Wednesday, February 17, 2010

The Multiple Solvency Goals Of Regulatory Reform

Everyone most likely agrees that the proposals for regulatory reform of the banking industry are attempts to lower the insolvency risk of financial institutions. The various regulatory reform mechanisms place prohibitions on bank activities and assets, increase a bank's required capital, or increase regulatory powers and oversight of the banks.

Solvency (Insolvency) is a single word with several meanings, but each definition requires different protective measures to protect solvency and prevent insolvency. The individual connotations are often unidentified in proposals or discussions and much of the debate about banking reform is really confusion over which form of insolvency the new rules are trying to avoid. Discussions of the ineffectiveness of a proposal often result from confusion over which form of solvency the rule is protecting as much as it is about the effectiveness of the proposal.

A sensible banking reform package first requires clear articulation of its goals and a determination that the industry modifications will achieve their desired results of protecting the banking institutions and the payment system from the many forms of insolvency.

To help with the process, I am republishing some definitions of insolvency that I first blogged about, "Understanding The Different Meanings Of Insolvency" from almost a year ago.

Solvency can take various forms:


There is regulatory solvency, which wants banks to have adequate and sufficient capital to meet regulatory and legal solvency tests. These tests determine if there will be a regulatory takeover or shutdown of the institution. When one speaks of too big to fail, one generally means that an institution failed the regulatory solvency test, but the regulators are too timid to take it over or shut it down.

Net Worth

There is GAAP (Generally Accepted Accounting Principals) positive net worth, which requires banks to have a positive net worth, more assets than liabilities, on their accounting statements, using the appropriate applicable accounting rules even if they require market value or other measures of the accounting value of the assets and liabilities on the bank's balance sheet.

Economic Value

There is the positive economic value of the bank as an operating entity, which requires an assessment that the bank will be able to pay back its debt and replace its capital if regulators allow it to continue to stay in business, despite its failure to meet other solvency tests.

Liquidation Value

There is positive liquidation value, which looks for a positive value after liquidation of the bank at today's market prices. Personally, I believe that most of the media and the public mistakenly believe that regulatory solvency and capital is equivalent to having positive liquidation value. It is not in most cases. In many cases, due to high leverage and due to many balance sheet assets not valued at current market prices, a bank's liquidation will fail to produce enough value from the assets to payoff the liabilities.


Finally, there is liquidity, which attempts to insure that bank has sufficient cash for its daily operation by holding cash, readily marketable securities and other assets that can easily become cash without a significant loss of value. Many banking crises begin as liquidity crises because as an institution starts to face operating difficulties other institutions are reluctant to lend it money or do business with it without additional assurances, such as more collateral.

Each of these five definitions of solvency behaves differently under different economic scenarios, risk taking and market conditions. Specific regulatory mechanisms to protect each form of solvency are therefore different. A scheme to protect one form of solvency is often inadequate by itself to protect another. Additionally, some schemes may overprotect and unnecessarily burden another form of solvency.

The ultimate goal is to protect the financial institutions and therefore regulatory proposals for reform need to deal with each type of insolvency. To guard each form of solvency, there will be overlapping requirements, over protection of some forms of solvency and unnecessary rules to shield against other forms of insolvency. A perfect regulatory reform package will prevent all forms of potential insolvency. In the end, an excellent regulatory reform package will significantly lower the insolvency risks in the banking industry.

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