Banks insolvency: An analysis
In a country with deposit insurance an insolvent bank will have its assets seized and sold off and subsequently depositors will be reimbursed gradually
Md. Harun-Or-Rashid
Over 65 U.S. banks have become insolvent and have been taken over by the Federal Deposit Insurance Corporation since the beginning of 2008 financial crisis. Combined, these banks held over $55 billion in deposits, and the takeovers cost the federal government an estimated $17 billion. The largest banks to be acquired have been the presumed Merrill Lynch acquisition by Bank of America, the Bear Stearns and Washington Mutual acquisitions by JPMorgan Chase, and the countrywide financial acquisition also by Bank of America.
Insolvency can be defined as the inability to pay ones debts which usually happens mainly for two reasons. Firstly, the bank may end up owing more than it owns or is owed. In accounting terminology, this means its assets are inferior to its liabilities. Secondly, a bank may become insolvent if it cannot pay off its debts as they fall due, even though its assets may be worth more than its liabilities, also known as negative cash flow or lack of liquidity.
Initially, a bank is in a financially healthy position as shown by the simplified balance sheet (assets-liabilities= shareholders equity). In this balance sheet, the assets are larger than its liabilities, which mean that there is a larger buffer of shareholders equity and leads to a gap between total assets and total liabilities that are owed to non shareholders. If we sold all the assets of the bank and used the proceeds to pay off all the liabilities, what would be left over for the shareholders? In the situation, the shareholders equity is positive, and the bank is solvent.
The bank has granted loans to its customers and some of its customers might default on their loans. Initially this is not a problem; the bank can absorb loan defaults up to the value of its shareholder equity without depositors suffering any losses (although the shareholders will lose the value of their equity). However, suppose that more and more of the banks borrowers either tell the bank that they are no longer be able to repay their loans, or simply fail to pay on time for a number of months or years.
The bank may now decide that these loans are under performing or completely worthless and would then write down the loans, by giving them a new value, which may even be zero. And, this scenario leads to the bank an early warning system of becoming insolvent.
If it becomes certain that the bad loans wont be repaid, they can be removed from the balance sheet. Now, with the bad loans having wiped out the shareholders equity, the assets of the bank are now worthless than its liabilities. This means that even if the bank sold all its assets, it would still be unable to repay all its depositors. The bank is now insolvent and subsequently leads to a bank run.
Notabilly, the bank may have some bonds, shares etc, which it will be able to sell quickly to raise additional cash and central bank reserves, in order to continue repaying customers. However, once these liquid assets have been depleted, the bank will no longer be able to meet the demand for withdrawals. It can no longer make cash or electronic payments on behalf of its customers.
If the bank is unable to borrow additional cash or reserves from other banks or the central bank, the only way left for it to raise funds will be to sell off its illiquid assets, i.e. its loan book. The bank needs cash or central bank reserves quickly. But any bank or investor considering buying its illiquid assets is going to want to know about the quality of those assets i.e. will the loans actually be repaid?. It takes time. If the bank really has to sell in a hurry, the only way to convince the current buyer to buy a collection of assets that the buyer hasnt been able to asses is to offer a significant discount.
The illiquid bank will likely be forced to settle for a fraction of its true worth. For example, a bank may value its loan book at BDT 1 billion; it might only receive BDT 800 million if its forced to sell quickly.
However, deposit insurance can play a vital role to stand against insolvency. In a country without deposit insurance an insolvent bank would not be able to repay people deposits in full. In the event of insolvency depositors would have to queue up with other bank creditors to reclaim whatever money they could from the bank. Remember, this is not the end of the story. The failure of one bank could lead people to worry about the financial position of other banks.
Furthermore, the insolvent bank would have certainly owed money to other banks, as would its customers. This can lead to a domino effect; a bankruptcy at one bank can lead to a cascade of defaults, bank runs and insolvencies as people panic. One way a bank can raise funds quickly in the event of a bank run is to sell assets. However, if distressed selling occurs on a large enough scale it may lead to a debt deflation.
In a country with deposit insurance an insolvent bank will have its assets seized and sold off and subsequently depositors will be reimbursed gradually. This is intended to prevent bank runs spreading and the mass sell-off of assets that may spark a debt deflation.
But deposit insurance may have some problems too. In a system without deposit insurance, depositors have a big incentive to monitor their banks behavior, to ensure they do not act in a manner which may endanger their solvency; economists call this moral hazard i.e. when the provision of insurance changes the behavior of those who receive the insurance in an undesirable way.
For example, if you have contents insurance on your house you may be less careful about securing it against burglary than you otherwise might be. When an actual systemic crisis comes, it seems inevitable that the need for governmental assistance will arise yet again, and we will be right back where we were in 2008.
The writer is a Certified
Finance Specialist
