Liquidity matters

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.


  1. Excellent description of the quandry some banks are in and a possible solution to the cancer that has got into the world banking system.

    I have two questions:

    1) Under EU law, can any central bank in the EU provide such injection of funds to the sovereigns? It may be possible to inject into businesses but as I understand it, Maastricht specifically bars central bank financing government, which is what injection into sovereigns would be.


    2) What would happen to the liabilities of a failed zombie bank which are (book) assets to their depositors? Many banks round the EU and wider which are not zombies may still have these on their books. Just dumping the zombies may well add to their number.

    And won't that mean that re-capitalisation will have to start afresh, ie there will be no money to lend for a long, long time as Basel 3/Vickers kick in to slam the stable door long after the horse has bolted?

    The world desperately needs leadership at the moment and the EU seems to have its various heads stuck in the sand. Once again we pin our pathetic European hopes on the US where Obama seems to be the man.

    Austerity is never going to get the economies back to work and the damage to the UK economy with its large banking sector may be terminal.

    1. Hi John.

      No, as it stands under EU law the central bank cannot fund sovereigns directly. But the EU is astonishingly good at changing, ignoring, redefining or otherwise fudging laws when it suits their political objectives. They would find a way of channeling money to sovereigns without using commercial banks, I reckon - if they really wanted to.

      Creditors of any company that fails have to share in the proceeds of the unwinding process. Although I accept that normal bankruptcy procedure is not appropriate for banks, we do need a mechanism for unwinding failed banks quickly and safely and reimbursing creditors as far as possible. But I don't accept that creditors should take no losses. I am generally of the same mind as Keynes on this, that debtors and creditors share equally in the responsibility for failed lending and default. And I am ABSOLUTELY certain that taxpayers should not have to pay for the bad debts of their country's banks. Banks must be allowed to fail if they are insolvent.

      I think that lending to the real economy, particularly small businesses, will have to come from the public sector for a while while the banking sector is cleaned out. We need state investment banks to replace the lending that zombie banks can't do. That is the current situation, actually. But while we are drip-feeding zombie banks we aren't directing money where it can really do some good. We're just pouring it down the drain. That's why I think countries (central banks) should stop supporting zombie banks and start funding people and businesses directly.

      Do you think Obama will survive the election?

    2. Frances - yes the EU is pretty flexible when it comes to breaking the rules! All Euro members have done it and the bigger the country, the more it is ignored. Hence Greece which may be a financial basket case is getting hammered because they thought it was small enough not to matter. The flight of funds from Spanish banks may have made them wake up.

      I watched Peston's piece on the Euro the other night - chilling stupidity that we are well out of but we will still be crucified because of our trading links, the size of our financial sector and the importance of London.

      At the moment all taxpayers are taking a hammering for the bank failures. I am not sure this will change in the UK and I am also not sure that it is not a political rather than economic agenda that is being followed here. But I do agree that an orderly unwinding has to be the solution if the zombies go to the wall otherwise the big French, German and British banks will become zombies themselves.

      Will Obama win? A year or so ago I would have given less than evens. He came over as far too cerebral and not quick to respond to the crisis in the Gulf for example where he fluffed about terribly. And of course he has been stymied by an opposition that went to the wire over the budget and have stopped some of his more 'socialist' reforms.

      But the Republicans have chosen a donkey in Romney who, faced with Obama's media and social network savvy machine, will not I think succeed. Had they chosen someone with charisma and leadership skills, Obama would have been history - in general politicians lose elections rather than win them. I suspect therefore that particularly if he is seen to move things forward on the world economy, Obama will reap the reward as long as it doesn't cost the US taxpayer a dime and their biggest market starts to pick up.

      Not everyone in the US is a red-neck!

    3. I guess to follow Frances' lead, the ECB would have to take the liabilies of all Euro zombie banks, close the bank down, and pay the creditors 50% on the Euro or whatever by creating the appropriate number of billions or trillions of Euros. What would happen to any assets in the zombie banks?

      But this means (a) that they will be paying a number of non-Euro banks quite considerable sums of money and (b) those banks anywhere that have already written their corresponding assets down or off will be in pocket.

      What will Merkel say to all this? And I wonder what this would do to the value of the Euro so maybe it would be a good idea if the Fed, BoE, BoJ and other central banks do the same in their respective currencies.

      Interesting, isn't it?

    4. Haven't they already done something remarkably similar with Greek sovereign debt? Only the haircut was larger than 50% - with interest it was nearly 75%.

      Remember that creditors include small investors, who should receive 100% on the Euro if their investment is below 100,000 Euros (EU deposit insurance rules). I'm not in favour of compensating higher-value creditors at all - they took the risk in order to achieve a return, they should suffer the consequences of their misguided investment.

      Assets that have value can be sold. Parts of the zombie banks may even be separately viable and can be sold as going concerns. Proceeds from asset sales would go to the ECB as a partial offset of the creditor bailout. Any unsold assets would also end up on the ECB balance sheet, probably segregated in an investment vehicle as they would almost certainly be seriously impaired.

      I'm actually not arguing for forcible closure of zombie banks. I'm arguing for streamlined windup and creditor compensation procedures to be put in place, then the liquidity injections to be stopped. Any that can't cope without central bank liquidity transfusions should go through the windup procedure. LET them fail - don't MAKE them fail.

      I think we would be likely to see capital flight from European banks if this path were adopted, which obviously would degrade the value of the Euro. It would undoubtedly be better if this was a global initiative.

    5. You could just give the first 100k Euros at 100% and the rest at 50% or whatever. But if the ECB took all zombie banks 'assets' on at the same time, it may not be as bad overall because some of assets may be liabilities of other zombies so would cancel out.

      It is not only Greek banks though - I would think the contagion will not be arrested unless the same approach was taken with all banks. There are other currencies for which this medicine would be appropriate - all those I mentioned. China would probably complain but it has done very well out of the spending spree in the west so tough really.

      The zombies need not close but clearly there must be some quid pro quo for making them viable again. The senior management would need to be replaced. In effect it would be some form of nationalisation - or super-nationalisation - at a European level. If this was proposed, at least the market would know that stability would come back eventually.

      But it would require careful planning and drilling down into the data so formats and other technical considerations need to be included.

      I was astonished to read recently that one of the reasons for no diligence on traded products was simply that they were all in different proprietory formats. There was no standardisation. Now the SEC, FSA/HMRC and many others require reporting in XBRL format and it is claimed that this makes it much easier to drill down into the products.

      Obama has pronounced now - let's hope that the Eurozone and Cameron.

    6. John,

      I found this on the FTAlphaville site today. It's a blueprint for zombie bank cleanup by Adam Posen, presented to US Congress in 2009. They didn't act on it, which is a pity. But it pretty much describes what we have been discussing.

    7. Frances - (the word 'listen' fell off my last post!)

      That's very interesting and comprehensive. I suggest it wasn't taken up because of the N-word - an anathema to American DNA.

      I haven't followed activity in the US too closely and had quite forgotten the S&L saga. But whatever has been done over the past few years has born some fruit in economic growth and some profit for the taxpayer.

      Unfortunately this small success will probably give comfort to the bank management worldwide that it can avoid the wholesale sort out that is needed.

      But aren't some of Posen's suggestions effectively what was done in the UK? Northern Rock and B&B were fully nationalised and I think the only reason for not doing so with RBS was that it would have cost too much and added about £2bn to the national debt. This inability was also why Lloyds-TSB, a fairly well run bank, was arm-twisted to take on HBOS rather than nationalise that as well. So having a large financial sector run haywire in a medium sized economy was the problem.

      After repeated 'stress tests' etc, as Posen says, EZ regulators should know now pretty much to the penny which are the category 3 Euro banks that need to be super-nationalised. But I doubt it will be done as the EZ is a committee of 17, each with a national bank (whatever they do) and egos to match, apart from the bank shareholders and senior management positions. On the other hand there is not the opposition to nationalisation in the EU - quite the opposite in fact. The issue really is, as presently constituted, could the ECB do any of it?

      Meanwhile the UK has been on a slash-and-burn diet for the past two years and it seems we are likely to take a £2bn hit on Northern Rock alone. Heaven only knows what hit RBS and Lloyds-TSB (surely a bad example of merging banks) will be and when it can return to private hands.

      I suspect Osborne will look at jam today but there won't be much around thanks to the Eurozone woes. He will just offload them to anyone with a few bob to spare - I am sure Dubai and Singapore sovereign funds will be happy to take them for a song. End of.

      We need a national bank for investment in business though, along the German lines. But given the lack of any support for business in the recent budget, this also seems unlikely as the banks will want to lend to the more profitable consumer while persuading governments that they are doing all they can, the lying toads.

    8. No, I don't agree that the UK's handling of its bank failures was right. Northern Rock and B&B were small banks that should have been wound up rather than nationalised. HBOS should have been nationalised outright, not forced into bed with Lloyds. And RBS should have been fully nationalised. Both HBOS and RBS should have been broken up: at the very least, Halifax and NatWest should have been demerged. The HBOS mistake was then compounded by the failure of the Vickers committee to recommend demerger of the enlarged Lloyds group - apparently on the grounds that it would bring the Brown administration into disrepute. The whole business was a total foul-up by a Treasury team that hadn't a clue what it was doing and was flying by the seat of its pants. Not that government across the Pond, or in Europe, was any better, though. The US kept its banks afloat but has totally failed to restructure and re-regulate the industry. Europe hasn't even managed to keep its banks afloat, really - they are zombies, as I've pointed out. And the UK still has an out-of-proportion and out-of-control financial services sector. Roll on the next banking crisis. Oh, wait, it's already here....

    9. You are probably right but I think the government was between a rock and a hard place and the policy steps were decided on the fly. But at least the banks kept working after a fashion, zombie or not. I don't know whether any of them are still zombies but if the EZ does the sensible thing, UKFI toxic assets inc may end up collecting quite a bit from Frankfurt!

      But wasn't the issue that the RBS total debts alone were £2trillion (typo above!) and that frightened the Treasury so much? I don't think nationalisaton of both RBS and HBOS would have been possible - the total national debt would have increased four-fold. Demerging Natwest and Halifax would have taken ages I guess although I would like to see this happening even now.

      [Our mortgage is with the Halifax and we bank with the NatWest. We don't want both of them going to the wall unless it means no mortgage or we can offer them 25p in the pound for it!!]

      But what would have been the consequences of winding up NR and B&B? Would depositors have got much of their money back? Wouldn't it have caused a mass panic? There was so much toxic stuff particularly in NR. This sort of thing led the Irish government to guarantee all deposits and that didn't do them too much good. Mind you they didn't ask for permission of the ECB I think.

      Vickers won't work anyway but I didn't think it was politically motivated - that's nasty.

      The next banking crisis is really upon us now. If the EZ doesn't sort itself out PDQ it will be much worse than 2008.:-(

  2. Nice run thru.

    In reality states don't go bankrupt they just deteriorate. The EUro seems to me to be acting like a Gold Standard thus if you dont have a printing press you can never solve the liquidity problem. Even with the GStd you always have a portion of the paper that had some value. With the EUro the states really can run out of money and thats got to be the most dangerous thing you can imagine. This I think is what is different about the EUro.

    Seems to me you market potentially dangerous breast implants and you go to jail, you market a potentially nuclear dangerous currency system you get the jet, the gold plated pension and a state funeral.

    I think it might be time for the riot act, we have every right to expect our neighbours not to burn down the neighborhood. Doing so is a hostile act.

    Aside, The Spanish banks you talk of are infact new banks constituted over the past 2 years into private banks from the mutuals/cajas, who are the source of the problem for Spain. Soon to be Public banks

  3. I like the explantion, comparing the country to a family. Bank of Mum&Dad giving money to their lazy children is the same as the government giving money to the banks.

    However I disagree on one of your last points. That of "Use the money directly to support businesses, develop infrastructure, put people back to work and restore your economies" along with "That's why I think countries (central banks) should ... start funding people and businesses directly." from your reply.

    Government shouldn't give money directly to business. For one thing it's an abysmal decision maker when it comes to deciding what is successful or not, and for another it's spending tax payers money doing so and doing so in the most ineffienct manner possible.

    Nor should governments spend on infrastructure. It's the slowest way to spend lots of money. Infrastructure takes years of planning to get going and whilst it is doing so is still eating up loads of money.

    Spending money on keeping people in jobs is not useful either. The jobs have to be productive jobs. Paying people to sweep streets is not good use of taxpayers money.

    Governments can give money to businesses indirectly however. By not taking it off businesses in the first place. A business knows best how to spend it's own money. It can use the money not spent on taxes on either investing, paying off debts, or salary increases. What ever it needs to do to keep going. Governments can also help new businesses start up by lowering the barriers to entry such as the minimum wage and regulatory and licensing requiremnts.

    1. I agree that infrastructure projects are a poor way of dealing with recessions. I agree that government should not "Use the money directly to support businesses…” Unfortunately, your alternative idea, namely that government cut taxes in businesses comes to almost the same thing as “support for businesses”.

      I suggest the basic purpose of economic activity is to produce what the consumer wants, both in the form of consumer goods and in the form of public spending items (NHS, etc). Thus the solution to a recession is to give the consumer more of that which enables the consumer to purchase more of what he/she wants, i.e. money (plus expand pubic spending).

      There is of course an argument to be had over what proportion of the tax burden is placed on businesses vis a vis consumers. But that argument is independent of how best to deal with recessions.

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  5. "The problem is, of course, whether there are buyers" - no, it's not a problem of buyers, but the problem of asset valuation. If Greece has assets (e.g. islands) and, as you say "no-one wants to buy them" it only means one thing - the price is too high. It's inconceivable that an asset can't be sold at a low enough price (sometimes the price is negative if the asset has negative NPV or, in other words, worthless).

  6. Very nice article, those phrases are indeed very oftenly mistaken (I especially liked your example of an insolvent bank that can still go on paying off their debts for a while).

    A little mistake in phrasing - since net worth is already assets minus liabilities, saying "My "net worth" is still more than the amount I owe" is like double counting, you should've put it "My "net worth" is more than zero" or something similar.


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