A central bank can regulate, but can it supervise?
BANKS and banking are often misunderstood. Comments on an article on this page by Vishnu Padayachee and me (Banking truths not as exciting as theories of intrigue, June 24) on the central bank and the fractional reserve system used by banks, confirm this observation.
This article stated clearly that banks cannot fund themselves and can therefore run into solvency and/or liquidity problems when borrowers fail to repay loans or when refinancing cannot be secured by means of replacement liabilities (capital, deposits, bonds, etc) when existing funding is withdrawn.
The recent decision to place African Bank (Abil) in curatorship confirms the importance of loan repayments and bank liquidity. There are many reasons Abil ran into difficulty. Two major ones are delinquent borrowers and the management of a furniture company. A third reason will also become apparent. With the loss of investors’ confidence, Abil would not be able to refinance its bonds.
Delinquent borrowers put, initially, its liquidity position and subsequently its solvency position under pressure. Even if Abil remained solvent, if loans were not repaid as expected, the bond financing on which it depended would dry up and it would face a liquidity problem. It would no longer be able to finance existing loans, let alone new ones. This simply shows that bank loans and advances to customers are not “created out of nothing”, as is often claimed by uninformed commentators, but are funded by bank liquidity. When these loans and advances are not repaid, banks run into the double difficulty of liquidity and solvency.
The performance of the Ellerines furniture group contributed to difficulties. The business model envisaged at the time of the purchase of the subsidiary simply did not deliver the desired results.
This experience shows that banks should stick to their knitting. They should excel in banking and refrain from trying to manage the companies that generate opportunities for funding.
In SA, bank bail-outs and assistance to banks in distress owing to liquidity problems have taken place from time to time. This assistance can in theory be justified in terms of the doctrine of the central bank acting as lender of last resort.
Central banks can provide such assistance on the basis of the balance sheet of a bank, or with a guarantee from the government for the account of taxpayers. The latter is often associated with banks experiencing solvency, rather than liquidity, problems.
SA’s authorities do not publicly announce all assistance to banks. The purpose of such assistance is to allow the recipient bank sufficient time to put its business on a sound footing, thereby restoring public trust, or to exit the system in an orderly fashion.
A public announcement may achieve the exact opposite by eroding trust in the bank. Two major cases of central bank assistance to South African banks are nevertheless public knowledge: Bankorp/ Trust Bank and Nedbank.
Apart from its responsibility as lender of last resort within the prescriptions of the South African Reserve Bank Act and the Banks Act, the Reserve Bank also has responsibility for bank regulation and supervision. In terms of bank regulation, which is the less complex of the two functions, the Bank must ensure a level playing field for all banks.
Regulation implies that banks can operate only with a banking licence. It also ensures a proper reporting framework, subjecting all banks to the same obligations. Bank regulation is an extremely important function in any economy, owing to information asymmetry between banks and their clients. Bank regulation gives bank clients reasonable assurance that they deal with a reputable institution.
Bank supervision is not as simple a principle as bank regulation.
Depending on the definition used, both “supervise” and “supervision” come very close to “management”.
This responsibility could then be interpreted to imply the prevention of bank failures, given the responsibility for the management of banks.
However, the management of banks is definitely not the function of the central bank or of the registrar of banks.
Which leaves the question for debate: is there indeed a function such as bank supervision and is it a doable job, or can we at best hope for efficient and effective bank regulation in ensuring a stable banking and financial system?