Jake's View

Not everyone will be safe when banks go bust

PUBLISHED : Thursday, 30 January, 2014, 5:01am
UPDATED : Thursday, 30 January, 2014, 5:01am

[The Hong Kong Monetary Authority] wants banks to set aside as much as 3.5 per cent of their capital as a countercyclical buffer compared with a maximum of 2.5 per cent required by Basel ...

Countercyclical buffers are meant to be built up during times of earnings growth so that they can be drawn down when things are not going well.

SCMP, January 29

Time for a reminder of Jake's No 7 Rule of Investment - No matter how wide you build the exits, they are never wide enough when a stampeding crowd wants out.

The thing about bank runs is that they do not happen in isolation. When things start to go truly bad for any one bank within a financial system, they generally go bad for every bank in that system and there is no steel-clad security for anyone's savings.

I concede that all other local banks remained sound in 1991 when the local operations of Bank of Credit and Commerce International were liquidated by government order. But this was because of a BCCI scandal abroad. The local operations proved in top shape. Creditors and depositors got all their money back.

Single bank failure may happen because of fraudulent practice but the occasion that comes to mind here was the failure in 1985 of seven local banks controlled by Malaysian interests who raided their Hong Kong deposit base to prop up their failed companies at home. Bad news tends to come out everywhere at the same time, even with fraud.

No countercyclical buffer could have saved those seven, however. They were already too deeply insolvent and there had been regulatory failure. The banking commissioner never knew what they had been doing.

The remedy on that occasion was the one that had always previously been used. The financial secretary went around a line of bigger banks and said, "You, you and you, they're yours now. Live with it and don't give me no grief."

But the Hong Kong total deposit base back then was about HK$350 billion. It is now more than HK$9 trillion, 25 times as great. Can failed banks anywhere be picked up any longer by simply passing the hat this way?

The answer is that they probably cannot be, which is why the Bank for International Settlements in Basel has taken it on itself to set standards for minimum amounts of capital that banks must maintain relative to their risk assets. It is also why our own monetary chief, jittery by nature, wants to do Basel one better.

But it still does not get around the basic problem that when banks go bust, they tend all to go bust at the same time. Upping that extra safety margin to 3.5 per cent from 2.5 per cent of risk assets will then give the system perhaps four more hours of solvency, perhaps five, not much more.

In the end, it will still have to be government that fixes things by very publicly lashing out money and making weighty pronouncements of standing behind all deposits, or at least making people think it has made such pronouncements. The relevant officials will have their fingers crossed behind their backs throughout.

And one day it will happen that people will not believe even government promises.

It will happen because every time that new protective measures are devised to prevent bank failure they only increase the propensity for risk-taking. They do not actually make things safer.

It's called moral hazard in the business. Every form of investment, even a bank deposit, carries risk and when you try to remove deposit risk you only make the depositor careless of the bank in which he has his money and more willing to put that money at higher risk for a higher return.

It's sad to think that to keep a banking system safe you need the occasional bank to fail and depositors to find they can only get back 70 cents on the dollar. Yet it is probably true. Pain is the best disciplinarian of sound practice.

I relish this prospect no more than you do but the alternative to personal prudence in banking relationships is wilder swings in the economic cycle and system wide financial crises again and again. No one can build exits wide enough to get everyone out safely.