By Assistant Professor Hassan Naqvi
Assistant Professor, Department of Finance and Affiliated Researcher of NUS Risk Management Institute
NUS Business School
There is a long and growing list of financial institutions that have failed across the world recently: Northern Rock, Bear Stearns, Washington Mutual, Kaupthing, IndyMac, Hypo Real Estate Holding, Bradford and Bingley, and many others.
A bank is said to fail when it is unable to service its obligations. But failure does not necessarily mean the bank is insolvent.
We need to understand the difference between a solvent and an insolvent bank. Insolvent banks are those that have made bad investments and, as a result, are unable to generate high enough returns to pay off their liabilities.
Solvent banks are fundamentally sound. But they too can fail if too many of their depositors decide to withdraw their deposits simultaneously. Since fire sales are inefficient, banks might be unable to fully realize the value of their good investments to satisfy their depositors and thus fail because of temporary liquidity problems. Such banks are solvent yet illiquid.
As lender of last resort, central banks can prevent the failure of solvent banks. They can provide liquidity to such institutions. The rescued banks can then pay off the central bank in the future when the returns on their healthy assets are realized. In the absence of central bank intervention, the assets would have been sold off at fire-sale prices. Thus central banks can improve the efficiency of the banking system by providing emergency funding to solvent institutions.
However, there is a catch here: In practice, policy makers can find it hard to distinguish between solvent and insolvent banks. Central banks should ideally bail out only solvent institutions. But owning to imperfect information, they could bail out insolvent institutions as well.
Did the United States government really know for sure that Freddie Mac, Fannie Mae and AIG were solvent and merely illiquid – and thus candidates for rescue; while Lehman Brothers and Washington Mutual were insolvent – and thus candidates for bankruptcy and government seizure, respectively?
In a competitive banking system, such asymmetry information can affect the risk-taking behaviour of banks. If they knew they might be bailed out even if they were insolvent, banks would make risky investments. They might end up holding sub-prime assets, and hence become vulnerable to shocks.
Central bank bailouts can be efficient insofar as they prevent the failure of solvent but temporarily illiquid institutions but they can be inefficient insofar as they induce banks to invest in risky assets. Does that mean we should scrap the bailout policy tool altogether?
The answer is no. Absent the power to rescue illiquid banks, the central bank will lose major ammunition in financial crises. What can be done is to mitigate the moral hazard problem.
This can be accomplished by making banks more transparent and by improving banking supervision. With greater transparency, central banks are less likely to bail out insolvent institutions that have made bad investment decisions.
At times, central banks do knowingly bail out institutions that are insolvent. This is because such institutions might me too big to fail, in the sense that their failure would wreak havoc on the financial system. For instance, AIG was provided with emergency funding of US$85 billion (S$126 billion) because it was so intertwined with the financial system that its failure would have had unprecedented contagion effects.
Another tool that regulators have at their disposal is deposit insurance. If a bank were to fail, the provider of deposit insurance – be it a government or a commercial entity – pays the depositors.
But insurance can also give rise to moral hazard. For example, someone with car insurance might take less care of his car compared to someone without such insurance. Analogously, banks whose deposits are insured might be tempted to hold risky assets.
Nevertheless, by giving depositors the peace of mind that their money is safe, deposit insurance can discourage panic runs. In recent weeks, many governments have raised deposit insurance coverage. The US government increased deposit insurance coverage from US$100,000 to US$250,000. The British increased retail deposit protection from £35,000 (S$89,500) to £50,000. Australia, Hong Kong and, most recently Singapore have decided to fully insure all deposits.
There can be circumstances when deposit insurance can be inadequate. Even with insurance, when a bank fails, depositors may have to go through a process of red tape to get their money. For instance, when the British bank Northern Rock collapsed last year, it took months for depositors to be paid off.
People have bank accounts to get ready access to liquidity. Even in the absence o bureaucratic hassles, depositors may still be tempted to withdraw their cash for peace of mind. For instance, depositors withdrew their money from Ice-save as soon as they heard the bank was in trouble, despite deposit insurance.
Deposit insurance does provide relief. But it can build up problems for the future. For instance, following the failure of Washington Mutual, the reserves of the US Federal Deposit Insurance Corporation (FDIC) were so depleted that it could not afford another rescue. On June 30 this year, Washington Mutual had US$143 billion in insured deposits about three times the size of the deposit insurance fund. Fortunately for FDIC, JP Morgan Chase agreed to acquire the banking operations of Washington Mutual. Cynics say that the FDIC raised the deposit insurance coverage subsequently to avoid another failure.
Deposit insurance and central bank bailouts of solvent but illiquid banks are essential policy tools. But the authorities especially in the US and Europe, need also to identify and deal with the roots of the problem – toxic assets on bank balance sheets and inadequately capitalized banks, among other things – before the financial crisis further undermines the real economy.
The Straits Times©, 22 October 2008
Singapore Press Holdings Ltd
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