A V Rajwade: Banks, central banks and Basel II

WORLD MONEY

In an earlier series of three articles beginning August 27 ("When risk becomes uncertainty"), I had argued how change in liquidity transforms measurable risks in financial markets into un-measurable uncertainty. I had also noted that several European banks seem to have been affected by the sub-prime mortgage crisis in the US, more than American banks themselves. The latter part of the statement needs to be corrected now with the subsequent declaration of losses by US banks.

But to come back to European banks, while initially a few German banks needed to be rescued, a British mortgage bank, namely Northern Rock, came into trouble in mid-September, and only a government guarantee of all deposits in the bank averted what could have been a major loss of confidence and crisis in the UK's vaunted banking system. Incidentally, the last run on a British bank occurred almost 150 years ago, in 1866. More recently, there was also the secondary banking crisis in the UK in 1973-74, which I had occasion to see closely as I was working in London at that time. It had started with the collapse of Cedar Holdings, an aggressive property lender. The background of the crisis then (as in the US and UK now) was the increasing property prices which, apparently, were expected to continue to rise for ever! But this crisis had mainly affected "secondary" banks, more like finance companies specialising in real estate lending. The Bank of England took the lead in floating what came to be called a "lifeboat" to rescue the secondary banks. It was financed mainly by the major so-called "clearing" banks, and not much public money was needed.

But to come to the case of Northern Rock, it once again evidences two old adages: first that banks are "special" and, if reasonably large, would be rescued despite all the lip service paid to the "moral hazard" such rescues lead to. The second is what Lord Keynes said: that banking is an illusion "" of the depositors that they will get their money when they want it, and of the bankers that they will be repaid by their borrowers; that everything works fine so long as the illusions persist. In the case of Northern Rock, once the sub-prime crisis hit the headlines, depositors queued for withdrawal of money and, as the pictures kept appearing on TV screens, the queues lengthened, till the government was to step in with its guarantee.

In many ways, Northern Rock was asking for trouble, given that as much as 75 per cent of its resources represented market borrowings, rather than hard core depositor funds: it was the doubt about rollover of market borrowings that first caused the run. Over-dependence on market borrowings has created problems for banks in the past as well. The case that comes to mind is that of Continental Illinois Bank of Chicago, a couple of decades ago, then one of the largest US banks. To me, what is perplexing is how the Financial Supervisory Authority of UK tolerated (and therefore, perhaps tacitly encouraged?) such over-dependence on market borrowings. Our own central bank, for example, restricts market borrowings to a far lower percentage.

The second weakness of Northern Rock was the "originate and distribute" model of banking business it was following aggressively. (Earlier, it had succeeded so well that its share was the best performing amongst all the banking stocks in the UK last year.) This means that the business of banking is not so much about taking deposits for lending money, as about originating loans and securitising them for sale in the capital market. As much as 40 per cent of Northern Rock assets have been securitised. To my mind, this model is similar to "trading" in financial assets, an activity from which banks are earning an increasing proportion of their profits. In an earlier article ("Proprietary trading: Risks and rewards," June 8), I had argued that the profits are very high in relation to the reported risk measure (VaR) and, given the unbreakable bond between risk and reward, the risk measure and also the regulatory capital charge perhaps need significant upward revision.

The Northern Rock case also raises several other issues relating to banking supervision. In the UK, has the separation of banking supervision and central banking really worked? (In the UK, there is a single supervisor for all financial markets including the stock market and insurance business.) When even a medium-sized financial intermediary comes into difficulties, can central banking principles and autonomy be upheld? When a crunch comes, can Basel II capital charges be of much use? For financial intermediation, are confidence and liquidity, howsoever illusory the former may be in Keynes' words, more important than solvency? But more on these issues in a later article.

avrajwade@gmail.com