Global Agenda: Liquidity and solvency

Liquidity is to the financial system what oxygen is to living creatures. If you cut off the supply, the result is a rapid collapse.

By PINCHAS LANDAU
Euro 311 (photo credit: Wikimedia Commons)
Euro 311
(photo credit: Wikimedia Commons)
The event of the week in the financial world was encapsulated in yet another acronym – LTRO. If you are really interested to know what that stands for, you could Google it, and find out via a site called (what else if not) acronymfinder.com. You would then be presented with a choice, ranging from Legal Technology Resource Officer, which doesn’t sound very suitable, to Locate the Remaining Oil, which is certainly not what you want to do and comes via (who else but) the Shell Oil company. Long Term Refinancing Operation, from the European Central Bank (ECB), seems much more promising and is, in fact, the right answer.
The LTRO event took place on Wednesday and involved the ECB offering an unlimited amount of money to European banks for a three-year period – an unusually long time for a central bank operation, hence the LT part of the name. The demand was expected to be large – the consensus forecast was 300 billion euros – but it proved to be enormous and reached almost 500 billion, with over 500 banks participating in the auction.
What, you may ask, was the great attraction? Was somebody giving away money free? Well, basically – yes.
The interest rate on the money was very low, at around 1% per annum and the maturity period, as noted, was exceptionally long. The exercise was aimed at providing European banks, which have been under considerable funding pressure recently, with cheap and plentiful funds, and this aim was certainly achieved. The event was therefore hailed as a great success.
Immediately, the LTRO was completed and it was clear how successful it had been; the markets sold off. The euro fell against the dollar, share prices went down and so did the prices of bonds of the troubled European countries. Why was there a negative response to this seemingly highly successful and promising development? The simplistic answer is that this was yet another example of the market adage “Buy the rumor, sell the fact.” The markets had risen strongly in the days prior to the LTRO auction, on the expectation that it would be successful – and that it would make a major contribution to resolving the European debt crisis gripping both banks and sovereign states. Once the expectations had been realized, smart traders took profits by selling. This answer is probably partially correct, but is by no means the full explanation.
It can’t be the full explanation, because the hopes placed in the LTRO were not fully realized. The expectation that the banks would take full advantage of the offer and would thereby relieve the funding pressure they were suffering was more than realized. But the hope that this event would mark a major step forward in resolving the wider crisis was entirely unrealized.
Indeed, quite a few analysts noted that the success of the LTRO, so far from moving the crisis nearer to a solution, actually moved it further away.
In order to understand why the success was partial and why even 500 billion euros didn’t help and may actually make things worse, all you need to do is understand one thing – the difference between liquidity and solvency.
But if you understand that, you have effectively understood the entire European and global crisis and why it hasn’t been – and may never be – resolved.
Liquidity is to the financial system what oxygen is to living creatures. If you cut off the supply, the result is a rapid collapse of all vital systems and then death.
Solvency is a much more fundamental state of health and insolvency implies ultimately inevitable, but not immediate, demise. A simple example would be a person suffering a heart attack or some other traumatic medical event. The ambulance that rushes to his aid will immediately give him oxygen and apply procedures to resuscitate him – and then rush him to hospital. If they don’t do that, he will be DOA (dead on arrival) and the hospital will not be able to help him. However, if they keep him alive, they haven’t begun to solve his real problems, which are whatever caused the heart attack, for instance clogged arteries. This will require a long, complicated and dangerous operation, followed by a protracted recovery period – after which, hopefully, he will be able to resume a normal life.
That, in essence, is the difference between addressing a liquidity crisis and solving a solvency crisis. The European sovereign debt crisis is, and always has been, a solvency crisis. But the politicians and central bankers, for various reasons, have regarded it as a liquidity crisis and treated it as such. Providing oxygen keeps the patient alive but does not prevent his underlying condition from continuing to deteriorate, necessitating larger and more frequent interventions to provide oxygen, blood, etc.
On Wednesday, the ECB provided 500 billion euros of oxygen – the largest dose since the near-death experience the financial system underwent in March 2009. That has not healed any of Europe’s sick banks and countries. It has merely kept them alive and, in some cases, extended their agony. That’s why the markets gave the LTRO only one or two cheers and then re-focused on the absence, indeed the further deferment, of a plan to resolve the solvency crisis – if it can be resolved