``HSBC lowered its dividend to raise its core tier-one capital ratio to 8.5% and HSBC`s definition of capital excludes mark-to-market losses on asset-backed securities (ABS). Particularly demanding critics say that it also excludes mark-to-market losses on its loan book. HSBC carries these at book value and impairs as customers default. However, include these items and the core tier-one ratio would drop to just 2%. Treating loan books on the same basis, JPMorgan would be at 5% and many other banks would be insolvent.``
Economist Article
The treasury functions of governments across the world have been dropping lending rates offered to banks and in some cases these rates have nearly hit nearly zero. In normal markets this would stimulate lending but in stressed markets it is appearing to have the opposite effect.
One measure of this effect is the TED spread - The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (T-bills) and is an indicator of perceived credit risk in the general economy.
Bloomberg TED Spread
T-Bills are of course considered to be risk free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases there is a sign that lenders have higher counterpart risk. During the month of October in 2008, this indicator shot up to five times its mean rate and it did this over the matter of a few days. Lately it has been easing but banks have another problem to consider; their capital adequacy.
The capital adequacy of a banks` balance sheet is generally the net difference between assets and liabilities and, it is measured by taking the institutions capital tiers and dividing them by the Risk Weighted Assets of the institution.
Such a simple equation but if we are to look at the denominator part of the equation which is the banks Risk Weighted Assets, we will find that credit risk probably makes up over 60% of the entire pool of the Risk Weighted Assets in a lending institution.
Now if we break down these Risk Weighted Assets in a bank`s typical credit portfolio or single contract, the value of the RWA is calculated by convoluting three variables (in simple terms):
Probability of Default (PD) x Loss Given Default (LGD) x Exposure at Default (EAD).
Where: The PD is the likelihood that a borrower or group of borrowers will fail to meet their repayment obligations. The LDG is the magnitude of loss on the exposure and EAD is the extent of exposure the bank suffers if default occurs. The EAD is calculated by taking into account the underlying asset and its forward valuation at liquidation.
The problem in a recession is that the Probability of Default is rising across the portfolio and the future value of the assets (EAD) that are collateralising these obligations is falling. The combination of these two factors together causes a higher load on a bank`s capital requirements even if the loan portfolio doesn`t change by the bank selling another loan.
The solution of course is that all banks in such a situation must respond by adding new capital to their balance sheet to ensure adequacy is above the regulatory floor, they must do this to remain solvent and well before they can write another contract to their books.
This is the fundamental reason why banks are not willing to lend and it is exacerbated by the mark-to-market reporting requirements which banks perpetually communicate to the market. Continually reporting deteriorating credit portfolios drives projected EAD rates lower by the day and limits the markets perception that the bank will remain solvent.
Something has to give; banks are struggling to sure up more capital through equity channels as their current market capitalisation has collapsed. Governments can of course respond by bequeathing banks not additional liquidity or financing but some form of capital relief and they can do this by either acquiring toxic Risk Weighted Assets off their books or by resetting the capital ratio floors. Until one of these policy techniques is enacted across the board, lending on any rate is going to be difficult.
There is a nasty side to all of this and while it appears straight forward, the capital adequacy requirements of lenders in stressed markets is far from lucid.
Firstly if governments were to acquire these Risk Weighted Assets from banks, then how long should they hold them? What price should they pay or sell them at and when do they release them back to the market? Not all assets are the same of course and if governments are to take control of this paper which borrowers and segments do they select and, what is the economy wide opportunity cost of choosing one contract type over another?
Next point is more of a philosophical problem. The current credit crisis was caused by lending past the natural growth function, paying high rates of return for short term structures and inverting the yield curve. If governments extend credit by taking control of the Risk Weighted Assets equation, the denominator of capital adequacy, they might simply extend the duration of the recession. They could actually end up making the recession deeper, longer, difficult to recover from and surely such policies are enacting a similar process that brought us to this position in the first place.
All for consideration but simply demanding banks to lend is a futile exercise. It can be likened to asking a person to swim without touching water.
