Banks and funny money

It is a familiar story. Whenever we are confronted by a fresh crisis, we cannot help some recycling of vocabulary on banks, regulators and politicians.

So, let me keep it simple. Banks accept deposits from customers. The domestic economy cannot absorb it. So they put the money in Greek bonds. Thanks to the sovereign crisis, Greek bonds suffer a huge haircut. So, banks lose a lot of money. They go under and given their bloated size, drag down their country.

This, in simple terms, is what happened in Cyprus. There are several other countries with bloated banking systems — five to seven times the respective countries’ GDP. (We are just about the same as the GDP; financial deepening is still a work in progress in our country.)

There are several lessons of the financial crisis that are lost on various players — and lost by a wide margin.

Light-touch regulation!

This definitely is not a ‘black swan’ event. It is a double white swan event! Cyprus’ banking system was too bloated at over eight times its GDP. This bubble would not have formed overnight. It is a classic case of regulators sleeping on the wheel.

Or maybe, a case of light-touch regulation. The important lesson of prudent regulation is lost on regulators. Even the recent financial stress tests revealed a shortfall of capital of just about $1 billion. And the bailout package turned out to be more than 10 times that sum.

How reliable are stress tests? The long-held suspicion about unreliability of stress only gets strengthened.

Small but significant

Many dismiss the Cyprus crisis as too small to bother about. When compared with other bailouts for Spain and Greece running into hundreds of billions of dollars, the monies involved are small beer at just about $10 billion.

Besides, the Cyprus economy is too tiny, representing just about 0.5 per cent of the EU economy. But the resolution mechanism involving a haircut on deposits, the first of its kind in this case, is too significant to ignore, particularly in terms of its potential ramifications on depositors’ trust. This sends warning signals to uninsured depositors.

Foreign banks’ ability to access retail deposits across nations, particularly above the insurance threshold, would be impaired.

Some estimates indicate that the profits of Euro banks could be impacted by as much as 6 per cent, because of the increased cost of deposits, and this could cost Euro Zone banks €15 billion. The days are not far when retail depositors could ask banks their capital ratios before they trust them with their money.

Haircut, a new model?

The resolution model involves conversion of a slice of deposits to equity and further freezing of deposits without interest. The losses for uninsured depositors are estimated at over 60 per cent, and in the case of Laiki Bank it is feared to be total. Depositors of all kinds suffer a huge liquidity loss in view of exchange controls and restrictions on deposit withdrawals.

This resolution model is never in the script of global regulators. It sets a dangerous precedent not just in Cyprus but across the globe. After howls of protest, small and insured deposits up to €1,00,000 were spared. Dutch Finance Minister Dijsselbloem initially touted this new ‘bail in’ prescription as a model for others. Depositors worldwide did not approve of this bail-in prescription. Dijsselbloem quickly retracted his statement, dismissing it as a one-off event. But the damage had been done. This leads to fundamental questions on whether financial institutions are becoming extractive in nature, failing their nations? Some form of deposit reinsurance, at least on a regional basis, is a possibility.

Alternate currency

The Geeks have rushed in. Such is the loss of faith in formal/fiat currency that Bitcoin is emerging as a sideshow in this drama. Bitcoin, a digital currency, looks novel but is highly suspect and dangerous. This privately mined currency, circulated anonymously by a network of people, suddenly zoomed to over $1 billion and its value skyrocketed to over $140 in the aftermath of Cyprus from $2 in 2011. Enough signs of bubble, if any were needed.

This informal currency is not issued by a central authority. This is a creation of computer geeks and this is ‘mined’ by participants using complex algorithms. Of course, this is a bubble designed to go bust. The tulip mania looks tame in comparison.

The trust levels in formal banking systems, currency and bank deposits have plummeted to such lows that people rush into novel and enticing traps.

Proponents of Bitcoin argue that even the currency issued by central banks and governments is not backed by tangibles such as gold, and can be confiscated, as in Cyprus.

The unabated printing of currency that goes by the name of ‘quantitative easing’ makes the whole system unstable.

It is high time the Bitcoin bubble is pricked early. Surprisingly, there is no clampdown from regulators.

Better regulators

The dangerous link between weak and reckless banking and the damage it inflicts on the real economy and the aam aadmi needs to be broken. Should we not think of deploying effective firewalls to break this link? Daron Acemoglu and James Robinson in their treatise Why Nations Fail illustrate in detail how extractive institutions undermine nations. Have financial institutions become extractive?

Is this doctrine of too big to fail (TBTF) driven by economic efficiency and good principles of political democracy? Why does this malaise of privatising profits and socialising losses still flourish?

To quote Martyn Hopper of the Financial Services Authority: “The consistent complaint from the industry is that those supervisors do not adequately understand their business. And the consistent complaint from the regulators is that senior management in financial institutions may not adequately understand the business for which they are responsible.”

(The author is Director, Institute for Development Research in Banking Technology, Hyderabad. Views are personal.)

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