Banks, depositors, taxpayers

The YES Bank episode raises some questions that no one any longer asks. But these are important for the 21st century because they concern bank collapses, how to deal them, and who bears the cost.

This is important, at least in my view for what it’s worth, because the received wisdom of the last half century is that bank collapses must be avoided by getting the taxpayers to pay for saving them. This in turn has engendered the belief that banks are “safe as houses”.

But why does everyone think that banks are risk-free and that you can deposit as much you want — lend, actually, because the bank pays you interest, howsoever tiny — and live happily ever after? Second, who created this myth? Third, when was it created? Fourth, why?

You have to be very naïve to think that risk in any financial transactions is zero. It’s always there. This is so even when the loan you have made to the bank is fully guaranteed by the government.

So at least three questions have to be dealt with when a bank, for whatever reason, goes bust. First, does the principle of caveat emptor — buyer beware — apply to depositors? Second, why should a bank have a higher degree of responsibility than any other business? Third, if “financial stability” is to be financed by taxpayers, how is it “good”?

Unfair treatment

Just see. Thanks to the Securities and Exchange Board of India, we are constantly told how mutual funds come with risks attached. This is nothing more than caveat emptor. So how come no such warning is issued about banks?

I think not only should suitably worded advertisements be issued regularly by the Reserve Bank of India, every bank should print that warning on its cheque books. The customer, not just the shareholders, should know the risks.

I am not joking. It’s no different from cigarettes and it’s going to get worse.

Secondly, it’s now received wisdom that banks must behave with a markedly higher sense of responsibility than other businesses. But see how this is an utterly paradoxical statement: A fully responsible bank’s loan book will be zero because of uncertainty.

Due diligence and compliance, etc are all very well but they are technical boxes to be ticked. These things can’t tell you whether the borrower is a cad or if China is going do a Wuhan on the world. That’s what uncertainty is all about. 

Also, when the risk is higher — and it’s never zero — banks charge a higher rate of interest. But think about it in the context of a higher deposit rate where the bank is signalling to the customer that it is taking higher risks.

Thirdly, if systemic financial stability is threatened because one bank fails, why should taxpayers, who are not party to any contracts, save the shareholders? This, in fact, is the big gorilla in the room because it completely validates the economics concept of “moral hazard”.

The concept refers to a situation where any kind of insurance increases the propensity of the insured to take risk because someone else bears the cost of those risks. This also makes a nonsense of the traditional warning of caveat emptor. Yet we go on making the taxpayer bail banks out.

Are banks special?

In 1907 J P Morgan started the idea that banks are special and needed to be treated differently. He put forth the proposition of a “bank of last resort” and was chiefly instrumental in creating the US Fed, whose job it would be to save the shareholders of US banks. Morgan thought depositors could take their chances but not shareholders. 

The European central banks, on the other hand, were created only to print currency and to lend to the government. They were often privately owned. The second oldest of them, the Bank of England, was privately owned till 1946 and the RBI was privately owned till 1949. In some countries they are still privately owned. 

Till the 1970s there were two types of central banks: Those that saved governments and those that saved banks. Since then they save both. The taxpayer pays.

But remember: Depositors are a subset of taxpayers. A depositor also pays tax. So what he gains as a depositor he may well be losing as a taxpayer.

The dogma that banks must be saved at all costs has become pervasive because of the political pressure. The cost of not doing so, it is said, is an economic collapse of gigantic proportions, the Gabbar Singh threat. 

But here’s the problem: Why should governments intervene only when things go phut? That’s why I think we need to revisit this apocalypse theory and the sooner the better because it’s ok when governments have money but what if they are broke and a financial meltdown is looming?