Watch out for holes in bank safety net

UNSURPRISINGLY, local banks have cheered the Reserve Bank’s announcement that it will create a liquidity facility to help them in the event of a shortfall.

There are many reasons for this positive reception.

For one thing, it is widely accepted that the distress of banking institutions often leads, through contagion, to external costs that run beyond those experienced by the struggling bank itself.

It is precisely this risk of contagion that underpins the justification for banks being subject to pretty strict rules on supervision.

It is with that in mind that the central bank, in its capacity as lender of last resort and in line with the global trend, has had to set aside R66-billion to maintain the soundness of the banking industry by insulating it against liquidity shortfalls.

Given that, globally, bank rescues have had to be borne in part by taxpayers, South Africans should breathe more easily: this means that when a bank experiences a solvency shock, taxpayers will largely be shielded from having to bail out that institution.

Crucially, it is also reasonable to suggest that this safety net will protect depositors to some extent as the scheme will have the effect of ensuring the liquidity of their bank.

Nonetheless, there has been a sniffy reaction to this news in some quarters.

Cynics have scoffed at the idea that the short-term rescue mechanism has more positive than negative outcomes.

It is true that depending on how safety nets are designed, their existence may bring about unintended consequences.

The central problem would be that of moral hazard — a situation where banks, knowing they do not have to bear the full consequences of their actions, become less prudent in the way they conduct their activities.

The Reserve Bank has sought to mitigate the risk of moral hazard by requiring banks to subscribe for this facility by paying premiums. Let’s hope that paying these premiums doesn’t give the banks a sense of entitlement to this facility in every situation.

It will be important that there is discretion and confidentiality when that capital is made available to any of the banks.

When it comes to a bank bailout, what is required is not transparency but constructive ambiguity — a policy favoured by the US Federal Reserve — in the wording of the safety net’s provisions and the way it will be effected.

It might seem controversial, but deliberately not disclosing which bank is benefiting from a rescue package would curtail the public panic that inevitably surrounds a bank collapse, which can lead to a run on a bank often fuelled only by rumour.

Given these factors, the Reserve Bank will have to tread extremely carefully: balancing the need for public confidence in the financial system by avoiding the collapse of banks, while not creating an expectation that banks can take whatever risks they want.

If you consider the public anger in the US over how taxpayers bailed out their banks (after Lehman Brothers collapsed, of course) on the basis that these banks were “too big to fail”, there is a wider political risk that a ham-fisted policy could spill over into the political arena, too.

But the people who deposit their cash in banks have little cause for celebration, because the new rules don’t go far enough to give depositors the protection they urgently need.

For one thing, they provide only a short-term cure, and second, it is inconceivable that the facility will have the effect of rescuing every distressed bank.

Trying to prop up all illiquid banks would fly in the face of the economic reality that some institutions must be allowed to fail.

Should the safety net fail to resuscitate the liquidity of their bank, depositors would lose because there is no deposit insurance scheme in place.

Put cynically, the safety net protects the interests of the banks — not the people who put their money into them.

Kawadza is a banking and finance law lecturer at the University of the Witwatersrand