Anyone who has had to reconstruct a balance sheet knows what a depressing experience it can be. Normally, the starting point has been a pattern of risk which seemed prudent at the time it was incurred, but has been overtaken by events. The result is that reserves have been drawn down, and net asset values have fallen. Debts, which may originally have been well controlled, have become burdensome. Borrowing capacity, which may have seemed ample, now looks uncomfortable or inadequate. The task is to restore the balance sheet to satisfactory ratios. This inevitably involves the realisation of assets or their refinancing.
No-one who has never experienced this process can be regarded as fully experienced. It is not a sign of recklessness; indeed the job of reconstructing a company’s balance sheet often falls to people who are brought into a troubled business specifically for this purpose. That is the time when the marketing men move out and the accountants move in. One problem which business people experience is that they hate to liquidate their most cherished assets, which may represent to them the achievement of years.
In all such operations, a primary objective is likely to be the maintenance of solvency; though solvency is not always at risk, it draws a limit on the company’s freedom of action. In a credit crunch, companies which have not worried about solvency for years may find that borrowing has become much tighter. Cash deposits, which may have seemed a waste of opportunity have suddenly come to have the buoyancy of a life belt. The first stage of a reconstruction is, therefore, the establishment of a cash float which must cover two needs, the ordinary trading needs of the company and the risk of a further deterioration in trading or financial conditions.
The need to build a new cash base is likely to be under time pressure. If the cash is needed it is likely to be needed now; indeed cash is only too often needed yesterday, or a month ago. This time pressure forces the company to make decisions which either involve the sale of assets below their value in more stable circumstances, or the introduction of new finance on unfavourable terms. There may also be personal time pressures. The Chief Executive who exposes his company to a cash squeeze, and has to accept disadvantageous liquidation of the company’s assets, is likely to find his own job is included in the liquidation.
Even after the initial crisis is passed, time is of the essence. The reconstruction of a balance sheet always takes longer than companies or their managers expect. Specialist company doctors, for this reason always try to do “too much, too soon”, because they have repeated experience of the dire consequences of doing “too little, too late”.
There are important differences between reconstructing the balance sheets of a corner shop and a global bank but there are also important similarities. It is usually easier to reconstruct a small company than a big one. The chain of command is shorter, the number of debtors is fewer, though the debts may proportionately be equally large. The debts are not so big that they would be a strategic risk to the potential lenders.
Nevertheless, the pressures of cash and time are similar – as is the pressure of sleepless nights on the decision takers. Since last August, the global banking system has been nervous about access to adequate cash. Banks have been reluctant to lend to each other.
For all practical purposes, the whole banking world has been forced to reconstruct its balance sheet at the same time. It is like the married couple who both feel chilly at night when they only have a single bed blanket on a double bed. Everyone is trying to maximise their cash take from everyone else. The Central Banks are the only people, in these circumstances, who can provide the cash; they alone can restore confidence.
The European Central Bank has provided huge quantities of cash to protect the Euro banking industry. The U.S. Federal Reserve and the Bank of England have been more cautious. I believe that the Central Banks have little choice but to go on pumping in money until confidence returns.
In that, the E.C.B. is making the correct judgment. In classical monetary theory this will risk financing a new inflation. The Central Banks hope that can be avoided, without incurring a global recession. It will be a delicate judgment. In the meantime, prudent bankers are still concerned to strengthen their balance sheets.
for The Daily Reckoning Australia