By W.A Wijewardena –

Dr. W.A. Wijewardena

Raghuram Rajan’s Wisdom

Reserve Bank of India Governor Raghuram Rajan, an illustrious academic but now a practising central banker, is reported to have left an important message to central bankers from South Asia at a seminar held in the Central Bank of Sri Lanka two weeks ago. He is quoted as having said: “When you have long term liabilities there would no control in what the banker does with the assets. The liability structure affects the kind of structure that you make. If you have long term liability without corporate governance, the investors will have no control. In having short term liability, banks are forced to manage risk properly and have enough liquidity to pay lenders and collect the loans within a specific timeframe. All of these help discipline a bank” (available here ).

Money given to undisciplined people will disappear

The message delivered by Raghuram Rajan in technical language can be translated into laymen’s language as follows: Money given to banks by way of capital either by shareholders as equity capital or by people who have invested in their long term bonds as loan capital is permanent resource which a bank’s management can play with freely. That is because they do not have to worry about repaying capital and in the case of bonds there is no repayment obligation at least immediately. Hence, unless they do not know what they are supposed to do in the best interest of people for whom they work – called good governance by academics – it is likely that they will use that money recklessly just like a child eats up all the candies in a jar with no lid. But if banks know that money with them is temporary and can be denied to them at any time they will behave responsibly exercising a kind of self-discipline in using that money. It is like a man with knowledge of dying one day is prone to control his activities better than a man who has no that knowledge. In essence, Raghuram Rajan’s message was that ‘when you give money to people who have no discipline, that money will disappear faster than they have got it’.

Capital is not a panacea

Raghuram Rajan is questioning the current wave of belief among bank regulators that capital is the panacea for the ills of the financial institutions worldwide. He is telling his colleagues that capital is necessary but not sufficient to keep a financial institution in good health. There are many other requirements which have to be put in place if regulators are genuinely interested in maintaining stability in the financial system and thereby helping the economies concerned to have sustainable growth. These essential requirements are in fact within the control of individual bank regulators and it is in their own interest to keep them in proper place as both necessary and sufficient conditions for financial system stability.

Basel I and its capital adequacy prescription

Capital became an important element in the regulation of financial institutions after the Basel Committee on Banking Supervision, created under the patronage of the Bank for International Settlements or BIS, prescribed capital adequacy requirements in its recommendations known as Basel Accords. Accordingly, in Basel I which came into effect in 1992, banks were required to assess their assets in terms of given risk factors called risk weights and keep an adequate capital based on those risk-weighted assets. Capital was broken into two parts, Tier I capital and Tier II Capital. Tier I capital was the owners’ capital contributions as paid up capital and retained profits. Banks were required to maintain Tier I capital at 4% of the risk weighted assets. Tier II capital constituted borrowed funds and both Tier I and Tier II capital had to be maintained at a minimum of 8% of the risk weighted assets.

Regulations cannot tackle unexpected events

The problem with any regulatory measure is that it can handle a crisis that has already happened. Thus, if the same crisis happens again, it is pretty much effective. But, the world is so complex that the likelihood of it being hit by the same crisis is far remote. The new crisis which is an unexpected event is a total stranger and the old regulatory measures in place are not capable of handling such crises effectively. This was exactly what happened to Basel I Accord because the new crisis that hit East Asia in 1997/8 came from not because capital was inadequate but because wrong credit, exchange rate and macroeconomic policies pursued by the countries concerned. For instance, to promote economic growth, the authorities in the countries concerned had followed policies that promoted credit growth through low interest rates and to support the governments in power had pursued fixed exchange rates despite the demand in the markets was for rates to depreciate. The first led to the development of credit bubbles which burst without warning making banks sick. The second brought the economies concerned under speculative attacks by smart investors who knew that these countries could not continue with fixed exchange rates for long given the fragile macroeconomic conditions. The result was as expected: the economies concerned were hit by an unprecedented financial crisis that spread from one country to another like a wildfire. Hence, the East Asian Financial Crisis of 1997/8 was the handiwork of the authorities themselves. Thus, in countries where the authorities were saner, the effect of the crisis was minimal.

Basel II: Expand the coverage

Clearly, the events that unfolded in late 1990s showed that the provisions of Basel I Accord concentrating only on capital adequacy for banking stability were inadequate. Accordingly, the Basel Committee on Banking Supervision proposed further measures to strengthen the soundness of banks that came in the style of Basel II Accord in 2004. In this Accord, capital requirement was strengthened and in addition, two other measures that would be helpful in maintaining system stability were also proposed. One is the strengthening of the supervisory oversight of regulators and the other is getting markets to discipline banks. The market discipline meant that ill-managed banks had to be closed down as a punishment for misbehaviour since markets do not have either friends or foes.

No quick-takers of Basel II

When calculating risk weighted assets for capital adequacy under Basel II, three important risks were reckoned, namely, credit risk, operational risk and market risk. In all of them, complex risk calculating measures needing long learning and testing periods before being implemented were introduced. After calculating the risk weighted assets, the total capital was strengthened by additional buffers of capital to be maintained by banks. All these new systems worked out to an average capital adequacy requirement of about 13% of their risk weighted assets compared to 8% in Basel I. The system was so complex and costly that there were no many quick takers. As a result, even as late as end-2015 only 95 out of a total of 190 countries are to be fully compliant with Basel II Accord.

Financial crises are made by regulators

Even before the member countries thought of considering the implementation of Basel II Accord, the Western world was hit by a new crisis, the Sub-prime Mortgage Crisis of 2007/8. This was also a crisis created by authorities, the US Federal Reserve System – the central bank in USA – supported by US government. Two measures taken by US authorities had gone wrong here. One was the low interest rate policy to promote economic growth and the other was the promotion of housing loans to give a house to every American irrespective of his ability to repay loans. The result was the creation of twin-monsters, a credit bubble on the one hand and a low-quality housing mortgage bubble on the other. In terms of natural laws, both bubbles were to burst once they expanded to their maximum level and US authorities were not prepared to face the consequences. It led to a massive financial crisis followed by a prolonged economic slow-down in the Western world.

Long time-frame for Basel III

Basel Committee on Banking Supervision reacted by coming out with a new Accord known as Basel III Accord which had to be fully implemented by 2018 but now further extended to 2019. This introduced two other measures: one was the introduction of a limit for banks to acquire funds through deposits and borrowing without capital known as ‘limiting their leveraging’. The other was the introduction of a liquidity requirement to enable banks to meet their short-term financial obligations including cash requirements of depositors. While many new features have now been added to Basel Accords, capital still remains the principal instrument of ensuring banking sector soundness.

Yet, capital has a useful role

Basel Committee or any other individual regulator cannot be faulted for relying on capital requirement as the principal instrument of keeping banks healthy. This is because capital provides a multiple service to a bank. If a bank is to be closed because it has become bankrupt, the amount of capital provided by shareholders protects the depositors’ money to the extent of the capital in the bank. This is because the losses of a bankrupt bank are borne by shareholders to the extent of capital they have introduced passing only any excess losses onto depositors. Capital also helps a bank to go through loss-making bad years without having to be closed down. It thus gives a breathing period for it to recover. Finally, it helps banks to finance their establishment as well as expansion expenses without having to use the depositors’ money for that purpose. Hence, capital is important and it should be maintained at appropriate levels.

Regulatory capture the worst public enemy

But capital alone is not sufficient to ensure soundness of banks. Even the elements which the subsequent Basel Accords have introduced are not sufficient to maintain the soundness of banks. That is because the problems for banks arise from sources totally different from what Basel Accords have recognised. Raghuram Rajan has mentioned one, namely, the governance requirements. But there are two others which he has omitted to mention. One is the bad macroeconomic policies adopted by authorities. The other is taking bank regulators as prisoners by politicians and other powerful groups to enrich themselves out of banking business which economists have now termed as ‘regulatory capture’. The effect of regulatory capture was discussed in a previous article in this series (available here ).

Governance is important for banks as well as central banks

Governance is the way a bank should relate to those who have an interest in them – known as stakeholders – while pursuing its objectives. Bankers hold other people’s moneys and therefore they are trustees. A trustee is required to handle such money in the same caution and care as he handles his own money. It requires them to be accountable, transparent, precautionary, protective and above all prudent in all dealings. This has to be exercised by the boards, senior managements and employees of at all levels. Adherence to governance simply as a duty and not something coming from within – say from heart – does not help them to meet the requirements of the stakeholders. Recent financial scandals involving the leading banks in the world where regulators have imposed them thump fines are all cases where there had been severe breaches of governance principles. Governance has to be equally practised by bank regulators too and how it should be done in central banks was discussed in a previous article in the series on Principles of Central Banking under the title ‘Governance of Central Bank Boards’ (available here ).

Bad macroeconomic policies a villain

Bad macroeconomic policies also lead to the creation of unsound banking systems. If central banks continue to maintain low interest rate regimes in a bid to promote credit levels to boost economic growth, the resultant credit bubbles invariably burst threatening the stability of the financial systems. This has already been experienced in the East Asian financial crisis of 1997/8 as well as the sub-prime mortgage loan crisis of 2007/8. Similarly, continued complacency about high foreign commercial borrowings by governments, banks and private entities drag economies which do not have sound trade and services accounts in the balance of payments to eventual debt crises. A banking system is the first victim of such an external debt crisis.

Regulators offering a yielding hand to politicians

Political interferences are the unseen enemies of sound banking systems. That is because such interferences are not visible and in most cases kept hidden from the public eye by banking regulators who support them with a yielding hand. Thus, with the connivance of banking regulators, bank resources are siphoned off by politicians and those who are related to them. The resultant haemorrhage continues to weaken banks as individual institutions and the system as a whole without being noticed by the public and civil society institutions which normally function as watchdogs. If authorities suppress the civil society institutions, the problem becomes further aggravated. This was exactly what happened during the 32 year long reign of President Suharto in Indonesia as now documented by many writers on the subject.

Capture of banks by Suharto family

The US based Time magazine ran a cover story titled ‘Suharto Inc.’ in 1999 one year after Suharto was ousted from power alleging that he and his family had amassed some $ 73 billion through various corrupt deals. Suharto’s estate successfully contested the story in Indonesia’s Supreme Court which had ordered the magazine to pay compensation amounting to $ 106 million. Through a protracted legal battle, Time magazine finally managed to get the earlier Supreme Court judgment against it quashed in 2009.  But now, its initial revelation supported by other independent researchers has shown the extent of the involvement of his family in ruining the country’s banking system (available here ). While some of his children had direct ownership in banks, the most common modus operandi had been to get businesses and high income earners to contribute to various charitable projects, known as ‘yayasans’, started by Suharto. If anyone wanted to do business in Indonesia, he had to first make a donation to this charity under the influence of Suharto’s friends.  Moneys in yayasans were deposited in banks to show that they were transparent projects but in turn borrowed by his family members and related parties for dubious projects where the loans were not repaid as promised. By 1997, 16 of such banks had become bankrupt and when the central bank tried to close them down, those who had stakes in them had prevailed upon Suharto to sack the Bank Indonesian Governor Sudradjad Djiwandono thus preventing their closure by the regulator (available here ).

Capital alone is not sufficient

Thus, enemies of banks come not from capital inadequacy side. They come from other areas which have to be remedied if central banks are interested in assuring stable banking systems. These areas relate to breaches of governance codes, bad macroeconomic policies and undue political interference in banks. It is of importance to eliminate these viral infections if banking system stability is to be delivered to a country.

*W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com