The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.

If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.

But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.

Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.

The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.

A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.

First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.

And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.

The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.

To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.

Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.

Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?

And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.

To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.

One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!