The anatomy of a solvency/liquidity spiral December 13, 2011 at 3:58 pm

I’m reading the FSA report into the RBS failure (so you don’t have to, and because I griped about it not yet being out last week, so I can’t really ignore it). I’ll post in coming days on various aspects of this long and juicy document, but for now let me concentrate on what I think is clearly the mechanism by which RBS failed: a solvency/liquidity spiral.

First, some quotes from the report.

RBS did not have a solvency problem.

“Many accounts of the events refer to RBS’s record £40.7bn operating loss for the calendar year 2008. But that loss is not in itself an adequate explanation of failure. Most of it indeed had no impact on standard regulatory measures of solvency:

  • Of the £40.7bn loss, £32.6bn was a write-down of intangible assets, with impairment of goodwill contributing £30.1bn. Such a write-down signals to shareholders that past acquisitions will not deliver future anticipated value. But in itself, it had no impact on total or tier 1 capital resources, from which goodwill had already been deducted.
  • In fact ‘only’ £8.1bn of the £40.7bn (pre-tax) operating loss resulted in a reduction in standard regulatory capital measures.

Given that RBS’s stated total regulatory capital resources had been £68bn at end-2007, and that it raised £12bn in new equity capital in June 2008 (when the rights issue announced in April 2008 was completed), an £8bn loss should have been absorbable.” (Page 38)

RBS had a liquidity problem…

“The immediate driver of RBS’s failure was … a liquidity run (affecting both RBS and many other banks)… it was the unwillingness of wholesale money market providers (e.g. other banks, other financial institutions and major corporates) to meet RBS’s funding needs, as well as to a lesser extent retail depositors, that left it reliant on Bank of England ELA after 7 October 2008.” (Page 43)

“The vulnerabilities created by RBS’s reliance on short-term wholesale funding and by the system-wide deficiencies were moreover exacerbated by the ABN AMRO acquisition” (Page 46)

… which was driven by concerns about its potential insolvency

“Potential insolvency concerns (relating both to RBS and other banks) drove that run.” (Page 43)

In other words, people were not sure RBS was solvent (even though it was)

“In the febrile conditions of autumn 2008, however, uncertainties about the asset quality of major banks and the potential for future losses played an important role in undermining confidence.” (Page 126)

“The inherent complexity of RBS’s financial reporting from end-2007, following the acquisition of ABN AMRO via a complicated consortium structure, also affected market participants’ view of RBS’s exposures.”

“It is clear that RBS’s involvement in certain asset classes (such as structured credit and commercial real estate) left it vulnerable to a loss of market confidence as concerns about the potential for losses on those assets spread.” (Page 135)

A significant factor in this was that RBS was seen to be too optimistic about what its assets were worth

RBS marks vs ABX

“Deloitte, as RBS’s statutory auditor, included in its Audit Summary report to the Group Audit Committee a range of some £686m to £941m of additional mark-to-market losses that could be required on the CDO positions as at end-2007, depending on the valuation approach adopted… a revision of £188m was made to the valuation of these positions and was treated as a pre-acquisition [i.e. pre-ABN acquisition] adjustment. No other adjustment was made.

Deloitte advised the Group Audit Committee in February 2008 that an additional minimum write-down of £200m was required to bring the valuations of super senior CDOs to within the acceptable range calculated by Deloitte… The Board agreed that additional disclosures should be made in the annual report and accounts, but supported the view of RBS’s management that no adjustment should be made to the valuation.” (Page 150)

“those exposures [i.e. CDO positions] became a focus of concerns by market participants and thus played a significant role in undermining confidence in institutions active in these areas… RBS’s relatively high valuations of super senior CDOs were scrutinised by market comment in early 2008, and there was concern among market participants that further write-downs would be needed, at a time when RBS’s low core capital ratio was already a source of market comment.” (Page 151)

To conclude then

Liquidity risk and opaque/inadequate disclosures, which give rise to concerns about possible insolvency, are enough to doom a bank even if it actually remains solvent.

There will (I know, I know) be more on this tomorrow.

9 Responses to “The anatomy of a solvency/liquidity spiral”

  1. […] — Speaking of opaque regulatory disclosure… read this post by David on the FSA report. […]

  2. […] — Speaking of opaque regulatory disclosure… read this post by David on the FSA report. […]

  3. […] buying ABN Amro on a drunken dare without any due diligence, which combined with some other stuff led to unpleasantness for RBS. The FSA considered going further up the chain to punish people for putting Jonny in charge, but […]

  4. […] failure: regulatory change since the crisis, and how it measures up given what we know about RBS. As before, the FSA report into the failure of RBS will provide our […]

  5. […] – Anatomy of a solvency/liquidity spiral. […]

  6. A liquidity problem is just the other side of a solvency problem, and only superficially independent of it (and vice versa). If you won’t lend to me, my liquidity problem arises because you perceive me as being less solvent than all the other potential destinations for your money. If I depend on your loan for survival my relative insolvency becomes absolute. Looks like the regulators put too much faith in the book values (because they’re objective …?) of assets whose value is, in large part, determined by their resilience (or otherwise) to liquidity problems.

  7. […] was brought down by liquidity issues even though it was solvent (and so can […]

  8. There’s also the matter of the funding cost/solvency spiral which is not addressed. In particular, while an £8bn loss is not all of £68bn stated tier 1 capital, it certainly non-trivially geared the already bloated balance sheet of that behemoth.

    Furthermore, these were all mark-to-model losses anyway, and accounting firms hardly have any better record than rating agencies in judging fundamental values. Which isn’t all that surprising considering they have the same business models cum massive conflicts of interests. And that’s before considering that such a thing as fundamental value does not exist anyway, due to the inherent circularity in asset valuation.

    Bottom line, as Minsky makes a point of, when a central bank exchanges its liabilities for those of a government, corporation or financial institution, it puts a floor under those asset prices. So was RBS solvent? Ask the BOE & Treasury what they decided.

    Here’s the short version of the post-mortem: RBS was one of the most egregious Ponzi borrowers participating in the local melt up climax of a credit bubble that’s been steadily expanding since the 70s. As such, it was among the first to succumb to a Minsky moment. The rest is parlor games.

  9. Thank you all. There will be more on this particular dynamic on DEM in a little while.