Bank runs: who’s going to clean up the mess afterwards?

By Frances Coppola

In my post on the anatomy of a bank run, I suggested that the rule should be “provide central bank liquidity support to everything, taxpayer support to nothing”. This is because in a bank run/liquidity crisis, it isn’t realistically possible to distinguish between those institutions that are suffering from a disastrous shortage of liquidity and those that are actually insolvent. Financial institutions that are both liquid and solvent prior to the crisis can quickly become illiquid as markets freeze and they are unable to borrow to meet commitments, then insolvent as asset prices collapse due to fire sales in the desperate search for cash in the absence of market funding. Stopping the run is the top priority, and that means providing liquidity. Since insolvency is difficult to distinguish from illiquidity when markets have frozen and asset prices are in freefall, Bagehot’s Dictum cannot apply. Central banks should simply supply unlimited liquidity to anything and everything until the run stops. And they should do it early. Leaving it until asset prices are collapsing is too late.

We should not need direct government intervention in the form of guarantees, loans and equity stakes to stop bank runs. But when the run stops – and if central banks provide enough support, it will – then what remains will be the most almighty mess. This is where governments come in. It is not their job to stop the run. But it is their job to clear up afterwards.

The aftermath of a major bank run/market panic resembles the end of a battle. The floor is littered with bodies. Some are dead and need to be disposed of. Others are still alive, but mortally wounded. Still others are seriously wounded but could recover with appropriate treatment. And there may be a lucky few that appear to have escaped virtually unscathed – but they may have unsuspected internal bleeding that causes them to collapse later on.

Sorting out the dead from the alive, despatching the nearly dead and administering field surgery to those with some hope of surviving is dirty work. And governments are abysmal at it. They keep alive the mortally wounded, fail to do necessary surgery on the injured and – most bizarrely of all – resurrect the dead. All too often the result is a population of zombies. And as anyone who has watched Night of the Living Dead knows, zombies are high maintenance. They drain the life out of the economy living creatures with their seemingly insatiable appetite for human – well, in this case we can say “activity”. Or “money”, upon which much productive activity depends. When financial institutions are badly damaged they soak up money like sponges, draining the real economy to keep themselves alive while giving nothing back. Actually, so do damaged corporations if they get the chance. It isn’t just financial institutions that can be seriously damaged by a financial crisis. Japan’s zombie corporate sector was propped up for years by its equally zombie banks. And the US bailed out General Motors in 2008.

Anyway, the point is that the mess left after a financial crisis seriously needs cleaning up so it doesn’t cause long-term damage to the economy. This post is an attempt to put together a blueprint for what should be done.

The first thing to note is that worthy though this appears to be, introducing layer upon layer of regulation and intrusive supervision in the hope of completely preventing financial crises is not realistic. There will always be financial crises. Indeed it could be argued that periodic financial crises are necessary in a well-functioning financial system. If we consider the financial system as a living thing – after all it is a system created from the actions of living things, so it might be expected to behave much like a living thing itself – periodic expansion and contraction of credit can be regarded as the financial system “breathing”. Attempting to prevent this squeezes risk-taking out of the system, and risk-taking by financial institutions is essential to the economy – that is how investment capital is provided to businesses, enabling them to grow. If financial institutions are prevented from taking any risk at all, the result is slow economic death. Suffocate them with regulation and supervision, and you turn them into zombies.

This is not to say that regulation and supervision is not necessary: but we do have to consider how much is “enough”. We don’t want to turn bankers into box-tickers, so busy complying with a myriad rules that their real job of risk analysis and management is neglected. An over-regulated bank is either useless (because it can take no risks) or dangerous (because it doesn’t understand the risks it takes). I would be the first to agree that there was insufficient regulation and supervision prior to the 2008 crisis: but I think we are now in danger of going too far the other way, coming up with piles and piles of new regulations but not actually addressing the real issue – which is how we manage, rather than prevent, financial crises.

If we accept that financial crises are inevitable, the question is firstly, what do we need to protect from the worst effects of financial crisis, and how should we do this? And secondly,  how do we go about cleaning up the mess? Or better, can we minimise the amount of mess that financial crises create, while still allowing them to happen?

Much of the mess arising from financial crises is caused by the interconnectedness of the financial system. A bank run such as happened in 2008 is only possible because of the extensive interconnections between banks, shadow banks and corporations. So there have been suggestions that interconnectedness should be reduced. But this is idiotic. It is that very interconnectedness that makes the financial system vibrant and dynamic, enabling it – when working well – to support the wider economy.

pando-trembling-giant (2)Financial institutions are like aspens: they appear separate, but in fact they are all part of one single organism. Cut an aspen off from the rest and it will wither and die. Reduce the interconnectedness of the financial system and you reduce its effectiveness as a monetary transmission mechanism to the wider economy. The question should not be how to reduce the interconnectedness of the financial system, but what parts of it do we wish to protect from the effects of a bank run/market panic, and how should we go about this?

As a general rule, it is the parts of the financial system that circulate money that must be protected at all costs. These are the payments network (including transaction accounts), the interbank funding network and the central bank itself. Once these are protected, commercial financial institutions can and should be allowed to fail, as I shall explain.

In a modern developed economy the payments network is the lifeblood of the economy. If it breaks down even for a few hours, the economy comes to a shuddering halt, causing untold damage to households and businesses. In a bank run, payments systems come under considerable strain, simply because of the very large and unstable flows of funds that go through them as deposits are withdrawn. But perhaps more importantly, the payments network is dependent on the banks that administer it remaining upright. When RBS failed in the UK the payments network nearly went down with it. We have to make it possible for a clearing bank to fail without bringing down the payments network. The heart of “too big to fail” is “can’t let the payments network fail”.

I am personally in favour of detaching payments systems from commercial banks. I don’t have a problem with payments systems themselves being privately owned and administered, but they should not be dependent on banks. There should be a common payments gateway utility, available to all banks but not owned by them or dependent on them.

But isolating the payments network is not enough. If a clearing bank fails, a lot of people lose access to transaction accounts. The payments network may still be working, but those people can’t make or receive payments. Deposit insurance, certainly in Europe, does not pay out fast enough to protect those people. They need emergency lines of credit, either at other banks or as a last resort at the central bank. When there is a financial crisis, businesses and households need a lender of last resort so that we don’t have to keep dead banks alive.

I don’t see a problem with central banks providing this facility. There is no reason why liquidity support should only be available to financial institutions: if other businesses and households are distressed as a consequence of financial system problems, the central bank should provide them with liquidity too. It’s all about maintaining the flow of funds around the economy.

This brings me to the final part of the “plumbing” that must not be allowed to fail – and that is the funding mechanism for financial institutions, both banks and non-banks. This is the heart of my argument that in a crisis central banks should provide liquidity to everything. When financial institutions can’t fund themselves they fail in a disorderly fashion, causing asset price collapse and widespread insolvencies. Central banks can prevent this by maintaining the flow of funds around the financial system even at the height of a widespread bank run.

In fact financial institutions fail all the time, but they don’t normally cause a crisis despite being critically interconnected with others. Like aspens, they can die without harming the whole plant. They are quickly and easily resolved, either by being wound up and their assets distributed, or by being taken over by other institutions. But in a financial crisis the extent of failures may be much greater and the whole plant is under stress – hence the need for the central bank to support the “root”, and for the central bank itself to have the backing of its government. My statement “taxpayer support to nothing” actually meant “nothing except the central bank”. Yes, I know that central banks can continue to provide liquidity indefinitely even if they are technically insolvent. But markets don’t necessarily believe that, and financial crises are essentially failures of market confidence. If asset prices fall so low that the central bank’s solvency is at risk, an explicit commitment from government to recapitalise it if necessary may be needed to prevent further market panic.

So if the plumbing – the “root” – of the financial system is isolated so it cannot fail in a crisis, can individual components be allowed to fail in a crisis as well as under more normal circumstances? And if so, how do we go about this? In a crisis, takeovers may not be possible or desirable – some terrible mistakes have been made with forced takeovers. But that doesn’t mean windups aren’t. Just as dead aspens are a source of nutrients to live ones, so the assets of dead banks can help to revitalise living ones.

So we survey the battlefield after the run has stopped. The first priority is to identify which financial institutions are actually dead. This is not as easy as it sounds. When the place is flooded with liquidity, banks may look alive when they are actually dead. Liquidity can also disguise mortal wounds, in much the same way as blood transfusions can prolong life when there is undiscovered internal bleeding due to catastrophic damage to vital organs. One of the biggest problems in Cyprus was that the Eurosystem had provided liquidity to Laiki bank for far too long and almost certainly in breach of its own rules: Bagehot must have been turning in his grave. There is no real doubt that Laiki was rendered insolvent by the Greek debt restructuring in March 2012. But it was not allowed to die for another year. By keeping it alive, the Eurosystem increased the indebtedness of the Cypriot banking system – a debt which had to be made good by increased haircuts on large deposits at Bank of Cyprus. And it also made the eventual windup of Laiki bank more traumatic, because people believed that it would be bailed out. It would have been better if it had been allowed to fail a year before.

Regulators need to be able to recognise when a financial institution is actually dying or dead. It is kinder to cut off liquidity support sooner rather than later. We need the equivalent of a Liverpool Care Pathway for financial institutions, so we don’t prolong life unnecessarily and expensively. Regulators should examine the accounts of all financial institutions that remain dependent on liquidity support after a bank run has stopped or other catastrophic failure been resolved, and close down any that are unable to bring their capital levels up to minimum standards. A bank that cannot raise even minimum levels of capital isn’t worth saving, however long it has been in existence. There is no room for sentimentality on a battlefield.

But what about banks and financial institutions that are wounded but viable? Should they be simply allowed to continue as before? Well, no. If they are wounded they need treatment, possibly including radical surgery. A damaged bank is damaging to the economy, which itself is also damaged by the crisis. We cannot afford the time for banks to heal themselves, and if left to their own devices they may never do the necessary surgery at all. So once again it is up to regulators to determine “treatment plans” for banks and financial institutions that are receiving liquidity support but meet minimum capital requirements. This might simply be a question of imposing conditions, such as requiring them to raise more capital or retain earnings until capital levels are restored. Or it might require more radical action such as stripping out portfolios of toxic assets and disposing of them, perhaps by means of a state-backed “bad bank”. This needs to be done quickly. The approach taken by the UK, whereby damaged banks retained large amounts of toxic assets on their balance sheets and unwound them over a period of years, was very damaging to the economy. Damaged banks don’t lend productively to the economy – they are not in a position to take on more risk since their balance sheets are already very risky. RBS, Lloyds/HBOS, HSBC, Barclays, Nationwide and – we now know – the Co-Op (or rather, Britannia Building Society) all should have had their toxic assets stripped. Had this been done in 2008/9, the UK economy might now be in a very different shape.

But how do we prevent financial crises being so catastrophic anyway? Key to this is of course my suggestion that central banks should provide liquidity support to EVERYTHING – not just banks,shadow banks and other financial institutions, but if necessary businesses and households too. This maintains the flow of funds in the economy and prevents serious damage due to liquidity failures in various sectors. But looking beyond that, we should seek to prevent widespread die-off among our aspens. After all, if a plant loses a lot of its top growth it is weakened and less productive.

The key to this is capital. I’m sorry, but it is. The fact is that the more highly leveraged a financial institution is, the more likely it is to fail in a financial crisis. I’ve already said elsewhere that I think a leverage ratio should be used in conjunction with a risk-weighted capital ratio to determine minimum capital levels. I’m actually in favour of two capital requirements – an absolute minimum below which a financial institution would simply be closed down, and a “standard” level below which a financial institution would be regarded as in “special measures” (as the Parliamentary Commission on Banking Standards put it). Financial institutions whose capital is below the “standard” would be banned from issuing dividends and bonuses until capital levels were restored, and could be encouraged to raise capital by other means such as rights issues. There is considerable debate at the moment about how much capital banks should have, ranging from Matthew Klein’s idea that all lending should be backed by capital not debt, Miles Kimball’s suggestion of 30-50% equity to total assets, Anat Admati’s minimum 25-30% equity to total assets (she recently said she would prefer 40%), to the IMF’s recent suggestion that all of that is overkill and a figure of 9% equity to total assets would be enough. Clearly there is room for considerable debate, but at least everyone is agreed on one thing – the paper-thin ratios of the past cannot be allowed again. I would venture to suggest that maybe the IMF’s figure could be used as my “minimum” below which an institution would simply be closed down, and a “standard” figure could be much higher. I would also suggest that both the “standard” and “minimum” figures would need to be determined according to the needs of the supporting economy: for example, both would need to be higher in a small economy with a large financial sector (such as the UK) than in a large economy with a relatively smaller financial sector (such as the US).

And finally. Even with unlimited liquidity and higher levels of capital, it is still conceivable that there could be a financial crisis that leaves virtually all of a country’s banking sector in “special measures” – weakened and with limited lending capacity. Stripping bad assets out and forcing banks to increase capital helps to minimise this effect, but there could still be a need for direct reflation of the economy, bypassing the damaged institutions. Central bank liquidity support to households and businesses may have to morph into government financing of households and businesses. In the UK we are heading fast down that road: the Government is already providing funding to businesses via a range of different initiatives (although there are huge problems getting this funding to the businesses that need it, not least because Government is useless at communicating), and now some households are receiving help too through the Help to Buy scheme. The problem is that once Government starts offering direct assistance to businesses and households, it is very difficult to withdraw it once banks are restored to health. I can’t help feeling that if Government had fixed the banks as I suggest four years ago, much of this direct support of businesses and households would not have been necessary.

Related links:

Anatomy of a bank run – Coppola Comment
Mortgages are dangerous beasts – Coppola Comment
What Glass-Steagall 2 gets wrong: Everything – Matthew Klein (Bloomberg)
The bankers’ new clothes – Anat Admati & Martin Hellwig
Anat Admati, Martin Hellwig & John Cochrane on Bank Capital Requirements – Confessions of a Supply-Side Liberal
How much capital should banks have? – Lev Ratnovski, IMF (Vox)
Changing banking for good – Parliamentary Commission on Banking Standards (pdf)
Night of the Living Dead – YouTube (video)
Pando, the single largest living organism on earth – Amusing Planet

I am indebted to Heidi Moore for the “aspens” idea.

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