Finance Weblog: Why do banks go into bankruptcy? - Instituto de Empresa Business School

Octubre 09, 2008

Why do banks go into bankruptcy?

Antonio Rivela

Let’s make a long story short: Why do banks default in their liabilities?

If you asked a child he would say… because they lack money?: well…True.
Funnily enough, not even market practitioners know it yet.

Why? Because It is not as straight forward as it may appear in Academia or even the financial industry.
In this article I will try to explain how a bank is perceived by financial analysts and how easy it is to get lost in the financial statements forest.

We are taught to focus on over simplistic ratios to rationalize the scheme of things. As you will see in this article I am not a big fan of ratios. Ratios are useful in an stable scenario. But trying to use them to understand what’s cooking now is like trying to value a money-losing start-up with a price to earnings ratio.

If you read the financial press these days you will find “experts” talking about many of them. I have chosen the following:

Gold medal of bank ratios are the so-called capitalisation ratios. These ratios look at equity divided by assets. They are strongly promoted by regulators. And they are pretty much…. Bullshit! Why?

First of all the equity component is fake. It is not the shareholders stake what goes in the numerator but a much more elaborated variable that includes hybrid products. A hybrid is a product that lies between debt and equity. For example my beloved Warren Buffet just bought Goldman Sachs ´s 10% coupon preferred debt or equity if you wish. The issue is that banks do not dare to default in their hybrids because that would kill their reputation in the market so hybrids don’t operate as equity but as crystal clear debt! So regulators… learn this lesson… Lets only look at common stock.

Secondly the assets component is fake as well. Even though it is adjusted by risk factors only internal auditors know the quality of bank assets. For the sake of an example: Lehman risk weighted assets looked pretty decent a month before the US investment bank went into default.

Silver medal would go to the leverage ratios. The tend to measure the opposite. That´s why journalists love to talk about these “hedge fund” scary type of figures like “a bank is 40 times leveraged!… Vow!”. Do not get scared. It is not that meaningful. Sorry guys but we missed the point again. Who cares if we are leveraged. Shouldn’t we focus more if we are able to repay our debt? And secondly you could massively leverage up 80 times a US treasuries position but be massively in trouble with a single non leveraged hedge fund investment.

Bronze medal would well be deserved by the so-called liquidity ratios. They attempt to have an appreciation of the whole sale funding component of the funding basket. Why? Because if financial markets are dry it becomes very difficult to obtain whole sale funding. One of the many reasons why I think Emilio Botin is a smart-ass is because he was able to place a Santander-linked convertible bond issue into the Spanish retail base. The beauty of it was that their funding level became super cheap because the average grandmother does not have an exact idea of where the equity volatility lies if you know what I mean! But that´s an ethics problem not a financial problem.

I found two ratios that caught my attention pretty much:
• Whole sale funding / non equity funding
• (Whole sale funding – Liquid assets) / Wholesale funding

Being honest. These latter ratios are interesting but do not address our issues: do they?

So… Is it any light at the end of the tunnel?: I think so but we would not observe it based on financial engineering grounds but cash flows ones: Yes... as my NYU accounting teacher used to say: Cash is king!

What would a street-wise business owner do to see if he or she can afford the service of debt? Look at debt characteristics? … oh dear! We do not need to hire a McKinsey expert for that… do we?

C’mon boys and girls!… Lets look at debt types, volumes and mostly maturities, mostly at short term maturities.

Bloomberg gives us a pretty accurate image of banks redeeming decent sizes of debt in the remainder of 2008 and 2009: CommerzBank (EUR 65bn), Deutsche Bank (EUR 45bn), Barclays (EUR 40bn), Santander (EUR 38bn),RBS (EUR 25bn), UBS (EUR 18bn) … can they pay or no? The answer is yes they can. I hope this back of the envelope exercise has been of any use to heart attacked deposit takers!