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Perspective and real solvency of banks

Can a universal bank go bankrupt ? An objective, rigorous and professional answer is built in three stages: credibility of the banks performed stress tests - assessment of prudential regulation to come - understanding the evolution of the banking business model

Article also available in : English EN | français FR

As a professional market practicing my activities in a bank, I am naturally very often solicited as a professional point of view than a personal perspective on the health of banks. And I often myself faced with the question that kills: Can a universal bank go bankrupt ? In my opinion the answer is no, but still we must explain objectively, with rigor and professionalism, why. Especially trying to avoid unnecessary and self-fulfilling catastrophism which would lead a financial institution to trouble; also, by trying to avoid the politicians and economists complacency, talking about the strength of the European banking system (it is necessary to know that the strength implies a comfortable situation in terms of liquidity and solvency, what we are going to talk about, serious and credible stress tests should be able to assess objectively)

So answer the question of whether French banks and European in particular are strong must be done in three stages:

The best way to check the health of banks is actually implementing serious bank stress tests
Mory Doré


This is about testing the banks solvency. In other words do they have sufficient capital to carry on their lending activities and to cope with a sudden impairment ? It also about testing the banks liquidity: stability of customer deposits and the ability to raise capital easily with normal "liquidity spread" in the interbank market or through certificates of deposit in the short-term and bonds issues in the medium to long term markets

Reviewing the bank stress tests – July 2011

As was seen during the stress tests carried out in July 2010, the latest ones published by the European Banking Authority on the 15th of July 2011 do not include a proper measure of market systemic risk. This hinders their (...)

It is a real dilemma in any case that such exercise:

- If we stress violently risks called systemic, then we create the phenomena of self-realization and it can be counterproductive. Indeed, if the markets were convinced that the banking system as a whole was inadequately capitalized (thus displaying solvency ratios below the regulatory limits) and especially if they believe that the strongest countries , the IMF, the EU and guarantee funds created recently were not able to refund as needed, then we would have been in the following vicious circle: banks are unable to continue lending to the economy and investing into the financial markets because of insufficient capital; so collapse of the real economy and drop in almost all financial assets; so higher provisions =in the income statement of banks and further destruction of capital, so new threats on banks solvency.

- However if one does not, you lose total credibility, and trust that you will be sought at all costs to save, will not be restored for all that.

In fact the establishment of transparent and credible stress tests assumes that when one takes into account the systemic dimension of the crisis (which was never realized). It should have been considered in both the bank stress test of 2010 and the one in 201, the two types of recent systemic events in the recent market history: the bank systemic risk and that of the general liquidity crisis; the sovereign systemic risk and its consequences on the provisioning of banks and insurers portfolios (solvency crisis) and above all, being more pessimistic about the haircuts included. At the recent Greek bailout, we know that these impairments were set at a flat rate of 21% nominal for the Greek securities due before 2020 (21% is ridiculously low and limited to positions maturing before 2020, it is too reductive)

Beyond the sovereign systemic risk, should have been stressed in volume, the liquidity and not only in terms of price because it is here that we can really test the strength of a bank. This means shareholders and analysts being able to judge banks with the followings:

  • Reserves of liquid secured and highly rated securities of the institutions and the capacity of these securities to be readily marketable, including in situation of market disruption
  • Capacity to refinance the institution in the markets or from the central bank, which means to evaluate the richness of the mobilized collateral (securities and credit claims eligible for ECB bids; mortgages and asset backed securities)
  • stability of resources and savings of the balance sheet, collected from customers
Regulatory changes need to secure the banking system
Mory Doré


At this stage, we should consider two reserves

- The future environment of Bale 3 certainly protects the economic agents savings by strengthening the constraints of banks in terms of regulatory ratios; on the other hand it complicates (we’ll talk about it) the financing of the economy

- Regulatory changes may unfortunately be unsuited to the economic period ahead the next 5-10 years: competition increasingly fierce between public and private issuers on capital markets; rebalancing absolutely violent of international capital flows with a gradual disappearance of the savings surplus in emerging countries. We will therefore come back to a regulatory environment that will have to be applied to a 2013-2020 economic period probably inappropriate to this new repository, and that should have been applied to the 2003-2007 economic period, a period with low risk aversion and not sufficient reward of certain risks with ridiculously low credit spreads on the number of issuers from banks and corporate .

Basel III: regulators seem to ignore market failures

The changes in our regulatory framework (BASEL 3) and the widespread use of inappropriate IFRS rules will not solve the imbalances of the international financial and economic system

What is at least certain, is that Basel 3 will make capital more scarce and more expensive with banks that will legally and perhaps even economically hold more capital; and they will finance long term credits with long term resources.

Banks will be more stable and stronger, but this can only be achieved at the expense of the economy: with a higher cost of capital and liquidity, the interest rates charged to customers can only rise and the price of banking services will no longer fall

At the same time, beyond the necessary capital to strengthen the balance sheet, care must be taken at the balance sheet to save money by strengthening the investments requiring low capital (governments bonds with good rating even though they become more and more risky at the expense of corporate and emerging countries assets inherently superior). Warning; when you start to over-invest n a particular class of assets for accounting reasons or compliance with regulatory ratios and not for purely economic reasons, that generate bubbles followed by new crises. Certainly the regulators that lead us to overexpose in public debt now above suspicion may still have a "war" behind.

What is needed above all to understand is that the banking business model will change significantly
Mory Doré


- a. First of all the core business that is processing is called into question

The new expected ratios LCR (Liquidity Coverage Ratio) and NSFR (Net Stable Funding Ratio)are intended to ensure that the match between the maturity of the jobs provided and those of their refinancing remain the highest possible.

The LCR, which should replace the monthly liquidity coefficient will measure the ability for an institution to survive a period of intense stress for a period of one month and is calculated as the ratio between the 30 days liquidities available (consisting of hyper active assets) and the 30 days liabilities.

Reconciling bank processing and prudential regulation

The introduction of new liquidity ratios could undermine banking core business

The NSFR is the ratio between the amount of funding available and stable (equity and resources with maturity greater than one year) and the estimated funding requirements of maturity greater than one year. the need to maintain the one year debt to assets ratio higher than 100% significantly reduces the processing capacity of institutions and challenges the bank’s core business, namely the changes in maturities and the long-term use of resources borrowed in the short-term.

the questioning of this lucrative business during a steep yield curve (which is historically mostly the case) will reduce the processing margin of banks (the difference between the yield on long-term loans and cost of funds in the short-term) and therefore strongly weigh on bank profitability; all this to say that it is not the viability and solvency of banks that is threatened but their profitability with no doubt.

- b. The need to re-develop new forms of securitization

We know that the securitization involves transforming some illiquid receivables included in the bank’s balance sheet, into liquid securities. with this technique, lending institutions remove debt from their balance sheet: there is risks transfer, improvement of solvency and a return of the liquidity. We know in the context of new regulations to come, the solvency ratio is doubly penalized; the side of the numerator (the concept of equity has become more restricted) and the side of the denominator (the risks on assets is more outweighing). Securitization is a good way to reduce the weight of the denominator and transfer the risks to other market participants. It is still necessary to find investors able to subscribe to simple and transparent securitizations, with no resemblance to the opacity and complexity of securitization of 2005-2007. And to do this, the most important is to set up programs that have managed to securitize receivables, so future income of quality.

- c. The changing business model and their greater security go hand in hand with the introduction of new rules by central banks

Their role should no longer be confined to the management of key interest rates and the monitoring of bank’s liquidity. It should also be linked more and more on five type of interventions to enhance the stability of the banking system. This is what we are observing more and more frequently

  • Use of reserve requirements (both on deposits and loans), instrument widely used today by the Asian central banks
  • Establishment of a ceiling for the famous loan-to-value ratio for mortgages in order to limit credit risk in case of housing market downturn.
  • In the same vein, a ratio of Debt service / income, which should avoid granting loans to customers with poor credit rating. Indeed, we remember the subprime crisis. The crisis involved a segment of the U.S. housing market for a few creditworthy customers on which the system worked on the basis of floating rates with a guarantee indexed on the property financed. This was ideal when the two conditions were met : the continuing rise in the housing markets with interest rates kept permanently at low levels; that one of these conditions and the beautiful building collapsed.
  • Monitoring of certain ratios and balance sheets limits (capital adequacy ratio, size of the borrowed resources and levels of interest rates gaps and liquidity gaps)
  • Monitoring of excessive risk-taking to restore profitability of capital. if they retain the same requirement regarding the return on equity as it was established before, many financial intermediates will choose the riskiest assets, for the same capital consumption. So it will eventually challenge the current standards of return on equity in this sector. it must be remembered that the introduction of excessive leverage and large risk-taking associated join this stupid and unrealistic race about profit goals disconnected from the economic fundamentals

Mory Doré , September 2011

Article also available in : English EN | français FR

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