Posted on October 6, 2008 by Ben Connard
A small drop in the value of a bank’s assets can be trouble. A bank is required by the Federal Reserve to have a 6% Tier 1 Capital ratio. Tier 1 Capital is loosely defined as equity, so banks need their equity to be 6% of their assets. For example, a bank with $100 billion in assets would need at least $6 billion in equity ($94 billion in liabilities).
Recently, bank assets have fallen in value, specifically mortgage backed securities, when they have been “marked to market” as required by law. This is due to the underlying mortgage being of poor (subprime) quality and the lack of a market for the securities, meaning a liquidity discount is also required. (This is why lawmakers want to suspend mark to market rules- putting a finger into the dike.)
But even a small fall can have large implications. Using the example, assume the assets are now worth $99 billion. A 1% fall doesn’t seem like much. But since the bank’s liabilities are the same, the Tier 1 Capital ratio falls to 5% ($5 billion equity/$99 billion assets).
A low ratio doesn’t mean the end of the bank if they can raise cash and increase their assets by selling shares. Current conditions have prevented this as investors feared more assets would be written down and banks would not be able to sustain their required capital ratios. And banks haven’t been able to sell these assets because, as mentioned, the market for them has gone dry. The result is banks with large liabilities and low (or even worthless) assets — bankruptcy.
The increased risk of bankruptcy trickles into the interbank lending market. Banks lend to each other when they have an imbalance in cash. A bank that needs money due to substantial loans will borrow from a bank with excess cash; the borrower gets money to fund its loans, the lender profits from its excess cash. The lending rate is based on how risky the lending bank views the borrowing bank, the size of the loan and how much the lending bank has already lent the borrowing bank. The LIBOR (London Interbank Offer Rate) is the standard benchmark rate.
In stable economic times the system works well. The loans are short term (overnight to 3 months), lending banks view the risk as minimal and there are many banks with different cash needs. However, given the ease with which banks are failing, the perceived credit risk has increased and banks are hoarding cash. This has increased the LIBOR rate (the 3 month LIBOR rose from under 3% to over 4% during September) and slowed lending.
The slowing interbank lending market trickles down to Main Street. Without banks lending, there’s nothing to prime the pump on Main Street. Banks lend each other money in the short term in order to make long term loans. The best example is mortgage lending. A bank makes a $500,000 mortgage loan to John Q. Public. In order to make the loan, Springfield Community Bank needs to borrow $500,000 from Bank of America for 3 months, and rollover that loan every 3 months as John Q. Public pays back his mortgage over 30 years.
With limited interbank lending, the mortgage isn’t made, which given recent mortgage loans may not be a bad thing. But the lack of funding effects more than just mortgages. Businesses rely on loans and revolving lines of credit to meet short term cash needs, such as payroll.
John Q. Public works at Widget Inc. Widget Inc. just got a big order of 1 million widgets which they’ll sell for $10 million over a 12 month period starting in 3 months. It’s going to cost them $8 million over the next 3 months to make them—meaning they have a funding gap. They need $8 million now but won’t see any cash from sales for about 3 months. Widget Inc. goes to Springfield Community Bank and asks for an $8 million loan, to be paid back in installments starting in 3 months. Under normal conditions, Springfield Community Bank says “no problem, we’ll lend the money then borrow from Bank of America in 3 month periods over the next year.” However, given current conditions, Springfield Community Bank might just say no, or might come back with loan rates that make the project unprofitable for Widget Inc. Springfield Community Bank has to lend at a rate higher than the LIBOR to make money, so when the LIBOR increases so does its loan terms.
Either way the widgets don’t get made and John Q. Public is out of a house and a job.
Has this scenario actually played out? We know banks are failing (Lehman, Washington Mutual) and interbank lending has slowed (see LIBOR and the increased money available to banks through the Federal Reserve) but are Main Street businesses being affected?
Companies with large amounts of debt are especially affected. Circuit City suspended expansion plans beyond commitments it has already made and is looking to close stores. Advanced Micro Devices Inc., a chipmaker, is looking to raise capital or it may go out of business.
Small businesses are also being hit hard. They are being forced to alternative financing—using personal credit cards and selling accounts receivables. And some are being hit hard when their variable rate loans reset.
Governments are also in a bind. Maine has had trouble raising money for highway repair. Washington DC has stopped plans to expand and improve Dulles and Regan National Airports.
The pain of Wall Street is being felt on Main Street. Some things will not go back to pre-August 2007 levels. Mortgage underwriting should improve so that tenuous loans are not extended to weak borrowers. The era of cheap funding for municipalities and variable interest loans is probably also over. On the other hand, bank lending will eventually return as banks are re-capitalized and become less risk averse.