What does bank solvency mean? November 29, 2009 at 12:03 pm

Every so often, a commentator either states `Bank A is insolvent’ or suggests that it might be. Wikipedia’s article on Citigroup, for instance, states (at least as I write this)

During the most recent tax-payer funded rescue, by November 2008, Citigroup was insolvent

What exactly might this mean, and how can we judge if claims like this are true? This is quite an important question, after all, so there should be no room for loose language.

Unfortunately, there are two senses in which `solvent’ is used. The first is

Being able to meet obligations as they become due

I.e. liquid, and the other is

Having a positive market value

I.e. value of assets great than the value of liabilities.

Thanks in the main to the actions of central banks, very few banks recently have suffered from the threat of illiquidity. The massive opening of the window since Lehman has ensured that banks can borrow as much as they need to meet claims, and thus the risk of the first type of insolvency has been averted. Therefore as a practical matter if this is what you mean by insolvency, no significant institution has been insolvent since Lehman.

The second notion, balance sheet insolvency, is more subtle. This is because in order to judge if the value of a firm’s assets is greater than the value of their liabilities, we need first to value both the assets and the liabilities. That is hard for two reasons:

  1. We need a valuation principles for each class of asset and liability; and

  2. We then need to apply those principles to obtain values.

The first, then, implies that everyone agrees how to value assets and liabilities; and the second, that carrying out that process is more or less mechanical.

Neither of these things is true. The extent to which fair value should be used is controversial, for instance, for much of a bank’s balance sheet. The recent fight over IFRS 9 is evidence enough of that. Then even if we can agree how much of the balance sheet to apply fair value to, determining those fair values is difficult, as is determining the appropriate level of loan loss provisions. That is why accountants are paid the big bucks*.

In other words, determining the truth of a statement like `RBS is solvent’ or `Citigroup is insolvent’ involves an enormous amount of work, and reasonable men can reasonably differ on the right answer. Without a substantial additional statement about how the bank concerned’s assets are to be valued in practice, such a statement is essentially meaningless.

The clearest definition of solvency – being able to meet claims and having a positive value under audited accounts – is met by pretty much all banks all of the time. So if a commentator says that a bank is insolvent despite being able to meet claims and despite having audited accounts showing it is solvent in the balance sheet sense, you might want to ask them what exactly they mean by that statement, and in particular what valuation principles they adhere too.

* This is what passes for a joke among accountants. Least said, soonest mended.

8 Responses to “What does bank solvency mean?”

  1. You do not mention intangible assets (explicitly). Even if a bank has a negative net value in tangible assets/liabilities, if it has sufficient positive “goodwill” it should be able to trade its way out of its difficulties (so long as the reserve bank provides the necessary liquidity over the interim). A bank can really only become insolvent by messing up so badly that it loses this goodwill.

  2. You have not mentioned the point that without extraordinary support, through the Fed and Government directly, Citi would be insolvent on the first measure (or would have been, at least).

    I forget who said that “market risk can hurt you, but liquidity risk can kill you”.

  3. John Hempson does this issue to death in a comprehensive and insightful posting at

    http://brontecapital.blogspot.com/2009/02/bank-solvency-and-geithner-plan.html

    he discusses five different possible definitions:

    Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?

    Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?

    Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?

    Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.

    Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?

  4. Harry

    Thank you for the Hempson reference. Of his five definitions, 1. (regulatory solvency) isn’t solvency at all – it is capital adequacy; 2. (positive net worth under GAAP) is balance sheet solvency under current accounting; 3. (positive economic value) is meaningless, as we cannot know what might happen if the entity is allowed to continue – things might go well or badly; 4. (positive liquidation value) is balance sheet solvency but using fair value for the entire balance sheet; and 5. is cash flow solvency. Note that a judgment of 2. will potentially change as accounting standards do, while 5. is reliant on the actions of the central bank.

  5. James

    You are of course correct – but on the other hand, without central banks there are very few institutions which would be liquid.

  6. Dave

    Interesting point, thank you. I guess my take is that the judgment of balance sheet solvency is sufficiently complicated that knowing whether it is true or not at a given point is very hard. Certainly it may very well be that a bank which (it turns out at one point in the past) had been insolvent can turn around if sufficiently provided with liquidity, whereas it can also come to pass that a firm which is not liquid is still solvent (e.g. Bear Stearns).

  7. I think my comment aligns with Hempson’s “Positive Economic Value”, which is the sum of both tangible and intangible assets/liabilities. I don’t agree with you that this is “meaningless”, but it is certainly unmeasurable and so not very helpful in assessing solvency. A good solvency measure should be (a) objectively measurable and (b) a reasonable proxy for economic value.

    Of course, in an efficient market, a firm with positive economic value should never be insolvent or illiquid, since it should be able to raise capital as needed.

  8. Dave — Agreed: the ability to determine solvency objectively is key. What I was hoping to do with the post was to point out that that is not a piece of cake… Cheers and thanks for reading. D.