By Karamjeet Paul
For the first time in history, regulators are requiring financial institutions to have a specific amount of liquid assets on hand to withstand a 30-day run by creditors and depositors, should a sudden crisis strike again. This is a right step to keep the system from freezing as happened in 2008.
However, will focusing on liquidity prevent what can devastate institutions in crises as experienced by Bear Stearns, Lehman and Wachovia? No, it will not, because institutional liquidity problems in crises are caused by a more fundamental factor.
It is well known that the banking model is fundamentally based upon the illiquidity of borrowing short and lending/investing long. This works only because it is based upon marketplace confidence. This inherent illiquidity built into its business model means that a bank could never maintain adequate liquidity reserves if there is a loss of confidence in the marketplace.
A crisis can quickly turn the confidence-based liquidity model into an illiquid institution. By the time an institution needs to tap into its liquidity reserves to allay a confidence problem, it is often too late and the marketplace begins to suck the remaining liquidity out of the institution. Bear Stearns, Lehman Brothers, and MF Global had extreme liquidity crises before their collapse because the marketplace stopped believing in them as going concerns and lost confidence. So if there is a confidence problem, no amount of additional liquidity reserves can help preserve a going concern because of the fundamental nature of its business model. In fact, it’s the other way around. Preserving the marketplace confidence in a going concern makes adequate liquidity available.
In order to maintain the marketplace confidence, an institution must be perceived as capable of sustaining as a going concern at all times, and particularly through a financial crisis. And, to sustain through a financial crisis with confidence, an institution needs a set of disciplined pre-planned activities, or an effective sustainability-management plan, that prevents extreme events from turning into a life-threatening liquidity crisis.
Banks fail for a fundamental reason. Financial investing is based upon the theory of probability. Therefore, actual results may be favorable or unfavorable versus expectations. Unfavorable results fall into two categories. They can fall short because of the expected everyday ups and downs (“normal risk”). Revenues from other transactions cover such shortfalls/losses. Or they can be massively off because of unexpected events (“tail risk”), and the shortfalls/losses exceeding revenues from all transactions must be absorbed by capital. In extreme situations, such losses can exceed total capital. When they do, the bank fails.
Except for cases involving fraud or financial misconduct, bank failures have always been caused by problems with tail risk.
Actually, to lose the marketplace confidence, an institution doesn’t need to have lost all its capital. Only a perception will do. So if there is a question about a bank’s ability to survive, a chain of events can lead to its demise. All institutions – ranging from Continental Bank to Bear Stearns to MF Global – lost that confidence and in the end were choked to death because the marketplace wouldn’t provide liquidity.
Therefore, a financial institution should never be in a position in which the exposure from an extreme event or tail risk can adversely impact the sustainability of the institution as a going concern and thus turn into a crisis of confidence.
And no amount of liquidity can save a bank in a crisis if there is a perception problem due to the disproportionate amount of extreme-tail risk.