Equity and liquidity, why they are indispensable

Banks in the eurozone, burdened by the debts of their own countries must bail out, increase their “equity”.

The principle is – almost – acquired. Banks in the eurozone, burdened by the debts of their own countries must bail out, increase their “equity”.

Why? Because equity – also called own funds – banks serve as collateral in case of problems. An example: when the institution grants 10,000 euros of credit to a household or a company, it must set aside, in its “chests”, part of this sum. If the household or business in question is ruined, the bank will not be totally destitute. The more bad creditors the creditors have, the more money the institution has to put in reserve.

Equity is used to measure the solvency of a bank. Not to be confused with its liquidity, which represents its ability to finance itself day by day by borrowing from other banks, and which can be just as fundamental for the survival of a financial institution. Thus, Lehman Brothers, at the time of its bankruptcy on September 15, 2008, had the necessary capital but insufficient liquidity.

The regulation on the solvency of banks is very strict, the bankruptcy of an establishment being considered unacceptable because it can endanger the savings of thousands of taxpayers and paralyze the financing of the economy.

Very solid assets

In France, a bank must have a solvency ratio of 8%: for 100 euros lent, it must put the equivalent of 8 euros in reserve. These 8 euros are not exactly bank notes, but very strong assets. Among them, there are funds “very clean”, because of ultra-solid, called “Core tier one”. They must represent 3% of the ratio.

From 2013, banks will be subject to requirements strengthened by the so-called Basel-III rules. The ratio of “very clean” capital, in particular, will have to be increased in quality and quantity. Banks have until 2019 to comply with these rules. But, given the prevailing worries, most have planned to speed up the movement.

Should we do more? The European sector is penalized by the sovereign debt crisis. A credit granted to a state, supposed to be less risky than a loan to a company, has become a potentially toxic loan.

In addition, the economy in Europe is financed 70% by bank loans and 30% by the market, via bonds (in the United States this proportion is the reverse), banks have much larger balance sheets than other -Atlantic. This explains, in part, that stress is focused on European institutions more than American.