When the Credit crisis hit, many banks faced a liquidity crisis. This means they didn’t have access to enough cash in the short term. They had assets, but, they were tied up in long term loans. If a bank lends a £100,000 mortgage to someone, it can’t ask the homeowner to sell house and payback mortgage straight away.
Many banks faced a liquidity crisis because they had got used to borrowing money on the ‘money markets’ Short term borrowing was cheap. But, after the crisis hit, money markets dried up and many banks couldn’t get access to enough cash. This is a liquidity crisis, which can cause panic as it might appear the banks are unable to meet their commitments.
In this case, it is helpful for governments / Central Bank to offer short term liquidity. By offering cash and short term injections of money, the Central Bank ensures people have faith in the banking system. It prevents everyone lining up outside their bank to withdraw cash (like Northern Rock). In theory, this intervention will only need to be temporary. The banks aren’t insolvent, they just have a short term liquidity problem.
If governments / Central Bank didn’t maintain cash flow, it could lead to a catastrophic bank run, where everyone goes to get out their cash. The great number of bank collapses was one of main reasons for Great Depression.
However, what happens if a bank is insolvent?
Insolvent means you have insufficient assets to meet your liabilities. This is not just a cash flow problem. It is a situation where even if you could sell all your assets, and withdraw all loans like mortgages, it still wouldn’t be enough to meet liabilities (deposits).
In this case, the Central Bank / Government would need to give more than just a temporary cash injection, it needs to cover the real loss of the bank, plus any additional liquidity.
Why Might a Bank Become Insolvent?
A bank could become insolvent if it made bad loans that people defaulted on. Irish banks are facing insolvency because there has been
- a rise in loan default due to recession
- A fall in house and asset prices. If someone defaults on a mortgage, in theory, bank gets ownership of the house. But, if house prices have fallen 30%, the bank has still lost 30% of its initial loan.
This difference is important for the case of Ireland.
Irish banks are not facing a liquidity crisis but real insolvency. The Irish Government offered a blanket guarantee to all Irish bank liabilities. This is why the Irish government debt is spiralling out of control. The Irish government took on the debt of the Irish banks. Furthermore, with the recession getting worse, the losses of the banks are greater than expected.
In effect the Irish government has said, banks and bank investors will not lose anything. The taxpayer (plus IMF and EU bailouts) will pay for everything, investors in Irish banks who may have benefited in the good times will not really have to see a decline in their investments. The Irish have spent 10* more per person on their bank bailout than US bailout [2. Irish Bailout]
Many economists say, in this situation of bank insolvency, the pain of dealing with bank losses should not be borne just by taxpayers, but, should be spread to include those who own bonds and investment in the bank.
Note: At the start of the crisis, Irish government debt was very low (about 27% of GDP). Now two years later, it has shot up to over 115% and looking at % of GNP it is closer to 140% [1. Irish Debt] ). Certainly, tax revenues have fallen because of the recession. But, the bulk of the debt is related to bank debts.