It’s the funding, stupid

By Hugo Dixon
November 29, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — Running out of cash — rather than insolvency — is what causes financial crises such as the euro zone’s. Yet the lion’s share of the effort by policy makers around the globe has been to shore up solvency not funding. Unless that changes, the world will lurch from crisis to bailout and back again.

Ireland’s bank crisis is only the latest example of how seemingly solvent institutions can be brought to the brink because they can’t fund themselves. It was only four months ago that Allied Irish Banks (AIB) and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they only stressed solvency not liquidity, although that may be remedied next year.

Ireland’s banks didn’t have a large enough base of retail deposits. AIB’s and BoI’s loan-to-deposit ratios are just above 160 percent. That made them excessively dependent on wholesale money. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.

Sadly, this is an all-too-familiar story. Funding was the Achilles’ heel of banks that went to the brink in 2008. The likes of Lehman Brothers, Northern Rock, Washington Mutual, Royal Bank of Scotland and Fortis may have had inadequate equity. But death through insolvency is a slow one. Death, or near-death, through lack of liquidity is a rapid one.

If Portugal’s banks also get sucked into the maelstrom, funding again will be the trigger. Banco Espirito Santo and Millennium BCP have high capital ratios; but they also have loan-to-deposit ratios of over 160 percent.

The issue isn’t exactly the same for governments because they don’t fund themselves through deposits. However, they do need to keep on rolling over debt as well as financing new deficits. The more stable their funding sources — typically if their own domestic private sector is flush with cash — the better.

The lack of such stable funding is the reason why the Spanish government is vulnerable. Its debt/GDP ratio is expected to end the year at 63 percent, below the euro zone average. But the country has a current account deficit of 4.4 percent of GDP — meaning it is dependent on attracting large sums of capital each year from abroad. The government’s habit of funding itself with relatively short-term debt — it needs to refinance 149 billion euros next year — puts it even more at the mercy of the markets.

Unstable funding isn’t just the main cause of crises; it also forces bailouts. It’s thought too risky to let a bank (or government) go under because the creditors who get hurt will withdraw their cash from other banks (or governments) with similar funding profiles. That, indeed, was the experience with Lehman. It was also the argument used not to haircut the senior creditors of Ireland’s banks. In a febrile climate, even such relatively small institutions are deemed too big to fail.

Given the danger posed by unstable funding, one would have thought policy-makers would have done something about it. And they have done something: the new Basel III regime addresses the issue (which is better than Basel II, which didn’t even mention it). But no action is required until 2018. Yes, 2018 — that’s not a typo.

Similarly, some governments — notably the UK, France and Germany — are planning to impose higher taxes on banks the more that they rely on short-term hot money. This is an excellent idea, as it would give banks an incentive to secure more stable sources of funding. The snag is that this initiative has been diluted because it won’t be global. A plan for such a levy in America by Barack Obama seems to have been killed off by Congress.

In the meantime, there will be more crises and bailouts. And banks, governments and their creditors will draw the logical conclusion: it pays to be foolish.

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