Handling bankrupt banks: Gone are the bail-outs and enter the bail-ins

Banks are like paper castles

Banks are wonderful institutions which help people to acquire assets, make money and prosper. In the process, the prosperity of people will bring prosperity to a nation as well. But they are all built on thin paper like paper castles without solid assets of worth since all their assets are just book entries. Hence, if their paper castles are set ablaze – either by events outside their control which economists call ‘external shocks’ or by their own not-properly assessed business deals, known as imprudent lending or by both – they will burn to ashes, causing similar burns to all those who have been helped by them as well as to those around them.

These occurrences are called banking crises – national if they are confined only to a domestic economy and global if they have repercussions in the whole globe. Whatever the confinement of the crises, when they hit economies, everyone stands to lose their wealth and they, therefore, reduce the economies concerned too to ashes. The recent banking crisis followed by an economic crisis too in Cyprus is a case in point.

Mechanisms for maintaining bank stability

In view of the unimaginable destructive force which banking crises deliver, all nations have set up mechanisms to handle those crises. The establishment of autonomous central banks or independent financial authorities with powers to supervise and regulate them so that they will not take undue risks and leave room for others to set fire to them is one such mechanism.

Central banks have been given power to provide money to them when they are desperate for funds to pay out to their customers but are unable to raise such funds from the market anymore – a system known as its role as the lender of last resort. Some countries have guaranteed the repayment of deposits up to a certain value through mandatory deposit insurance schemes when they are being closed down on account of not having enough assets to pay depositors on their own.

Why do banks fail?

Despite all these mechanisms, banks get into trouble from time to time. Hence, it is important to understand how banks can get into trouble and how they could be resurrected after they have died or are on the verge of dying.

Regarding the first – how banks get into trouble – the American economist, Hyman Minsky, has come up with an explanation which he first developed in 1960s as ‘Financial Instability Hypothesis’ and published in improved form several times since then. Regarding the second – how to tackle the dead or dying banks – the nations initially had two solutions: Either allow the bank to die accepting fatality as a natural outcome or get the taxpayers to bear the burden which came to be known as ‘bailing out problem banks’ or simply offering ‘bail-outs’.

But now, the vogue has been to free the taxpayers of the burden and get the depositors, as general creditors of banks, to bear the burden of resurrecting the dead or dying banks. The London based journal, The Economist, coined in 2010 the term ‘bail-in’ to describe this solution.

Minsky wisdom: Financial Instability Hypothesis

According to Minsky’s Financial Instability Hypothesis, a financial system, before it degenerates to a crisis state, will go through five different but interrelated steps: Displacement, Boom, Euphoria, Profit taking and Panic.

When Minsky presented his hypothesis, he was not received well even by his academic colleagues let alone bank regulators. But today, many critics point out that the root cause of the financial crisis in 2007-08 has been due to ignoring the fine methodology he had suggested to identify the causes that eventually lead to financial instability. The Minsky reading of the economy in these five steps can be explained as follows.

Positive events build hopes

The displacement occurs when banks and the economies concerned get high hopes about the future after a major event. It could be the discovery of a vast deposit of natural resources like oil, gas or in the present context, rare earths. Or it could be a major innovation which will place the country concerned above all its competitors, like the present 3D printing manufacturing. Or simply, it could be the end of a costly war as is the case in Sri Lanka today.

What Minsky meant was that these events encourage the banks and the people to place the economies concerned on a high growth trajectory encouraged and supported by impressive growth forecasts made by policy making authorities, practising bankers and supposed-to-be independent analysts as well.

Hopes lead to booms

Then, when everyone acts on positive high hopes, the boom occurs. Banks ride on the boom drive increasing credit to people and state institutions that function as drivers of the boom. For instance, if the state is engaged in a major infrastructure drive like building of highways, ports, airports, power plants and buildings, banks seek to capitalise on the new opportunity by extending credit to these institutions without proper credit analysis.

In other words, in a boom situation, banks normally lower their credit standards because the objective is to get the best of the emerging economic opportunities before their rivals get into them. Driven by bank credit and new hyperactive population, economy too throws out high economic growth numbers reinforcing the confidence which has already been built in banks and their customers about a promising future.

Success stories about booms fan euphoria

The impressive economic indicators and the success stories which people hear all around bring in euphoria. Euphoria is a state where everyone is driven by emotions and when inflicted by that state of mind, people fail to make proper risk assessment of what they do. It therefore reinforces the existing high hopes which they are having about the future.

From the side of the banks, euphoria leads to lending to dubious borrowers without making proper risk assessments. Borrowers also make use of these easy loans liberally because they do not see any difficulty in repaying those loans due to the belief that the emerging prosperity will continue unabated into an indefinite future. Politicians who take credit for the boom will capitalise on the state of euphoria by painting a still better picture about the future. If someone tries to draw their attention to the risks that are buried for the moment but can come up at any point of time, such counsel is grossly disregarded as irrelevant.

Wise guys take profits and exit in time

The problem starts to hit the economy when it passes through the next stage, namely, profit taking. Some smart people at the top realising that the boom cannot continue forever choose to take profits and many of them repatriate those profits outside the country or reinvest in unproductive forms such as land and buildings commonly known as real estate. When the economy reaches its potential level and finds it difficult to maintain the growth unabated continuously, starting from the lower levels, borrowers start defaulting loans.

A case in point in Sri Lanka is the financing of three-wheeler taxies, motorcycles and light transport trucks financed by banks in heavy volumes during the boom period. When the economy is moving on the good side, they are able to repay; but when it moves in the other direction, they find it difficult to do so and start defaulting loans.

Bad outcomes force banks and people to be panic

It takes about two years for banks to feel the impact of emerging loan defaults on the profit levels because they still could ride on the boom that had generated a good cash flow to them. But when the profits start to fall, they become panic and take extraordinary precautions to safeguard themselves. The panicky overreaction in the form of moving into high credit standards and better credit assessments dries out financial flows to the economy curtailing ongoing economic activities.

When the impressive economic indicators which had filled everyone with hopes in the boom time begin to become sour, the central banks try to rescue the affected economies by lowering interest rates, relaxing lending and pumping money to the economy. But many countries fail to introduce reforms in the state enterprises, government expenditure programs and obstacles for the private sector to do business. As a result, the economies fail to pick up and banks will emerge as number one casualties.

Booms should be built on structural reforms

Thus, booms based on unsustainable economic events are an ideal recipe for financial crises. Hence, it is necessary to take preventive action to avert a future financial crisis in the boom time itself. Such action requires central banks and other policy authorities concerned to be cautious of economic booms since all ‘booms’ are followed by subsequent ‘busts’ unless necessary ground conditions are created for their continuation unabatedly.

These ground conditions include a host of policies. Wide economic reforms as highlighted above, integration of the country’s economy to the global markets, acquisition of technology through quality foreign direct investments, improvement in human capital development through educational and healthcare reforms are some of them.

Look for early instability signs

When a financial crisis hits a country, it does not happen overnight. Many symptoms of an emerging crisis are made known to central banks as it had happened in Cyprus recently: The massive withdrawal of Russian hot money from the country.

Even in USA when it was hit by the sub-prime crisis of 2007, it was the low level financial institutions like the savings and loans associations, similar to finance companies in Sri Lanka that became the vanguard casualties of the crisis. Then, when the crisis progressed on, it hit the rearguard too and consequently a large number of national banks had to seek financial assistance from the US Government to rescue themselves.

Problem banks: Allow to die or rescue with taxpayers’ money

Traditionally, there have been two methods of addressing the issue of dead or dying banks. The first is to allow them to die so that the banking system could be freed from such problem banks. The second is to get the taxpayers to shoulder the burden of rescuing them. These two strategies have been adopted by authorities in many countries from time to time.

Allowing ‘dying’ is weeding out bad banks

The strategy of allowing problem banks to die is equal to weeding a garden: When the weeds are removed, the flower plants can grow healthily maintaining its long-term beauty. But the authorities would move into this strategy only when there is no any other option available and the problem bank cannot be rescued even with taxpayers’ money.

Since the shareholders of such banks have already lost their money, after the closure of the bank, action will be taken to collect its available assets and pay out to depositors – a process known as the liquidation of a bank. Since such banks do not have good assets, the amount which the liquidators would realise will be less than what it has to pay to its depositors. Consequently, the depositors will have to agree to forego a part of their deposits and receive only a fraction by way of repayment.

Taxpayers’ money to rescue banks

Using the taxpayers’ money to rescue a bank will mean that the burden will be passed on to taxpayers in general. A government will do so by providing capital funds to an ailing bank to improve its capital base or a loan to enable it to improve its liquidity. In the case of the former, it will get a share of the ownership of the bank and since the existing shareholders have lost their value altogether, it is akin to nationalising an ailing bank.  The objective is that it will be able to make a turnaround of the bank with new management and prevent it from falling in the market. When loan funds are provided, the bank will have to repay the loans out of the earnings which it will make after it is made functioning again.

Privatising profits and socialising losses

There are two criticisms against this move by a government. First, it is argued that it will encourage the owners of banks to take unnecessary risks and put the depositors’ money at risk while causing irreparable damage to the financial system and the economy as a whole. Economists call this moral hazard problem.

Second, it is not proper to get the taxpayers to bear the burden because they have not benefitted when the bank had been earning good money in the past. Those earnings of the bank had been shared by the depositors by way or interest and shareholders by way of dividends. Now when the bank makes losses, the general taxpayers are called upon to bear those losses. This is equivalent to adopting a policy of privatising profits and socialising losses.

Now comes bailing-in

In view of these criticisms, the modern trend has been to get the depositors to bear the losses of an ailing bank by converting a sizeable part of their deposits to equity – a scheme known as bailing-in of ailing banks. What it means is that the existing creditors, in this case the depositors, of a bank are required to bail out the problem bank and not the general taxpayers. This was attempted without success in the case of the recent financial crisis in Cyprus.

Bailing-in requires depositors to bear the burden

The bailing-in strategy of resolving problem banks is now gaining wide acceptance throughout the globe. For instance, the European Union has recently issued a discussion paper on the debt write-down tool involving bailing-in of problem banks. The paper has argued that “rather than relying on taxpayers, a mechanism is needed to stop the contagion to other banks and cut the possible domino effect. It should allow public authorities to spread unmanageable losses on banks’ shareholders and creditors”.

The Bank of England together with the Federal Deposit Insurance Corporation of USA has come up with a white paper arguing that it is the shareholders who should bear the cost of resurrecting the ailing banks by providing the required capital. But when they are unable to meet the full amount, the unsecured creditors, namely the depositors, should be prepared to write-down their claims and meet the gap in the capital requirements.

In a similar move, Switzerland has taken action to amend its banking laws to enable the banking authorities to compulsorily convert depositors’ money into the equity of problem banks. It is reported that New Zealand too is contemplating to introduce similar banking legislations.

Passivity of depositors is now costly

Up to now, depositors have taken a back seat when it comes to managing banks. They have relied fully on the banking supervisors and banks’ management teams to do the job on their behalf. But with the emerging development of bank bail-in strategy, they cannot remain passive spectators anymore. Since the bank regulators are planning to put the burden on them and bank managements do not do their job properly as highlighted by Hyman Minsky in his Financial Instability Hypothesis, depositors have to play an active role in the management of the banks in which they have placed their savings as deposits.

A suitable mechanism is yet to be developed to facilitate that kind of governance in banks.

(W.A. Wijewardena can be reached at [email protected].)