Solvency uncertainty August 26, 2011 at 10:02 am

I have said this before, but not as starkly as Steve Randy Waldman:

“hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless*. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.

(*I would say ‘uncertain’ rather than ‘meaningless’ here. These ratios do tell you something, just nothing precise.)

John Hempton gets this too:

Bank capital [ratios] can’t be accurately measured…

Because banks have quite a lot of discretion about how they book their losses and most losses can be spread over-time just running out of stated capital is not the common way for a bank to get into trouble.

You see banks deferring losses every cycle. When the crisis hits everyone screams the bank is under-reserving and guess what – everyone is right. But the bank gets to take its losses over time and that suits the bank because the bank tends to have high pre-tax pre-provision earnings in a crisis and time cures things. When you take losses is subjective most of the time. In bad times banks lie about losses because they can and it is their interest to lie. This is – as Buffett has noted – a self-assessed exam where the penalty for failure is death.

The key point is that most of the time this does not matter. The world thinks for instance that BAC’s ‘true’ capital ratio (to the extent that it makes any sense to talk about something that you could never discover) is between 6% and 12%, and as 6% will do, it doesn’t care. The problem comes when either losses or more likely concerns over likely future losses turns that range from 6% to 12% to 2% to 8%. In my judgement that was what the market was saying about BAC before the Buffett deal: that BAC just might be badly capitalized and no one knows.

We are always looking at large financials through a fog. Little about them – and nothing important about their solvency – can be seen precisely. It’s all about confidence. If the market is confident that you are OK, then it lets you borrow and, mostly, you are actually OK. If it isn’t, then you better find a way of restoring confidence pretty quickly because while solvency is fantasy, liquidity is very very real.

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