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.

Let's pay the people to vote

Another election; another poor turnout. 

In this week's county council elections the turnout was barely above 30%, not that we should be surprised. Four years earlier when the same seats were contested the turnout was again only 39.2%. In the local elections of 2011 the turnout was 42.6%. In fact the only recent local election with a turnout of over 50% was in 2010 when it coincided with the general election, and yet even for that general election the turnout was a fairly pitiful 65.1%. While this was an improvement on the 59.4% in 2001 and the 61.4% in 2005, it is still a long way short of the 77.7% in 1992. 

These figures should be worrying for Labour because it is the Labour Party that suffers disproportionately from differential turnout. At the last general election the average turnout in consistencies that returned Labour MPs was about 61%. For those electing Tories it was over 68%, and in one Conservative-held seat (Kenilworth and Southam) the turnout was a staggering 81%. Overall this means that approximately 10% more people vote in Tory-held seats than in Labour-held ones. This goes some way to explain why the Tories need a greater number of national votes to gain a parliamentary majority, and why with 24.6% more votes than Labour in 2010 they only won 19% more seats. 

It is partly this issue of differential turnout that allows the Tories to (falsely) portray the electoral system as being biased in favour of Labour, and thus to provide cover for their attempts to gerrymander the electoral system with policies like the recent one to equalize constituency sizes in terms of voter numbers. Of course their approach conveniently overlooks the other issue that damages Labour: the problem of voter non-registration in many urban areas. As a result there could be as many as an extra 10% of potential voters missing from the electoral roll in these predominantly Labour constituencies.

Taken in combination with the differential turnout problem, these figures suggest that the Labour vote may be over 20% below what it should be, which means that even at the 2010 election Labour's total vote should have matched that of the Tories at around 10.5 million votes, ceteris paribus. The question is, how many extra seats would this have yielded for Labour? I suspect not many as most of these missing votes are in safe Labour seats. Of course that suggests that the 19% extra seats that the Tories won in 2010 is entirely down to an electoral system that actually favours them, not one that penalizes them. So the big question is: how can this problem be rectified? 

So far most of the media analysis has concentrated on issues centred around political apathy. There are many causes for this malaise. The electoral system is clearly one. The combination of a first-past-the-post (FPTP) system and a large number of safe seats clearly makes many voters feel that their vote is worthless. 

Another problem is of course the lack of voter/consumer choice. With elections dominated by swing voters in marginal seats there is a tendency for all three parties to converge on the "centre ground" and to steal each other's policies. As a result most of the potential remedies have focused on changes to the electoral system, of which the AV referendum was a prime example. 

Other solutions have focused on improving the ease of voting. Thus strategies for increasing the number of postal votes have been proposed, as well as making polling day a bank holiday or putting it on a weekend. So far, however, no-one really appears to have considered financial incentives, with the possible exception of implementing some form of lottery. Why? 

Perhaps because it seems to resemble a form or bribery reminiscent of the rotten boroughs of the late 18th and early 19th centuries. Yet politicians bribing the electorate is nothing new, old, or unusually. The tax cuts, privatizations and council house sell-offs under Thatcher in the 1980s were little more than bribes to a certain section of the electorate. In that sense they were truly insidious because they were selective and divisive rather than universal. They only benefited those with large incomes, spare cash or current tenure of council properties. Those who fell outside these groups were left out of the feeding frenzy. Doubtless some would argue that such a measure would run counter to the provisions of the Ballot Act of 1872, but if the "bribe" is merely conditional on voting and not on voting for a particular candidate or party, would that still be so? 

Of course the principal reason why paying people to vote has probably not been considered is the cost. To make it attractive enough to the potential voter each would need to be offered over £100. Yet with around 45 million potential voters the total cost could then be over £4.5bn. If this was only applied to general elections, though, it would still only equate to £900m per annum. That is peanuts for the UK government. Yet there is another solution that would cost nothing in nominal term. Use the shares the government already owns in the privatized banks. The total government stake in RBS and Lloyds TSB is currently valued (according to their FTSE-listed share price) at over £30bn. That is enough to fund a voter giveaway at the next six general elections. 

Earlier this year Lloyds TSB claimed it was close to being ready for privatization. Now RBS is saying the same. However it is highly likely that any share sale would need to be staggered over a number of years in order to get the best price. 

Nor is the idea of giving these shares away a new idea. This is an idea that was originally proposed by some LibDems a couple of years ago. Then in February there were reports that George Osborne may consider giving bank shares away to all taxpayers (does that include poor pensioners and the unemployed?) It is therefore only an additional small step to suggest that such a gift should be conditional in some way. So why not make it conditional on a citizen exercising their democratic right, nay duty, at the ballot box? Let us call it the citizen's dividend. 

It should be clear that while all may benefit from this idea, the Labour Party and Labour voters will benefit the most. A typical Labour voter is more likely to be incentivized to register on the electoral roll and to subsequently vote by a cash windfall of £100-£200 than is a merchant banker living in Surrey. And when they vote they are more likely to vote Labour in order to ensure that the policy would not be discontinued. If the Tories and LibDems copied Labour's policy then they would still lose out because of the greater benefit to Labour in terms of differential turnout. If they fail to support the idea then they risk the loss of even more votes to Labour. And then there are the economic benefits. Most of the shares will be sold on receipt, and the proceeds spend. The result will be an urgently needed fiscal stimulus for the economy, while the universality of the share allocation will help reduce inequality. So where is the political downside?