Are Banks Special? Is this a Rhetorical Question?

‘Are banks special?’ This was the most fundamental question raised by the 2007 financial crisis. It remains just as relevant today especially given the prevailing Covid-19 pandemic. To any seasoned banker, the answer will automatically be “yes.” But let’s examine the question of the specialness of banks so that the reader can decide for himself/herself.

If banks are ‘special’ as compared with other firms, what does this imply for whether and how banks should be regulated; the respective corporate governance arrangements for banks; and the required standards of professionalism and corporate responsibility expected of bankers and their banks ?  We might argue pragmatically that banks are ‘special’ because they are more heavily regulated than many other kinds of firm and several bank-type regulations (like capital adequacy, reserve requirements, provisioning for impaired credit, approval of management members, compulsory reporting of quarterly financial statements) are atypical ones for banking. 

In the global arena, we also observe that banks are special because of the ‘too big to fail’ doctrine. Very big and important banks are invariably bailed out one way or another by the state if they get into serious difficulties.  Recent financial crisis indicate that when the banking system retrenches, the real economy suffers tremendously. Arguably, all of these empirical observations conspire and lend themselves to make banks special. However, they do not explain why banks are special and how we might best handle this ‘specialness’.

One view of banks is that they are the most important economic institution formed in modern history because of their ability to ‘transmute’ deposits into loans and investments, and this contributes strongly to economic growth and stability.  Basel III, for example, recognizes transparently this macro role of banks via the new countercyclical capital-adequacy rules. At the same time, though, banks are also one of the most dangerous economic institutions because of their periodic contribution and exposure to systemic risk events; the ‘specialness’ of banks is intertwined with this apparent conundrum.

 In modern economic thinking there has been a strong movement away from the idea that banks are special in any way. This can be observed from the challenges and questions targeted to banks on an increasing basis via electronic, print and social media platforms. The sacrosanctness and aloofness of banks dissipated following the financial crisis of 2007–2008 better known as the global financial crisis for its severe worldwide financial crisis. Excessive risk-taking by banks combined with the bursting of the United States housing bubble caused the values of securities tied to U.S. real estate to plummet, damaging financial institutions globally culminating with the bankruptcy of Lehman Brothers on September 15, 2008, and an international banking crisis. While banks of yester years could afford to wait for customers to come through their doors, modern banks set targets for customers they want to grow their market share annually. However, it is in the field of regulation that the debate has been most heated, especially since the 1970s and particularly in the US, and quite rightly so. 

 A primary economic function of important banking regulations (like prudential capital adequacy and liquidity rules) is to help reduce the incidence and impact of systemic risk events that could mutate into a financial crisis. Since financial crisis are exceptional disturbances in financial markets, it is always important to explore relevant historical experiences in order to understand why they happened and how they can be mitigated in the future. 

The 1930s banking crisis associated with the Great Depression in the US was the most severe banking crisis up to 2007 but it also had some noteworthy similarities. For one thing, it created a kind of free market experiment in banking, since the political philosophy of the day was laissez faire. As a result, when banks began to fail in ever larger numbers and in successive waves, it was partly due to the Central Bank not stepping in immediately to provide lender of last resort liquidity. 

Emerging from these experiences, some important principles of modern central banking were learnt the hard way especially that the Central Bank has to provide lender of last resort liquidity to banks in order to protect aggregate bank deposits. As when confidence in banks begins to weaken badly, no bank is safe as a run on the bank can destroy it even if it is stable and a going concern. And in these modern times, one can add that the media can play an important role in the erasing of incorrectly fuelled perceptions that can be detrimental to the lives of so many including those with their lifelong savings in the bank.

It is also from these events that modern capital adequacy rules (including stress testing) and techniques like deposit insurance were developed (the Deposit Insurance Act was established in 2018 in Guyana). Bank deposit insurance is rather unique to banking because its primary aim (unlike other kinds of insurance) is to help prevent the event (deposit runs) insured against. It does this by helping to bolster confidence in the banking system (depositors do not have the same incentive to run if they are covered by deposit insurance). The famous Glass-Steagall Act 1933 (which effectively separated retail and investment banking) was formulated from these experiences. It took over half a century to repeal Glass-Steagall and then the 2007 financial crisis to resurrect these same ‘ring fencing (separating)’ questions.

Banks in many countries since the 1970s have been strongly deregulated and free to compete more strongly and allowed to enter into new markets. The alleged omnipotence of the external market as the best allocator of banking resources was enshrined in Basel II, since the underlying philosophy of Basel II was to converge ‘economic’ and ‘regulatory’ bank capital. In practice, this meant giving the capital market a greater role in setting bank capital levels. Basel III, however re-asserted the relevance and importance of regulatory capital, where regulators (not the market) have the final say about how much systemic, risk-cushioning capital adequacy is needed.

With these additional measures, an important kind of ‘social contract’ emerges. Banks can earn higher profits and may be protected from the downside when things go badly wrong (as in a financial crisis) because of these additional, state-provided supports. As a result, the state also has to protect itself (i.e. taxpayers) via regulatory requirements like prudential supervision. 

If the free market model is to work more effectively in the banking industry, this implicit social contract has to be recognized. One way of addressing it is to ensure corporate governance rules for banks that would encompass senior bankers and bank directors becoming more responsible for those kinds of imprudent actions that can help to produce systemic shocks.  At the same time, there has to be a return to recognizing banking as a profession with wider economic responsibilities. 

A live example against the backdrop of Covid 19 is the reaching out by our Central Bank to local banks to come up with temporary relief measures to allow moratoriums on loan payments until December 2020; relaxation of sections 14 & 15 of the Supervision Guideline No. 5 to allow for refinancing of some facilities; offering of concessional interest rates and waiver of some bank charges particularly those applicable to senior citizens. These recommendations are not inconsistent with a bank seeking profit and targeting value maximization. 

Other examples include where the Government through the Ministry of Finance incentivizes banks with bank guarantees; tax breaks on interest earned; and waiver or reduced reserve requirements to push lending in new areas, example green financing, start-up businesses or the agriculture sector to mitigate against the associated risks of lending these areas may present.

An underlying thread that runs through this ‘mini history’ is that banks are apparently special because they borrow short term and lend for longer periods creating quite some mismatch. This kind of maturity intermediation is a fundamental economic process that helps to develop and sustain an economy via the increased lending and investing generated. But in carrying out this important function, banks are inevitably exposed to a liquidity risk, that is, the more they lend, the greater this risk.  As a result, confidence in banks is essential at all times in order to dis-incentivize depositors from running on a bank(s).  A run on any one bank or group of banks can produce a ‘contagion’ where confidence begins to weaken badly and even well-managed banks are no longer safe from a run. Banks should always be prudent (and seen to be prudent) in running their risks, but history has shown that additional measures (like Central Bank lender of last resort and deposit insurance) are also needed as added cushions.

Shaleeza Shaw (Ms)

Secretary and Chairperson of the Green Economy Committee

Georgetown Chambers of Commerce and Industry

Dip (Dist); B.Sc (Dist); LLB (Dist); CCP; MBA, CB, MCBIS (Dist).

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