proprietor of the Mortgage Implode-O-Meter for instance suggested that the 170 billion in cash is necessary to meet loan losses.

Let’s get this right.  A bank’s liquidity goes down when they lend money.  They lend their liquidity.

A bank’s liquidity does not go down when there are loan losses.  You do not need cash to deal with loan losses.  You need net worth to deal with loan losses.

A bank really needs liquidity to deal with people being unwilling to leave their funds either on deposit to a bank or on loan to a bank.  If a bank gets a run on deposits (even a small run) it needs liquidity and it needs it bad.  This is essentially unpredictable.  If it cannot roll its own funding it needs liquidity and it needs it bad however this is more predictable because there will be a known debt maturity schedule they need to meet.

Bank of America carries 170 billion in cash rather than the more normal 30-40 billion because it is scared of runs (both retail and wholesale).

The wholesale run is happening and has been happening ever since that fateful week in September when bank creditors realised that – on the say-so of Sheila Bair – they could lose their assets entirely.  [Washington Mutual as originally confiscated left the senior debt holders essentially nothing.]

Still fear – and fear alone – can run a big bank out of liquidity.  You do not need to be insolvent as a bank to become illiquid.  Pretty well the entire Norwegian banking system was illiquid and confiscated during the 1992 Norwegian banking crisis.  Capital was constrained but the government made a profit on the bank-bail-out suggesting (ex-poste) that the problem was a liquidity crisis and not a solvency crisis.  [Unfortunately nobody, government or private sector, knew for certain whether the issue was solvency or liquidity during 1992 though plenty of people expressed very strong opinions many of which were wrong.]

But get this – and remember it well.  In traditional banking cash held by the bank beyond simple transactional balances exists solely to deal with fear.  If there is no fear then banks have no liquidity problem.  And they will have no liquidity problem even if they are staggeringly insolvent.  Indeed many Japanese banks had no fear, staggering insolvency and operated for more than a decade.  Closer to home Conseco Finance was almost certainly insolvent a few years before it collapsed.

I got at least a dozen emails that thought that liquidity at Bank of America was to do with losses.  All of them misunderstood this simple and key point.  

Now investment bank liquidity is much more complicated.  The most controversial example is credit default swaps – especially margined credit default swaps.

Writing a credit default swap is in many respects very similar to making a loan.  The credit risk – the key risk – is almost identical.

But when you make loans cash walks out the door immediately.  You have to have cash to make loans.  If you have only limited cash then you cannot make unlimited loans and so you will tend to be selective about the loans you make (choosing better credits).  If you have to raise cash in order to finance lending then you need to go to market (issue bonds etc) and that imposes some discipline and costs on you.

When you write a credit default swap you just need someone to have faith that you are good for the exposure.

No cash walks out the door.  

Lending imposes the discipline of being required to have cash.  Writing CDS does not.

Felix Salmon (and others) have had long arguments about whether CDS caused or exacerbated the crisis.  In most this argument I agree with Felix, but the ability to write vast amounts of CDS without needing cash was important in some parts of the crisis.  Plain old lending has more discipline.  This was certainly a large part of the problem at AIG, MBIA and Ambac.  

But CDS have another property.  CDS (unlike loans) do not require cash when they are written.  But CDS (also unlike loans) cause a cash drain when they default.

A bank which writes CDS needs cash to deal with credit losses.  A bank which does traditional lending does not.

Unfortunately CDS cash requirements go up in a financial crisis.  That is when the cash gets called.  

And that is also precisely the time when banks have most fear surrounding them and hence most difficulty raising cash.  CDS give financial institutions a cash call at precisely the wrong time.  That is why – if anything – they exacerbated the crisis.  

Lines of credit written by banks (Citigroup and JP Morgan were huge writers) also require cash precisely in times of crisis.  Most the time you write the line of credit and there is no cash drain on the bank.  But when the customer is stressed the lines of credit will be drawn.  That also – by usual correlation – tends to be the time that bank liquidity is most difficult.

Still – and this is my reaction from picking apart Bank of America – most of the huge cash balance of bank of America is to deal with fear in the funding markets – and very little is required to deal with loan losses.

Capital – that is net assets – is what is required to deal with loan losses.  Cash on hand is frankly irrelevant for that.  Whether Bank of America has sufficient net assets to deal with their (large) loan losses is a matter of widespread disputes.  Many strong and differing opinions exist – and inevitably some of them will be wrong.