Financial Crisis

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Originally Posted by Student Mullet

Thanks, I think that's the point that had me confused. Is it correct then to say that capital includes money that the bank has on deposit?

In my simplistic model of the situation I've divided the money in the bank into two categories. The first is money that belongs to the bank like accumulated profits (minus whatever they've given back to shareholders) and the second is money that the bank is minding for someone else like peoples deposits or a loan from another bank.

The point of my questioning is to find out whether the losses that they're likely to make is greater than the amount of their money that belongs to them because if it is they'll have to dip into the second pool to make up the difference.

Unless I'm misunderstanding you, you're using the word 'capital' to describe a mix of both types of money.

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Firstly, there aren't two separate pools of money.

So broadly yes, banks are lending your money out and if a sufficient number of borrowers fail to repay borrowings (would need to be fairly sizeable to exhaust the capital buffer) then depositors money is at risk.

But bear in mind all this is dynamic and banks can raise deposits and reduce loan volume to provide additional coverage.

In practice what will happen is that the capital ratio will go below acceptable tolerances well before this happens and the banks will be required to get a capital injection. As happened in the UK.

I think either I'm not understanding you or you're not understanding me and, given our levels of knowledge on the issue, it's probably the first option.

My highest level of education in these matters (Junior Cert. Business Studies) used a definition of capital different from the one you're using. My notion of capital wouldn't include depositors' money but you're telling me that money which belongs to the bank can't even be conceptually separated from deposits and that's what has me confused. When I'm doing my own finances I look on money I own myself (from my grant or wages) as very different to money I borrowed but have to pay back, I don't see why the banks wouldn't draw a similar distinction.

When I saw the financial regulator on Prime Time he said that there's nothing to worry about because the banks have capital of 40 billion, or some other really big number. That put me at ease because I thought that, no matter how bad things get, there's no way that the banks could loose that amount of money. Now you're telling me that the big figure isn't what I'd call capital but mostly made up of depositors money. That brought be back to my original thought, do the banks have enough of their own money to cover their losses. I'm open to the possibility that I'm wrong and everyone who works in the world of finance is right but it seems to me that what should be the key number in all of this is being ignored in favour of long, complicated descriptions.

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Originally Posted by Student Mullet

My highest level of education in these matters (Junior Cert. Business Studies) used a definition of capital different from the one you're using. My notion of capital wouldn't include depositors' money but you're telling me that money which belongs to the bank can't even be conceptually separated from deposits and that's what has me confused. When I'm doing my own finances I look on money I own myself (from my grant or wages) as very different to money I borrowed but have to pay back, I don't see why the banks wouldn't draw a similar distinction.

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Customers' deposits have two a two fold effect with the bank. The cash deposited is now an asset of the bank but it is also recorded on the balance sheet as a liability owed to the depositers. I don't have a fraction of ORA's understanding but I don't know if that helps.

Yeah, that'd be correct.

I would imagine (and this is from an accounting background, not a financial background) that when the Financial Regulator says the banks have capital of E40bn, that's the nett capital per the balance sheet. This is everything the bank owns minus everything it owes. Going purely by this, deposits are irrelevant as the bank both owns and owes the money as Poor Student said. I agree that sounds like an awful lot of money to lose.

Where the worrying starts is if the bank runs out of cash, not capital. This would create a problem because, even though the bank may still be trading OK, you wouldn't want to put your PASS card into the machine, ask for E200 and have a computer come out to you.

Overall so, cash - be it the bank's or depositors' - can't be separated if you're worrying about liquidity (cash), but it can if you're worrying about capital. But liquidity is the one you really want to be keeping an eye on.

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Originally Posted by pineapple stu

Yeah, that'd be correct.

I would imagine (and this is from an accounting background, not a financial background) that when the Financial Regulator says the banks have capital of E40bn, that's the nett capital per the balance sheet. This is everything the bank owns minus everything it owes. Going purely by this, deposits are irrelevant as the bank both owns and owes the money as Poor Student said. I agree that sounds like an awful lot of money to lose.

Where the worrying starts is if the bank runs out of cash, not capital. This would create a problem because, even though the bank may still be trading OK, you wouldn't want to put your PASS card into the machine, ask for E200 and have a computer come out to you.

Overall so, cash - be it the bank's or depositors' - can't be separated if you're worrying about liquidity (cash), but it can if you're worrying about capital. But liquidity is the one you really want to be keeping an eye on.

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Everything you've said there is what I used to think before I read what the Derry fan had to say. He says that in this case capital includes both shareholders capital (am I using that phrase correctly, what I mean is money from the sale of shares plus profits minus dividends?) and 'other cash instruments'. That second thing sounds like it means people's deposits as well but I could be wrong.

I'm not particularly worried about the Banks having a liquidity problem. That strikes me as a short term issue, if they have the assets to cover what they need they'll find the money from somewhere, even if it's a temporary loan from the govt.

I'd be much more worried if they were insolvent because that puts the depositors/governments money at risk.

I looked up BoI on google and it said that it has a net equity of 6.5 billion. Would it be a correct reading of this to say that the BoI can loose 6.5 billion before becoming insolvent?

http://finance.google.com/finance?q=NYSE:IRE

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Originally Posted by Bald Student

Everything you've said there is what I used to think before I read what the Derry fan had to say. He says that in this case capital includes both shareholders capital (am I using that phrase correctly, what I mean is money from the sale of shares plus profits minus dividends?) and 'other cash instruments'. That second thing sounds like it means people's deposits as well but I could be wrong.

I'm not particularly worried about the Banks having a liquidity problem. That strikes me as a short term issue, if they have the assets to cover what they need they'll find the money from somewhere, even if it's a temporary loan from the govt.

I'd be much more worried if they were insolvent because that puts the depositors/governments money at risk.

I looked up BoI on google and it said that it has a net equity of 6.5 billion. Would it be a correct reading of this to say that the BoI can loose 6.5 billion before becoming insolvent?

http://finance.google.com/finance?q=NYSE:IRE

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I'm loathe to quote wikipedia but in the absence of a better explanation that doesn't involve an EU directive (see a few pages back)
http://en.wikipedia.org/wiki/Capital_requirement

Regulatory capital is a buffer. If the buffer is used up, deposits are at risk. Until it is used up, then they aren't.

The current situation is that the liquidity issue appears to have been addressed by Govt guarantee. This didn't address credit worries in the UK which forced UK Govt to underwrite equity investment to bolster the main banks capital buffer.

I still think it is likely that this will have to happen in Ireland sooner rather than later, despite people like Eugene Sheehy saying he'd rather AIB died that do an equity offer.

So, in summary, possible that depositors could lose if defaults were sufficiently catastrophic, in practice unlikely as Government would be forced to intervene well before capital buffer was exhausted.

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Originally Posted by Bald Student

Everything you've said there is what I used to think before I read what the Derry fan had to say. He says that in this case capital includes both shareholders capital (am I using that phrase correctly, what I mean is money from the sale of shares plus profits minus dividends?) and 'other cash instruments'. That second thing sounds like it means people's deposits as well but I could be wrong.

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When you get to large public companies, there's a couple of different ways of presenting accounts. I ignored that bit in college, to be honest, cos I knew it'd never be relevant to me. I think it all more or less comes back to the way I've outlined it, though (on the basis that two ways of describing the same thing can't really be different).

I think you're right about the E6.5bn. There's massive assets and liabilities because of all the deposits obviously (and stuff like houses that they own). You can also get BoI's accounts on www.CRO.ie. (It'll cost E2.50). Slightly more reliable than google, but it appears that that's the ultimate source for the link you provided.

Thats 6.5bn in the context of approx E150-200bn of total assets.

Absolutely (and a similar amount of liabilities). But it's ultimately the answer to his question.

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Originally Posted by OneRedArmy

I'm loathe to quote wikipedia but in the absence of a better explanation that doesn't involve an EU directive (see a few pages back)
http://en.wikipedia.org/wiki/Capital_requirement

Regulatory capital is a buffer. If the buffer is used up, deposits are at risk. Until it is used up, then they aren't.

The current situation is that the liquidity issue appears to have been addressed by Govt guarantee. This didn't address credit worries in the UK which forced UK Govt to underwrite equity investment to bolster the main banks capital buffer.

I still think it is likely that this will have to happen in Ireland sooner rather than later, despite people like Eugene Sheehy saying he'd rather AIB died that do an equity offer.

So, in summary, possible that depositors could lose if defaults were sufficiently catastrophic, in practice unlikely as Government would be forced to intervene well before capital buffer was exhausted.

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Thanks, I think the two of us are coming a bit closer together on this issue.

From that link, capital seem to mean roughly what I considered it to mean;

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Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses.

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and there's also Tier 2 capital which allows for a few oddments like land re-evaluation to be included.

What you're saying to me so is that banks must have enough of their own money to cover 6% of their 'risk adjusted assets'. And that the banks will run into trouble, not when they run out of their own money but when they loose enough of it to drop below this 6% figure?

Tier 2 isn't worth tuppence in reality. Markets/Regulators are now targeting 6.5-8% core tier 1 as a "safe" amount.

This presents a problem for Irish banks.

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Originally Posted by OneRedArmy

Tier 2 isn't worth tuppence in reality. Markets/Regulators are now targeting 6.5-8% core tier 1 as a "safe" amount.

This presents a problem for Irish banks.

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And Tier 1 is either cash they have sitting in a big safe somewhere (or whatever the equivalent means of storing money is) or stuff they've bought which they now own and which belongs to the bank and does not include any depositors money.

They must have enough of this to cover a potential loss of 6.5 to 8% of the loans they've handed out. The Bank of Ireland has 6.5 billion of this type of money and loans of 190 billion which means that they're nowhere near this 6.5-8% ratio. Because of this, they need to reduce the amount of money they have loaned out and that's why no one can get a loan from BoI at the moment?

Nearly! :D The ratio is based on Risk Weighted Assets, so it's not a flat 6 or 7% of total balance sheets assets.

If you think it's been complicated so far, working out RWA is a whole new beast!

Do risk weighted assets tend to be higher, lower or sometimes higher and sometimes lower than the figure for total balance sheet assets?

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Originally Posted by Bald Student

Do risk weighted assets tend to be higher, lower or sometimes higher and sometimes lower than the figure for total balance sheet assets?

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If I told you that I'd have to kill you ;)

Depends on the profile of the banks, ie what sectors it loans to and what the quality of its book is.

Also depends on whether it has permission to use its internal models to calculate RWA or whether it uses values provided by the regulatory authorities.

So sometimes higher, sometimes lower is the answer!

Not sure if the annual reports of banks provides RWA at the minute, certainly will have to going forward, in some granularity.

Sometimes higher, sometimes lower. Thanks.

Next question; if this figure tends to vary around the figure for total balance sheet assets, by how much does it tend to vary? Would they be in and around the same or can they differ by a lot?

Also; is it fairly safe to assume that the figure for Irish banks will be higher, given the state of the Irish property market?

Edit: Avoid phrases like "going forward, in some granularity". People might be tempted to assume that you're spoofing by using management speak, which I'm sure you're not.

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Originally Posted by Bald Student

Edit: Avoid phrases like "going forward, in some granularity". People might be tempted to assume that you're spoofing by using management speak, which I'm sure you're not.

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1) Thats the way people write in business
2) Frankly, I couldn't give a monkies what people assume!

As I said, its difficult to be anymore specific, without either giving out market sensitive information, or making sweeping assumptions/generalisations about other banks I don't have full knowledge of.

The Basel II Accord is really what you need to be reading for that level of detail
http://www.bis.org/publ/bcbs107.htm
but even with that, it doesn't get you much closer to what each institutions RWA is.

Edit: found this on the web
http://backup.aibgroup.com/errorpage...res2008pdf.pdf

In conclusion then, the numbers we need to judge for ourselves whether the banks are in trouble are kept secret so we'll have to trust our politicians to make the right choices.

The expression "going forward" is actually redundant in every context it's commonly used in. Think about it.

ORA, in the last page of this thread you mention the 1 in 100 event that banks collectively failed to anticipate. To what extent did VAR type models that attempt to quantify extreme events actually contribute to the mis-anticipation of risk? What I'm trying to ask is that as every bank used a similar framework and their framework was saying conditions are benign and at worst won't be that bad, the sheer scale of this misperception presumably ultimately led to its failure.

I met the person at [global rating agency] who developed their SIV rating methodolgy in the 90s. He said he quit as the SIV market grew because the same market value declines modelled when SIVs were merely a small part of the investment market could not be applied / assumed as the SIVs grew to dominate the market. He was right. Doesn't the same apply to VAR type risk assumptions?

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Originally Posted by Stuttgart88

The expression "going forward" is actually redundant in every context it's commonly used in. Think about it.

ORA, in the last page of this thread you mention the 1 in 100 event that banks collectively failed to anticipate. To what extent did VAR type models that attempt to quantify extreme events actually contribute to the mis-anticipation of risk? What I'm trying to ask is that as every bank used a similar framework and their framework was saying conditions are benign and at worst won't be that bad, the sheer scale of this misperception presumably ultimately led to its failure.

I met the person at [global rating agency] who developed their SIV rating methodolgy in the 90s. He said he quit as the SIV market grew because the same market value declines modelled when SIVs were merely a small part of the investment market could not be applied / assumed as the SIVs grew to dominate the market. He was right. Doesn't the same apply to VAR type risk assumptions?

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A lot of good points. A couple of things.

I think it was part "fail to anticipate", part "decide to accept the risk". Or to put it another way, the naive and the stupid.

Next, the models themselves, both market (VAR) and credit risk. In the absence of a time machine, a model is only is good as the data that was used to build it. Data gets patchier the further back you go and we have just come out of the longest period of positive economic performance the world has seen. Ergo, when a model tries to predict the future and it was built using overwhelmingly benign/positive data, then you have an immediate risk that the model can't really capture the downside.

Add in that modelling works a lot better in a world of normal distribution, rather than in the real world where tail events have proven to be fatter than people could've imagined.

And for the cherry on top, as you've identified, we've seen the modelling equivalent of groupthink, where most banks use the same model, which exacerbates every mistake by a huge multiple. This is because not only is everyone exposed to the same model risk, but as everyone is making the same broad decisions, which reduce the available risk premia, the only way to profit is to increase leverage again and again.

But, as I said previously, we have lots of new data to re-build models now :)