It used to be the case years ago that relatively minor financial difficulties could lead to a full-blown financial crisis. Depositors would line up on the street outside one bank, the word would spread, other banks would suffer a run and the financial system would come to a shuddering halt. Modern understandings of monetary affairs have virtually eliminated this danger. When it happens these days, central banks flood money into the market and localised panics are quickly brought to an end. It has been a painful process for banking authorities to learn when and how to do this, but the lesson has been learned. However, more fact-based financial crises still occur and when they happen, every time it turns out that the biggest problems lie in the banking system. Asian stock markets at the moment would be well on their way to recovery were it not for bust banks. There have been attempts to address this, most notably the guidelines established several years ago by the Bank for International Settlements that commercial banks must rigorously maintain defined categories of capital and reserves at a minimum of 8 per cent of their risk assets - effectively their loans. When big trouble comes it turns out that this 8 per cent is a ludicrously low level. In times of euphoria, risky loans keep struggling businesses afloat, rather than letting them sink as they deserve. Those loans quickly turn into bad loans which can amount to many times the firms' capital and reserves. One reason it happens is that commercial banks, with the support of their governments, still indulge in defiance of one of the basic rules - there is no such thing as a risk-free investment. They defy it because they encourage their depositors to believe that money deposited in banks is absolutely safe money. They can get away with it because governments also encourage this belief and back it up regularly with bailouts of bust banks and so-called deposit-insurance schemes. Depositors are then left to believe that it does not really matter which bank they put their money in. All banks are the same because all banks will pay it back and the best bank is therefore the one which offers the highest interest rates. This creates a whip for the backs of bank-lending officers. Bank X may pay higher deposit rates than Bank Y because it is happier to lend the money to dubious prospects at higher rates. If Bank Y does not follow suit it will lose business and therefore has an incentive to take on riskier business. This process can eventually lead to outright silliness - as happened in Asia for several years with bank-loan teams falling over themselves to push US dollars into the hands of anyone in the region who could come up with a well-presented business plan. It can be worse than just silliness. Defiance of deposit risk indirectly encourages venal politicians to pressure banks into lending to their cronies for dubious projects. But no matter how it is done, it all comes down to this: if you limit the downside risk of investment in any way while keeping the upside potential unlimited, you create an incentive to riskier investment. It is as true for banks as it is for hedge funds. The seemingly obvious solution - tell depositors that from now on they bear the risk themselves - has its own difficulties. It is not easy to eradicate a deeply rooted perception among the general public that banks are safe. It would re-introduce the dangers of localised panics and it asks too much of the man in the street that he have a competent understanding of the relative risks in all banks pitching him for his deposits. One gradual change in financial matters already addresses this conundrum. There is a growing trend, particularly in developed countries, away from bank deposits and into mutual funds or other shared-risk form of investments. But if the safety of bank deposits continues to be deemed inviolable, financial crises will continue to follow each other as surely as night follows day.
