Introduction
In a case where one of the leading banks
in the economy is facing liquidity issues, various risks are involved with the
main one being the escalation of the problem to affect the entire financial
system. Liquidity problems in banking institutions are in most cases a signal
that various things may be wrong or are bound to go wrong (Sullivan, 2003). It
is therefore imperative that an urgent inquiry be conducted to establish the
extent of the problem. However, since the inquiry could take a while for a
comprehensive finding to be reported, it is important that immediate
intervention be conducted. Financial markets are often volatile and should
information spread among depositors and creditors that the bank is likely to
fail; the problem would only escalate (Jackson, 2009; Quintyn and Taylor, 2004).
One of options that the bank could take would be to conduct a bailout where the
central bank provides the struggling bank with funds to meet their short term
obligations. The central bank could also guarantee the short term liabilities
of the company in order to lessen the pressure on their cash flows. In the long
term, it is important to re-examine the causes of the liquidity crunch and come
up with corrective measures (Centre for Economic Policy Research, 2010; Iyade,
2006). For instance, the regulations for lending could allow for excessive subprime
lending hence leading to massive defaults. This paper considers the situation
of the central bank governor who is faced with a liquidity crunch in one of the
largest banks in the economy. It evaluates the rationale for taking action,
examines the options available for action and the impact of such options when
implemented.
Risks of inaction
For action to be deemed as necessary, it
is important to understand the risks involved and the likely impact of
inaction. To begin with, the situation could lead to the destabilisation of the
financial system if left unattended. Other problems that could arise if the
situation is not swiftly resolved are asset management problems, loan freeze
and the zombie lending problem. The cardinal responsibility of the central bank
is to protect the depositors, ensure that the relationship between lender and
borrower is stabilised, and to ensure that there are no disruptions in the
banking functions in the economy (Aikins, 2009; Benson and Kaufman, 1996).
The financial system
plays a key role in market economies. It facilitates transactions and in many
cases acts as a crucial driver of economic growth. In most cases, the stability
of the financial system hinges on the confidence that the market have in the
main industry player- the mainstream banks (Jackson, 2009). In this case, the
biggest bank in the economy is facing liquidity problems. It implies that a
deterioration of the situation would not only lower the market confidence in
the concerned bank alone, but also in the entire financial system. A wavering
confidence in the financial system would lead to all persons having deposits in
banks moving to withdraw them in fear of the system collapsing and having them
lose their savings (Bank of England, 2011). The situation in the bank is
therefore likely to affect the whole economy and it therefore calls for swift
intervention.
If the situation is
allowed to persist, the bank may be forced to freeze loans. Such a move would
create a credit crunch in the economy in view of the fact that this is the
largest bank in the economy. The provision of loans drives economic activities
with most potent businesses often in need of short term and long term loans to
advance their organisational goals (Chartered Institute of Management Accountants,
2010; Dewatripoint and Freixas, 2012). A freeze would therefore have a massive
impact on the ordinary economic life with many organisations paralysed by lack
of working capital. The central bank therefore needs to take action and ensure
that economic activity in the economy is not disrupted by intervening in the
situation as quickly as possible.
Evaluation of bailouts and other
interventions
The interventions to be taken should
both be long term and short term. In the short term, the concern should be to resolve
the liquidity issue and ensure that customers can access their funds without
disruption. Other crucial banking activities such as lending should go on
uninterrupted due to their contribution to the economic welfare of the country
(Deringer, 2011). In the longer term, issues of regulation and correction of
faults in the system that could have led to the situation should be examined
and remedied accordingly. The systems could either be related to the regulatory
frameworks or lack of effective supervision of the players in the financial
services industry.
In bailouts, the
central bank allocates funds to the ailing banks to enable them overcome their
immediate liquidity problems (Stone, Fujita and Ishi, 2011). It is important
that an analysis be conducted to determine the level of bailout needed. Excess
expenditure of the bailout could prove to be wasteful while inadequate
intervention could be counter-productive (Stone, Fujita and Ishi, 2011). The
central bank should buy time for conducting a thorough analysis by providing
smaller proportions of bailout while need is being assessed. Bailouts have
attracted a fair share of controversy in the recent past with critics taking
the view that the tax payer was in such cases forced to shoulder the bill for
inefficient bank managers (New, 2010). This is especially the case where the
bailouts are conducted without an insistence on the restructuring of the
shareholding in such organisations. Bailouts have also been touted as a source
of motivation for bank managers to pursue aggressive and relatively reckless
approaches in their lending practices (The Treasury Committee, 2011). They
allow shareholders to shift risk to the tax payer. The knowledge that the bank
would be saved if things went wrong takes away the motivation for such managers
to be vigilant in risk assessment and vetting of borrowers. However, it is
important to appreciate the fact that bailouts are done to protect the very
same tax payers and to ensure that economic activity is stabilised. Recklessness
can be prevented by ensuring that bailouts are accompanied by restructuring
where initial equity holders lose their stake partially or completely (Treasury
Committee, 2011).
An alternative to the
bailouts option could be the use of guarantees. By providing guarantees, the
central bank lessens the pressure on the cash-flow of the banks (Norris, 2011).
Creditors can lend to the bank in full awareness of the fact that their debts
will certainly get paid. The complication with this option is that it may not
solve the immediate liquidity problem. However, it could be a good option to
pursue in the mid-term. It can also be pursued where the amount allowable to
provide for bailout may be limited. Some of the factors that could lead to the
inability of the central bank to give the desired amounts in a bailout could
include limits by legislation, the budget deficits in the government and a host
of other factors (Beck and Wieland, 2008). This option could be used to
subsidise bailouts where the former is insufficient.
The longer term
approaches deal with regulation: diagnosis of the causes of a crisis and
introduction of intervention to ensure that the situation does not arise again.
One of the causes could be the provision for low reserve ratios where banks are
allowed to retain very little funds and this would lead to a situation where
there are problems in a situation where withdrawals by depositors surge
significantly (Morgan, 2009). In most cases, the reserve ratios would be enough
to cater for withdrawal needs. However, poor compliance could see banks lend
more than they should and this could result in such a situation. The system
could also be affected by the practice of subprime lending where banks offer
credit to borrowers with poor credit ratings. This could lead to massive loan
defaults which could lead to the situation described above. It is in fact known
that the global economic recession was largely caused by subprime lending which
resulted in massive defaults (Morgan, 2009).
The processes involved
in underwriting property or the determination of the value of assets used as
collateral can also be a problem. This problem came to the fore in the global
recession where the underwriting processes were corrupted. Under corrupted
systems, people could take loans based on exaggerated value of assets and this
made it difficult for banks to recover their funds from defaulters (Almeida,
Fry and Goodhart, 1999). These are processes within the financial services
sector that the central bank can influence and ensure that timely interventions
are made. A review of financial processes leading up to the determination of
value of property and credit worthiness of individuals should be done. For
instance, infrastructure allowing for information sharing among banks on credit
record of borrowers could help in reducing the risk of massive defaults.
Expected outcome of actions taken
and possible risks
A bailout would be expected to help the
organisation work its way out of liquidity crunch and resume normal activity
(Almeida, Fry and Goodhart, 1999; Goodhart and Schoenmaker, 1995). It is
supposed to ensure that depositors can access their funds without fail with the
banks also being able to advance loans to creditors. It is expected that the
bailout funds would be used with care bearing in mind the poor practices that
may have landed the bank in question in its current predicament (Neuenkirch,
2012). Bailouts when used alone do not go far enough. They fail to intervene in
the weaknesses in the management practises and this implies that even the
bailout funds could be mismanaged with the banking institution in question
landing back into problems (Dombalagian, 2010; Morgan, 2009). In many cases,
the bailout funds are not enough to raise the capital levels needed by the
banks. The banks may therefore continue to freeze lending in order to raise
such levels. This could beat the very purpose of such bailouts. Other practices
such as zombie lending could continue despite the bailout and the central bank
must remain aware of such possibilities. Intervention through bailout could
also make things worse where the newly invigorated bank may seek to return to
vibrancy by lending funds to parties that would not have qualified under normal
circumstances (Lessiter, Bisping and Horton, 2010). In this case, the
availability of a bailout constitutes part of the problem.
The regulation approach
is very good in assuring the stability of the financial systems. However, they
tend to be long term approaches. The immediate concern among banks facing
liquidity issues is the need to ensure that the banking activities are not
interrupted and that the depositors are able to access their money at any point
(Donato, 2011; Li, 2007). Regulation, when used alone, could be too late in
that there may be no financial system to regulate by the time the interventions
are made since the damage to the market confidence would have already been
done.
Enhancing the effectiveness of the
interventions: lessons from the global recession
There are many lessons that could be
learnt from the global financial crisis where the financial systems in most
economies in the developed world were on the verge of collapsing. Governments
allocated substantial budgetary allocations towards the bailout of banks where
funds would be issued to banks to overcome their liquidity problems and resume
their crucial role in driving economic activity (Donato, 2011a). These quick
interventions led to the resumption of economic activity and the ending of the
recession. In fact, it must be appreciated that whereas the economic recession
was larger than the great depression, interventions were made to ensure that it
was ended in a much shorter time span (Ibanez, Jimenez and Garaizar, 2011). The
bailout by governments was accompanied by a focus on the financial systems.
Practices that had led to the situation were outlawed with other unregulated
practices brought under regulation. For instance, focus in the UK shifted to
the shadow banking sector and how the sector could be regulated to ensure
enhanced stability in the financial system (Ibanez, Jimenez and Garaizar, 2011).
Standardised ways of credit rating were also introduced to ensure accurate
pricing of risk. There was also a reversal of the approach to regulation that
had earlier emphasised self regulation where industry bodies would ensure
compliance (Ezeoha, 2011). This important function was taken back to the
relevant government agency to ensure that all loopholes that could lead to
liquidity problems were sealed.
This is the approach that
the central bank should take in this case. There should be a bailout to bring
reprieve in the short term followed by rigorous system checks to determine the
cause of the flaws and ensure that legislation is introduced to deal with any
weaknesses found.
Conclusion and recommendations
The stability of the financial system
should be the main concern of the central bank. This stability is for the most
part driven by the confidence that consumers have in the system. Depositors
need to have confidence that the money they keep in banks is safe and available
to them at will. Market players also need to have confidence that normal
banking practices will remain stable and that would inform their approach to
business (Li, 2007). In this case the largest bank in the economy is faced with
liquidity problems where it is not able to meet its obligations to depositors.
This is likely to affect the entire financial system and therefore warrants
immediate intervention.
The most available tool
for intervention is the use of a bailout. The central bank should provide the
organisation with the funds needed to ensure that banking activities are
stabilised. This bailout should be enough to return the company to normalcy
with any deficits catered for by providing guarantees aimed at making it easy
for the bank to obtain products and services from creditors. However, the
bailout should be accompanied by a systems audit to determine the causes of the
crisis and come up with ways of ensuring no recurrence in future.
To ensure that the bank
and other banks in the market remain vigilant in their approaches, the bailout
should be provided with some implications on the ownership and management
structure of the organisation where the initial equity holders may partially
lose their stake in the organisation. Such an approach would help in motivating
the directors and management of the banks to remain vigilant in their risk
management approaches to ensure that they do not put the financial system at
risk in the future.
The appropriate action
to be taken would therefore be to mix an appropriate bailout with the
institution of a corrective mechanism to institute stability in the bank and in
the entire financial system.
References
Aikins, S.K. 2009. Global Financial Crisis and the Government
Intervention: A case for effective regulatory governance. (Online)
Available at:
http://www.idt.unisg.ch/org/idt/ipmr.nsf/0/3677d9fbcd8a5cbfc1257671002a26b7/$FILE/Aikins_IPMR_Volume%2010_Issue%202.pdf
(Accessed
15 April 2012)
Almeida, A., Fry, M.J., Goodhart, C.A.E., 1999. Central banking in developing countries:
objectives, activities, and independence. New York: Routledge
Bank of England, 2011. Financial Stability Report. (Online) Available at:
http://www.bankofengland.co.uk/publications/fsr/2011/fsrfull1106.pdf (Accessed
15 April 2012)
Beck, G.W., Wieland, V., 2008. Central bank
misperceptions and the role of money in interest-rate rules. Journal of Monetary Studies, pp. S1-S17
Benson, G.J., Kaufman, G.G., 1996. The appropriate
role of bank regulation. The Economic
Journal, 106(May), 688-697
Centre for Economic Policy Research, 2010. Bailing out Banks: Reconciling stability and
competition. (Online) Available at:
http://www.cepr.org/pubs/other/Bailing_out_the_banks.pdf (Accessed 15 April
2012)
Chartered Institute of Management Accountants, 2010.
The Global Banking Sector: Current
Issues. (Online) Available at: http://e-finanse.com/RaportyCIMA/5.pdf
(Accessed 15 April 2012)
Deringer, F.B., 2011. Bank of the Future: UK Financial Regulation. (Online) Available at:
http://www.freshfields.com/publications/pdfs/2011/may11/30345.pdf (Accessed 15
April 2012)
Dewatripoint, M., Freixas, X., 2012. Bank
resolution: a framework for the assessment of regulatory intervention. Oxford Review of Economic Policy, 27(3),
pp. 411-436
Dombalagian, O., 2010. Requiem for the Bulge
Bracket: Revisiting Investment Bank Regulation. Indiana Law Journal, 85(3), pp. 777-849
Donato, M., 2011a. Exploring governance of the new
European Banking Authority: a case of Harmonisation? Journal of Financial Stability. 7(4), pp. 204-214
Donato, M.M 2011. Measuring the financial
supervision architectures and the role of central banks. Journal of Financial Transformation. 32, pp.9-14
Ezeoha, A.E., 2011. Banking consolidation, credit
crisis and asset quality in a fragile banking system: Some evidence from
Nigeria. Journal of Financial Regulation
and Compliance, 19(1), pp. 33-44
Goodhart, C., Schoenmaker, D., 1995. Should the
functions of monetary policy and banking supervision be separated, Oxford Economic Papers, 47(4), pp.
539-560
Ibanez, J.W., Jimenez, I., Garaizar, N., 2011.
Grabbing vs Helping- Banking Supervision Dilemma: A global approach enhanced
banking law compliance. Journal of
International Banking Law and Regulation, 26(3), pp. 119-128
Iyade, A.I., 2006. The impact of regulation and supervision on the activities of banks in
Nigeria (Online) Available at: http://www.stclements.edu/grad/gradiyad.pdf
(Accessed 15 April 2012)
Jackson, J.K., 2009. The Financial crisis: impact on and response by the European Union. (Online)
Available at: http://fpc.state.gov/documents/organization/127015.pdf (Accessed
15 April 2012)
Lassiter, J., Bisping, T.O., Horton, J., 2010.
Central banking in transition economies: Estonia and Belarus. International Journal of Commerce and
Management, 20(4), pp. 331-338
Li, T., 2007. Banking regulation around the world
patterns, determinants and impact. Journal
of Emerging Market Finance, 6(1), pp. 61-122
Morgan, J.,
2009. The limits of central bank policy: economic crisis and the
challenge of effective solutions. Cambridge
Journal of Economics, 33(4), pp. 581-608
Neuenkirch, M., 2012. Managing financial market
expectations: the role of central bank in transparency and central bank
communication, European Journal of Political
Economy, 28(1), pp. 1-13
New, T., 2010. New York
Times-Major Parts of the Financial Regulation Overhaul-May 2010. The
New York Times. (Online)
Available at:
http://www.nytimes.com/interactive/2010/05/20/business/20100520-regulation-graphic.html (Accessed 15
April 2012)
Norris, F., 2011.
Crisis Is Over, but Where’s the Fix? New
York Times. (Online) Available at: http://www.nytimes.com/2011/03/11/business/economy/11norris.html
(Accessed
15 April 2012)
Quintyn, M., Taylor, M.W., 2004. Should financial sector
regulators be independent? Economic
Issues, 32 (Online) Available at:
http://www.imf.org/external/pubs/ft/issues/issues32/index.htm (Accessed 15
April 2012)
Stone, M., Fujita, k., Ishi, K., 2011.
Unconventional Behaviour by Central Banks. Finance
& Development, 48 (3), pp. 21-42
Sullivan, A., 2003. Economics : principles in
action. Needham, Mass: Prentice Hall
The Treasury Committee, 2011. Financial Regulation: a preliminary consideration of the government’s
proposals. (Online) Available at: http://www.publications.parliament.uk/pa/cm201011/cmselect/cmtreasy/430/430i.pdf
(Accessed 15 April 2012)
No comments:
Post a Comment