There has been much discussion recently about whether banks are insolvent or simply illiquid, and indeed similar discussions about some European countries. Mervyn King said that the problem in Europe was solvency, not liquidity - but the ECB has been providing lots of liquidity to keep the banking system and, indirectly, European sovereigns afloat. So what is the difference between insolvency and illiquidity?
Here's an illustration. Suppose I go to the pub with a friend, and when I get there I discover that I have no cash. So my friend buys me a drink. Am I illiquid or insolvent?
It all depends why I have no cash. If the reason I have no cash is that the kids cleaned me out earlier and I forgot to go to the cashpoint, but there is money in the bank that is not earmarked for another purpose (and this is important), then I am illiquid. I don't have ready money available, but I'm not broke. Next time I meet up with my friend, I will have no difficulty buying him a drink in return.
But if the reason I have no cash is that there is no money in the bank, so I can't get any money out, then there are several possibilities.
- If I have reached the end of the month and run out of money, but payday is on Tuesday, then I am illiquid. I have a cash flow problem: in theory I have the money I need, but it isn't available when I need it. Most small businesses (including mine) have cash flow problems of this kind: we issue invoices, but we have little control over when we receive the money, and in the meantime the bills must be paid. Financing this kind of illiquidity requires working capital finance, usually in the form of an overdraft - although very short-term loans at high interest rates can be another way of covering cash flow problems.
- If I have no money because the mortgage payments on my house are taking every penny I earn and I can't afford to eat let alone buy a drink, then provided the house is worth more than the mortgage I am illiquid. I know people will struggle with this idea - surely if the mortgage is unaffordable I am bankrupt? No, I'm not. My money is tied up in assets that aren't easily realisable and my income is earmarked for debt service. If I were to sell my house, I would solve my problem. My "net worth" is still more than the amount I owe. People who are deeply in debt and struggling to meet the payments are often actually illiquid rather than bankrupt (insolvent): what matters is the total value of their assets versus the total amount they owe. If they were to sell everything they own at current market prices, would the amount raised be sufficient to pay off their debts? If it would, they are illiquid. If it wouldn't, they are insolvent. I hope this is clear, because the question of asset value is very important when it comes to considering whether the likes of Greece are insolvent or illiquid.
- If I have no money because I've lost my job, I'm renting somewhere but I can't afford the rent and I don't have anything I can sell to raise money, then I am insolvent. This may be a temporary problem - plenty of people are temporarily insolvent when they lose their jobs, but provided they can borrow some cash to keep them going while they look for another job, this can resolve itself. It is quite wrong to suggest, as some have, that no-one will lend to someone who is temporarily insolvent. The rates will probably be pretty high, but funds can usually be found. The question is how "temporary" the insolvency is, of course. As time goes on, it becomes harder and harder to borrow money, and the rising debt burden deepens the insolvency. Eventually insolvency becomes fixed - the individual (or business) is bankrupt, because the amount of money required to pay off the debts is more than they can raise even when they find another job. How quickly temporary insolvency becomes permanent depends on whether loans can be rescheduled, interest payments reduced and so on. But if I move in with Mum & Dad who are happy to fund me indefinitely, I may be technically insolvent but I can always buy drinks and I may never need to find another job. They will provide me with the money I need to service my debts and I will eventually pay off the debts (or rather, Mum & Dad will). Unless Mum & Dad die or go bankrupt, of course.
I'm sure it is clear by now that the distinction between illiquidity and insolvency is a very fine one. The "job loss" example is particularly confusing, because many people find it hard to tell the difference between temporary insolvency and illiquidity. The difference is certainty. Someone who has a contractual right to receive an agreed amount of money which is sufficient to meet their current obligations (debt service, rent etc.) is not usually regarded as insolvent even if the total amount they owe is greater than the value of their current assets. Someone who has no idea when they will get another job is insolvent if they owe more than their current assets, even if they can meet their current obligations, because they have no certainty of future income. And if someone's certain future income is insufficient to meet their current obligations, they would probably be regarded as insolvent if their assets are worth less than the total amount they owe, even though their immediate problem is lack of cash. I hope that makes sense.
Banks are illiquid by nature. One of their principal functions is "maturity transformation". This means that they borrow money on a short-term basis to settle lending that is much longer-term. Loans such as mortgages are "assets" to banks, deposits and other forms of borrowing are "liabilities". Bank assets tend to be longer-term than liabilities and not easily realisable. So banks have a cash problem. If lots of people turn up in their branches demanding to withdraw their money, they don't have enough money on hand to meet that demand - they may literally run out of money. Sudden large-scale deposit withdrawals are called "bank runs" and they can cause banks to fail.
Both insolvency and illiquidity are potentially lethal. It doesn't matter how much your crumbling ancestral pile is worth if you haven't got enough income to pay the council tax. You may be technically solvent, but your local authority isn't going to be very impressed if you can't stump up the cash. This is the problem with a bank run. Bank creditors - ordinary depositors - demand their money back, but the money is tied up in the banking equivalent of a crumbling ancestral pile (a big heap of mortgages and commercial loans) and the bank can't pay. This is what happened to Northern Rock. When the bank run happened, the Government assumed that Northern Rock's problem was lack of cash, so it provided funds. THIS IS A REASONABLE THING TO DO if a solvent business runs out of cash. Perfectly sound businesses - not just banks - can be brought down by cash flow problems.
Bank runs are NOT an indicator that banks, or the banking system, are insolvent. Insolvency is to do with the balance of assets and liabilities, not whether creditors can be paid. But in the financial crisis banks did turn out to be insolvent. Why?
In the financial crisis, banking assets - loans, and products derived from them - lost value. This is a complex area and I won't go into detail here, but suffice it to say that mortgages and mortgage-related products turned out to be worth considerably less than previously thought. The market for certain products completely collapsed, making those products effectively worthless. The asset side of bank balance sheets shrank dramatically, but the liabilities remained the same. At the time, banks had very little in the way of shareholders' funds (equity), which can be regarded as money they don't owe to anybody, so it didn't take a huge fall in asset values to force losses on creditors. This was insolvency: their total assets were worth less than the amount they owed. Now, remember what I said about temporary insolvency and the bank of Mum & Dad. If banks have good cash flow they can keep going forever even when they are actually insolvent. And in Japan they have been doing so for years - the central bank provides them with money and they keep trading even though their balance sheets are stuffed full of loans that will never be paid back. These are what we call "zombie" banks - they are only kept alive by constant transfusions of central bank funds.
So, looking at Europe now - are European banks really insolvent, or just illiquid? And are the distressed countries insolvent, or just illiquid?
These two questions are related. European banks are highly exposed to European sovereign debt. So if the sovereign debt of Greece becomes worthless because the sovereign is believed to be insolvent, its banks - which hold the highest proportion of its debt - are likely to be bankrupted, and so might banks in other countries if they have sufficient Greek debt to wipe out their shareholders' funds and force creditor losses. Germany's Commerzbank, which was partially nationalised in 2009, has taken significant losses on its holdings of Greek, Spanish and Irish debt, though it has narrowly avoided bankruptcy.
But European banks also have awful private sector assets. In Spain, it's not sovereign debt that is the trouble - it's private debt, bad loans left over from the collapse of the Spanish property bubble in 2008 that are still sitting on Spanish bank balance sheets. Spanish banks look like zombies to me. I'd regard them as insolvent, personally - but they are undoubtedly still trading, and as long as the ECB lends them money they will continue to do so. Nor are they the only ones. Ireland bailed out its banks after the collapse of its property bubble: the banks are now completely dependent on a highly-indebted sovereign. Portugal's banks have become dependent on ECB funding after being frozen out of interbank markets in 2008. Dexia, the Franco-Belgian bank, was split up and nationalised by the two sovereigns. The UK maintains two partly-nationalised banks, implicitly guarantees the rest (though it has ideas about unwinding this guarantee) and has just finished the largest QE programme in the Western world (I've pointed out before that LTRO and QE amount to the same thing). Austrian banks, especially Erste Bank, have large amounts of private loans to Eastern Europe, particularly Hungary which is something of an economic basket case. There are zombie banks all over Europe, with balance sheets full of dodgy loans and not much in the way of equity, because the EU leadership have totally ignored the desperate need for European bank recapitalisation. And central banks - principally but not exclusively the ECB - are spending humungous amounts of money keeping them alive. The European banks are like indigent jobless youth sponging off Mum & Dad. If the central banks cut off the funding most of them would be on the streets. Why are we propping them up, I want to know?
Now to the distressed Eurozone countries. The worst by far is Greece. Is it insolvent? Well, no. Remember my definition of insolvency - value of total assets less than the total amount owing. I hate to say it, but the assets of the Greek state are worth FAR more than the amount it owes. Anyone care to value the Greek islands? The problem is, of course, whether there are buyers, and whether Greece wants to sell. Regardless of how much assets are worth, if you won't sell them or no-one wants to buy them you STILL can't service your debts. This is - partly - Greece's problem. It either can't or won't sell enough assets to reduce its debt to manageable proportions. And the severe recession it has now been in for over four years is reducing its income. So although it is not strictly insolvent, it can't meet its obligations. What is needed - urgently - are measures to improve its income - and for a country, just as for a marginally solvent business with severe cash flow problems, that means DOING MORE BUSINESS. Cutting costs and collecting more of the tax owed may help, but they will not solve the fundamental problem. There has to be more economic activity. Somehow, Greece has to be pulled out of recession.
In fact NO country in Europe is insolvent. But Eurozone countries do have severe liquidity problems. This is because they have adopted a foreign currency - the Euro - and consequently have no control over money issuance or monetary policy. Countries that issue their own currencies cannot have liquidity problems unless they have large foreign currency liabilities (as Hungary does, for example). They can become insolvent, though, if the productive assets of the country collapse to the point where the currency is backed by not very much. For a currency-issuing sovereign the main indicator of insolvency is hyperinflation. The most recent example of this was Zimbabwe, which trashed its main industry - agriculture - while printing large amounts of currency, and predictably ended up with hyperinflation.
Personally I'd stop the central bank transfusions to Eurobanks and provide liquidity support directly to distressed European sovereigns. There is evidence (Japan, Ireland) that using government funds to maintain zombie banks depresses growth: zombie banks cannot lend, because their balance sheets are already too risky, and that prevents business getting the finance it needs to expand and develop, which is essential if economies are to recover. So my message to the European leadership would be: take your zombie banks off life support. Use the money directly to support businesses, develop infrastructure, put people back to work and restore your economies. And if the zombie banks fail, let them fail. The world will be a better place without them.