| Banks are central to the functioning of a modern economy: they are, in many ways, "special". One manifestation of this is the fact that, for a long time, no major bank has been allowed to fail in economies (and political systems) as diverse as the US, Japan and China. The authorities always prefer to punish the tax-payer by rescuing banks with public money, rather than allow the depositors to lose. The latest example is that of Northern Rock in the UK, recently rescued by the authorities. Bank of England's funding to Northern Rock has already amounted to £25 billion. |
| This incident emphasises how fragile the pillars of banking supervision are. Keeping banks solvent is at the heart of the elaborate framework prescribed by the Basel Committee on Banking Supervision. Basel-II, as it is popularly known, is a structure built on three pillars: minimum capital requirments; supervisory review; and market discipline. |
| Northern Rock is a case study of how weak and ineffective the three pillars are, even in a country like the UK which boasts of the world's largest international financial centre and an outstanding record of banking supervision; the previous instance of a bank failure occurred almost a century and a half back. |
| Take the first pillar, namely the adequacy of capital. Northern Rock not only reported excellent results for 2006 but the Financial Services Authority of UK had given its stamp of approval for Northern Rock's internal models for risk measurement only recently. The bank was highly profitable and well-capitalised, but this did not help it when problems arose. I have earlier criticised the complexity of the Basel-II capital charges but the very conceptual foundation has been brought into question by the case of Northern Rock. More worryingly, were the off-balance sheet "conduits" or "special investment vehicles", from which many banks have been hurt recently, the result of Basel-II? (Come to think of it, mortgage finance has a lower capital charge under Basel-II, and that has been the sector at the heart of the current turmoil in banking markets.) |
| The second pillar, namely supervisory review, has also failed in preventing the crisis. A decade back, UK authorities established a Financial Services Authority as the single regulator across all financial markets "" and separated the central bank from it. This was supposed to be a major reform. (Some commentators in India as well advocate such an institution in India "" whenever any of the regulators, RBI, SEBI and IRDA, does something which they do not like.) There was also a tripartite agreement between the FSA, the Bank of England and the Treasury (that is, finance ministry), governing the responsibilities of each and the mode of co-operation in a crisis. In the case of Northern Rock, there are questions about the failure of the three to act in a timely, co-ordinated fashion. While snafus can be expected when there is a situation which, luckily, does not happen very regularly, to me what is amazing is the failure of the FSA to do anything about the single biggest weakness of Northern Rock "" its customary dependence on market borrowings to fund as much as 75 per cent of its assets. |
| It has been the experience any number of times that, whenever there is trouble, banks are the first to cut credit lines "" both in the interbank market as well as cross-border finance. (In the Southeast Asian crisis a decade back, it was the refusal of lender banks to roll over short-term funding that triggered a crisis in Thailand, which quickly spread). The FSA does not seem to have done any kind of stress testing about the bank's funding pattern and its vulnerability to a confidence loss in the interbank market. |
| The third pillar, market discipline, has also not really worked in the way it is supposed to. The underlying idea is that greater disclosure would enable depositors and lenders to the bank to evaluate risks better. If this results into either non-availability of funding or higher costs, this itself will discipline the bank well before matters go out of hand. Depositors looking at bank balance sheets and disclosures before putting money in a bank, is as big a myth as investors reading the prospectus before deciding to invest in a company. But that apart, few of the market lenders seem to have been much concerned about Northern Rock's funding pattern "" else, the dependence on market funding could never have gone to the extent it did. |
| Keynes was right: banking lives on an illusion and everything is fine only so long as the illusion persists. Liquidity, not fundamentals like capital ratios, determines what happens. |
| Tailpiece: The recent political developments in Karnataka make one sad to think that a petty, opportunistic leader, bereft of any political values or commitments, who used to sleep through most important meetings, should have been our Prime Minister! Makes one wonder about the virtues of democracy! |
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