You’re right however on the proximate impact of a capital ratio below the regulatory requirement – it will result in a bank run. More specifically and dangerously it will result in an interbank bank run, where all sources of short term liquidity dry up save for recourse to the central bank. For most modern banks, that’s tantamount to ceasing to be able to function – interbank credit lines are essential for things like trade finance for instance.

You should really see capital ratios as an indicator not only of current solvency, but also expected future solvency. If you’ve had the bad luck or incompetence or bad economic environment (or worse, fraud) to actually fall below the regulatory requirement, the chances are likely that the situation will deteriorate further, especially if those circumstances are expected to persist.

If capital ratios fall to zero or negative, then you’ll also be unable to meet all your obligations, irrespective of long or short. The LTROs are time-limited maturity and asset quality transformation exercises – from long term risky assets (securities) to short term safe liquid assets (cash or equivalent), not net long term additions to bank balance sheets.

In simple terms, a liquidity crisis (lack of liquid assets) need not result in a solvency issue, but a solvency crisis threatens not only the ability of a bank to continue as a going concern, but also at the same time induces a liquidity crisis.

I’m speaking here from personal experience (one bank failure, and the takeover of another failed bank).

Maybe I’m unclear, what exactly is the repercussions of having capital ratios below the regulatory requirement? The best I could think of is loss of confidence in the bank.

But ultimately the capital ratio requirement is really regulatory requirement and inflexible to market conditions. It may be great during normal times in the name of prudence but I do think the ultimate test is the banks’ ability to service short term obligation, and Basel requirement is a burdensome factor in times like this.

So, in times like this, there should be some tolerance for deterioration of capital ratios. Maybe, there should be some kind of countercyclical treatment to it.

In terms of capital ratios, money is not fungible. You could be technically liquid in terms of meeting obligations (you meet liquidity requirements), but at the same time also insolvent (not meeting capital requirements).

If core capital ratios fall below 4% (I think) or overall capital ratios fall below 8% of risk weighted assets, you’re busted whether you have lots of cash or not. Only shareholders capital and certain forms of subordinated debt count towards capital ratios – the LTROs do not qualify.

Basel III ups the stakes even more, as capital ratios are set to be even higher than under Basel II. Even if they are solvent now, the Spanish banks will have to raise more capital by 2015. Again, the LTROs won’t count towards meeting those higher capital ratios.

@hisham I may understand how LTRO may not help with capital ratios and its balance sheet issues. But in the short run, solvency and liquidity are the same issue no?

I did think of how LTROs didn’t really help with deteriorating balance sheet through loss of asset value (due to bursting property bubble) earlier but since money is fungible, I’ve come to the conclusion that it shouldn’t matter where the money comes from. What matters in the short run is whether banks can meet up its obligations.

I mean, all these assets suffering from price depreciation are illiquid anyway. Regardless the liquidity of the asset, the price depreciation hurts confidence and that may encourage depositors to initiate a bank run (which is already happening in slow motion it seems) or that loans holders are not servicing their loans like in the US circa 2008. Considering that, I think the LTRO can essentially be the deposit guarantee. I think, it practically is, regardless of its function for refinancing exercise.

At the same time, if these banks need less than EUR100 billion, I think the LTRO would be more than enough. IIRC, there are about EUR200-300 billion LTRO unused still.

So, due to the fungible nature of money, at the very least, the LTRO should postpone the bailout requirement until 2014/15 when the LTRO ends. You can just refinance your impaired loans (though admittedly, under normal situation, nobody grant money to anybody who would do that) and worry about it later.

And many banks are redepositing their LTRO it with the ECB. Though that means free profits, I think it could better be used in addressing actual problem faced by the banks.