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Understanding the difference between capital adequacy and liquidity

The latest in our series of articles by guest economist J B Hearn

Before I head away for the long week-end here's another interesting piece from John. Be sure to follow him on Twitter and check all his blogs here

As always, do engage with John in the comments section below. We encourage constructive and intelligent debate.

Have a good and restful break everyone.Thanks again for all your brilliant input and support, and for those of you in the UK and Europe don't forget to put your clocks forward this week-end!

Understanding the difference between capital adequacy and liquidity

"There is a lot of misunderstanding about what is adequate capital and what is liquidity in financial services and certainly among economists and disappointingly so among regulators. In contrast the difference between these terms is understood well in private non-bank businesses because without this understanding a private business will not survive.

Further to this it is necessary to explain that there is one important difference between a bank's liquidity and the liquidity of other businesses. Liquidity for a bank is the ability to supply its customers with cash on demand, whereas for other businesses it refers to their access to money. As we know "all cash is money but not all money is cash". In fact 95% of money is not cash.

To understand the difference between adequate capital and liquidity we will firstly look at two private businesses that are not banks and then we can apply the same principles to a bank

Suppose there are two people identical in every respect, who set themselves up as one person businesses financed by an inheritance of £1million that was deposited in their bank account. Both calculate that this is just sufficient to cover all their costs in the first year of a new venture. At the outset both have £1m of liquidity and no capital in their respective businesses. The year goes well and each has revenue of £2m giving them a profit of £1m. If one person decides to spend £1m on parties and celebrating a successful first year in business then they will start the second year with £1m of liquidity and no capital. If the other person decides to put £1m into a reserve then they now have £1m of liquidity and £1m of capital (own funds) that will protect them against insolvency for a limited period of time.

It is easy to see why so many businesses fail in the early years, because they have not had sufficient time to build reserves of capital, and why staying in business needs a sound capital base. In these two firms it is now clear that one person has capital and the other person does not, but they both have liquidity in their current accounts which is the money they will use to settle all debts as they appear during the coming year.

Now if we look at a bank we can see that adequate capital is the same, in principle, as in any business. Also it should (I will explain "should" a little later) be made up of own funds that can be used to see the bank through any problems for a few years, or hopefully until they have revived the business. However liquidity is different as a bank`s liquidity is its access to the cash it requires to settle everyday customer demand. No one person who goes to a cash machine to take out £100 would accept a bank cheque being delivered from the machine.

Without any rules and regulations a prudent bank should hold sufficient cash to satisfy everyday customer demand (liquidity) and sufficient own funds (capital) to deal with bad debts, mis-selling claims, downturns in the market etc. A history of banking crises, going back hundreds of years, has shown that banks are not very good at doing this and has led to external regulation on banks from two main sources: an internal source, the Central Bank and an external source, the Bank of International Settlements ( BIS )

Internally, and before September 1971 when "Competition and Credit Control" was introduced, the Bank of England applied an 8% cash to total assets rule for the main banks. Along with another 20% of assets that could easily be turned into cash the Bank forced the banks to hold a 28% liquidity ratio. Since September 1971 banks have had a less precise liquidity discipline, but nevertheless an important one, which is determined by their own customers demand for cash. This has usually led to banks keeping 5%-10% of their total assets in cash.

Externally BIS, through the Basel Accords, has tried to exercise discipline over the capital held by banks. This has not been particularly successful hence three Accords which have gradually realised that Tier 1 capital is important and Tier 2 is not important and can easily be abused. This means that what banks have been required to hold in Tier 1 has risen from 4% to 6% and is planned to continue rising until 2019. Because Basel has got it wrong there is a lot of terminology that can be ignored and to understand capital adequacy I want to concentrate on just two elements, which appear in Tier 1, and explain their importance.

If a bank wants to protect itself against insolvency, and here I am ignoring loans, new equity and bailouts, it needs its own funds to draw upon during the bad years and these can be (i) accumulated retained earnings from previous year`s profits and (ii) current profits that have not yet been distributed to shareholders and are correctly referred to as shareholder funds. These are the only safe and sustainable sources from which to cover losses and remain solvent. There is not an unlimited supply of these funds so there is a time limit on the business not making a profit before it will go into liquidation.

Hopefully what is written above explains the basics: capital adequacy is having sufficient own funds to absorb losses for a limited amount of time during which it would be hoped the business can be returned to profit; liquidity is having sufficient cash to satisfy all current and expected demands by customers for printed and minted money.

Since the financial crisis Central Banks have become more involved in imposing capital controls on their banks and BIS has become involved in adding to the controls over liquidity. This is an over-reaction and there are good reasons for all of these controls to be simplified and come from single sources.

Firstly I propose that all controls on capital adequacy come from the BIS and apply to all the world`s major banks and in so doing produce a level playing field in international banking. Secondly I propose that individual Central Banks take total control over managing their own currency and in so doing they are tasked with maintaining a stable currency and always providing sufficient liquidity to the banking system."

John Hearn 21/3/2016

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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