I have been planning to write something on the relationship between capital and liquidity for a while. I have postponed however because the topic is complex and not especially well understood and I did not want to contribute to the body of misconceptions surrounding the topic. An article in the APRA Insight publications (2020 Issue One) has prompted me to have a go.
The article published in APRA’s Insight publication under the title “Capital explained” offers a simple introduction to the question what capital is starting with the observation that …
“Capital is an abstract concept and has different meanings in different contexts.
Capital being abstract and meaning different things in different contexts is a good start but the next sentence troubles me.
“In non-technical contexts, capital is often described as an amount of cash or assets held by a company, or an amount available to invest.”
I am not sure that the author intended to endorse this non-technical description but it was not clear and I don’t think it should be left unchallenged, especially when the casual reader might be inclined to take it at face value. The fact that non-technical descriptions frequently state this is arguably a true statement but the article does not clarify that this description is a source of much confusion and seems to be conflating capital and liquid assets.
The source of the confusion possibly lies in double entry bookkeeping based explanations in which a capital raising will be associated with an influx of cash onto a company balance sheet. What happens next though is that the company has to decide what to do with the cash, it is extremely unlikely that the cash just sits in the company bank account. This is especially true in the case of a bank which has cash flowing into, and out of, the balance sheet every day. The influx of one source of funding (in this case equity) for the bank means that it will most likely choose to not raise some alternate form of funding (debt) on that day. The amount of cash it holds will be primarily driven by the liquidity targets it has set which are related to but in no way the same thing as its capital targets.
Time for me to put up or shut up.
How should we think about the relationship between capital and liquidity including the extent to which holding more liquid assets might, as is sometimes claimed, justify holding less capital.
- Liquidity risk is mitigated by liquidity management, including holding liquid assets, but this statement offers no insight into the extent to which some residual expected or unexpected aspect of the risk still requires capital coverage (All risks are mitigated to varying extents by management but most still require some level of capital coverage)
- So the assessment that holding more liquid assets reduces the need to hold capital is open to challenge
- One of the core functions of capital is to absorb any increase in expenses, liabilities, loan losses or asset write downs associated with or required to resolve an underlying risk issue; the bank may need to recapitalise itself to restore the target level of solvency required to address future issues but the immediate problems are resolved without the consumption of capital compromising solvency
- Liquid assets, in contrast, buy time to resolve problems but they do not in themselves solve any underlying issues that may be the root cause of the liquidity stress.
- The relationship between liquidity and solvency is not symmetrical; liquidity is ultimately contingent on a bank being solvent, but a solvent bank can be illiquid.
- While more liquid assets are not a substitute for holding capital, a more strongly capitalised bank is less likely to be subject to the kinds of liquidity stress events that draw on liquid assets so holding more capital relative to peer banks can reduce liquidity risk
- Being relatively strong matters in scenarios where uncertainty is high and people resort to simple rules (e.g. withdraw funding from the weakest banks; even if that is not true the risk is that other people express that view and it becomes self-fulfilling)
- It is important to recognise that the focus of relationship between capital and liquidity risk described above is the capital position relative to peer banks and market expectations, not the absolute stand-alone position
- The “Unquestionably Strong” benchmark used in the Australian banking system to calibrate the overall target operating range for capital in the ICAAP anchors the bank’s Liquidity Risk appetite setting.
- Expressed another way, the capital requirements of Liquidity Risk are embedded holistically in the capital buffer the target operating range maintains over prudential minimum capital requirements.
It is entirely possible that I am missing something here – I hope not but let me know if you see an error in my logic