The One Thing You Need To Know To Understand Any Banking Crisis

The recent bank problems associated with Silicon Valley Bank and Credit Suisse have highlighted the important distinction between a bank's liquidity and its capital. Liquidity and capital are two crucial aspects of a bank's financial health, and both play a vital role in its ability to withstand unexpected shocks. However, the two are also routinely conflated and lead to a lot of misconceptions as well.

Liquidity refers to a bank's ability to meet its short-term obligations. It is the ability of a bank to pay its liabilities as they come due. For a bank, this means having enough cash or easily sellable assets on hand to meet customer demands for withdrawals or other cash needs of the bank, such as making debt payments.

Capital, on the other hand, refers to the bank's net worth. It is the value of the bank’s assets above and beyond what the bank owes. Much like a homeowner may have a house worth $300,000 while still owing $200,000 on a mortgage, leaving $100,000 in net equity, bank capital constitutes investors’ equity in the firm. Capital is critical because it serves as a buffer against losses, ensuring that the bank can absorb losses without risking insolvency (i.e., having negative net worth).

The recent banking problems have highlighted the importance of these two aspects of a bank's financial health—bank liquidity and bank capital—and also how the two concepts are related. Silicon Valley Bank's liquidity problems, for example, began when it experienced large losses on its bond portfolio. These were only paper losses at first. As interest rates rose rapidly in recent months, the value of SVB’s VB bond portfolio fell since bond prices and interest rates are inversely related.

However, the paper losses led to a loss of confidence and a run on the bank, with customers withdrawing funds, leading to a liquidity crisis. Had SVB been able to hold its bonds to maturity, it might never have had an issue. However, problems arose when it had to sell its bonds on the open market at a loss in order to obtain the cash it needed to meet customer withdrawals. This is how a liquidity problem can quickly morph into a capital problem.

Credit Suisse's problems were similar although they have taken longer to unfold. Credit Suisse’s share price has fallen more than 75% over the last year, largely as a result of some bad investment decisions, as well as turnover in top management. The company has been trying to turn things around, but the recent banking problems in America seem to have scared investors, leading some to think Credit Suisse may be the next domino to fall.

As Credit Suisse began facing withdrawals, Swiss authorities stepped in to help engineer a takeover of the company by its long-time rival, UBS. Note that UBS is unlikely to agree to such a takeover if it thought Credit Suisse was insolvent (although the Swiss government has agreed to share in some of Credit Suisse’s losses). Presumably UBS executives believe Credit Suisse’s net worth exceeds the $3.2 billion they have agreed to pay for the company, otherwise they would not sign off on the sale.

In response to the liquidity problems faced by European banks, the Federal Reserve and other central banks have ramped up swap lines to provide access to U.S. dollars. The swap lines allow foreign banks to borrow dollars from the Federal Reserve or their own central bank in exchange for their own currency or in exchange for some other asset, such as U.S. Treasury bonds. This provides the foreign banks with access to liquidity in U.S. dollars, which they can use to meet their short-term obligations.

Some have criticized the Federal Reserve in recent weeks for “ printing money ” or bailing out irresponsible investors. However, it is essential to note that providing liquidity to banks is not the same as a bailout. A bailout involves the injection of capital into an insolvent bank to keep it afloat, while liquidity provision aims to prevent a liquidity crisis from spiraling out of control.

The Federal Reserve acts as a lender of last resort, providing liquidity to banks during times of financial stress. This function is essential to ensuring that the banking system remains stable. Without the central bank acting as lender of last resort, banks might not have access to the funds they need to meet their obligations. This could lead to a self-fulfilling prophecy whereby customers lose confidence, banks sell assets at a loss to meet customer withdrawals, and customers lose further confidence as bank capital is eroded.

So the next time someone tells you that a bank has been bailed out, ask yourself if it is bank liquidity or bank capital that is being provided. The distinction is critical, and the ability to distinguish between the two is an important test of the seriousness of any financial pundit.

By James Broughel, Contributor