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