Tuesday, 14 May 2013

Banking lessons from Cyprus

Why is it that six years on from the collapse of Northern Rock there is still no semblance of any workable administration procedure having been put in place to deal with distressed or collapsing banks? With the recent banking crisis in Cyprus still fresh in the memory it is apparently not only me who is asking this question. Yet there is still no political or economic consensus regarding how governments should rescue banks. Perhaps the reason is because most people have failed to appreciate the paradoxes that the current system creates. The solution to this problem is, I believe, to fundamentally change the structure of bank deposits, as well to limit the way banks capital ratios are set and the way banks are allowed to operate over national borders. 

After 2007 the two big issues were contagion and moral hazard. The Brown government acted swiftly to protect all bank deposits in first Northern Rock and then other UK banks and building societies such as HBOS and RBS because they were worried about contagion. They feared that the collapse of one big bank could bring down another, and then another, and ultimately the whole system. 

The Bush administration in the USA on the other hand allowed both Lehman Brothers and AIG to collapse because they were more concerned about moral hazard. They were also politically antipathetic to any form of state subsidy or intervention. 

Now we have the Cypriot banking crisis where depositors are facing a 'haircut' on deposits above the EU depositor protection limit of €100k. The problem that we are now seeing is that all three of these approaches have significant downsides. At the crux of the problem is a triangle of paradox and conflicting aims or interests that renders the conventional approach unworkable. 

Ideally what most economists and policymakers want to see is an orderly restructuring of a bank in crisis. That means that three key objectives must be met. 
(i) The losses of the bank should be met by the customers and owners of the bank, not the taxpayer. This is the necessary condition to eliminate moral hazard. 
(ii) The bank must be able to continue operating normally throughout its restructuring without adversely affecting the wider economy. In other words, businesses that use that bank need to have their normal cash-flow operations protected so that they aren't destabilized. 
(iii) The restructuring must be carried out in such a way that there is no capital flight or run on the bank. Otherwise the restructuring won't work. The money to pay for it will vanish. 

The problem is that these three conditions are mutually incompatible. It is currently possible to satisfy at best only two of these conditions simultaneously, but not all three. 

For example, it is currently the wish of the overwhelming majority of people and also of most politicians for the excessive risk-taking of the bankers to be borne by the bankers themselves and not by the taxpayer. If a bank fails it should be the shareholders and the senior management that should bear the cost. However the RBS and HBOS situations show that this will never be enough to cover the cost of most bank bailouts. Depositors will invariably have to take a haircut on some of their savings above the €100k limit. But the Cyprus situation shows how politically difficult this could be to enforce. 

Suppose though that the €100k deposit limit can be implemented so that the taxpayer is protected from the cost of the bailout. The depositors will then know that they are all expected to forfeit a fraction of their savings over €100k. Now suppose also that the banking authorities attempt to continue normal operations of the bank while it is being restructured. Such action is essential to ensure that the bank's business customers can pay their bills and thereby safeguard the normal operations of their own businesses. Without this provision businesses will fail due to cash-flow problems, and there will be a domino effect of redundancies and business bankruptcies that will ripple outwards from the stricken bank over time. 

The problem is, if the bank is allowed to operate normally while it is being restructured, and the depositors are forewarned of impending deposit forfeitures, then capital flight is inevitable. No rational depositor is going to leave all their savings in a bank in the full knowledge that most could be confiscated. Thus if conditions (i) and (ii) above are implemented successfully, condition (iii) will clearly fail. 

On the other hand, if capital flight is to be avoided so that condition (iii) is achieved, then only one of the other two possible actions can be implemented. Either the bank is closed for business while the restructuring takes place (as happened in Cyprus) and the deposit write-downs are performed, or the bank remains open but deposits and depositors are fully protected. The first of these options means that only conditions (ii) and (iii) are met, while the second means that only (i) and (iii) are, with the State inevitably having to pick up the final bill for the cost of the bailout instead of the depositors. 

Finally there is a fourth problem. In most discussions of depositor haircuts there is an implicit assumption amongst most neoclassical economists that all depositors are fully aware both of the risks inherent in their choice of bank, and of the limitations in extent of the deposit assurance scheme. While the latter is certainly true now, the former is not and will never be. The balance sheets of most banks are impenetrable to even the most expert of financial advisers. You only have to see how the credit crunch developed post-2007 to appreciate how the culture of rumour and counter-rumour within the financial markets highlighted the widespread ignorance that existed over the size and whereabouts of all the toxic debt. If the market players don't know where the problems are, how can the humble customer? 

And then there is the question of fairness. Implicit in the €100k deposit protection limit is an assumption that those who fall foul of it are only those guilty of chasing excessive returns. Yet what about the homeowner who sold his home for more than €100k on the very day his bank collapsed. Or the business that received payment for a major order on that same day. They too will lose almost everything, not because they sought to overplay their hand, but simply because they happened to have accounts with the wrong bank at the wrong time. Such instances may be rare, but such instances of large payments happen every day in every bank. The probability that such misfortune happens to you may be small, but the probability that it happens at all will be close to unity. So you know it will happen to somebody. Should the financial system play Russian roulette with people's lives in this way? Isn't that what the insurance and regulatory systems are supposed to prevent? 

These then are some of the problems, but there are others, not least in the disjointed and often illogical approach that the current system of regulation takes. These regulations are enshrined in the latest Basel accords, denoted as Basel III. As I will argue in later posts, Basel III is unlikely to correct all the major problems within the banking system. It won't tackle the paradox inherent in the three conditions (i)-(iii) above. Nor will it address problems associated with capital adequacy, reserves, or banks being too big to fail. What are needed are new rules that are fit for purpose. These rules need to resolve the triangular paradox I have outlined here so that insolvent banks can restructure in an orderly and fair manner. But we also need rules that reduce the likelihood of bank failure occurring in the first place. That means introducing new rules on capital requirements that will actively compensate for asset price bubbles, thereby removing some of the main sources of risk in the banking system. It also means having reserve requirements that recognize the systemic risk of large banks and which therefore financially penalize excessive size.

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