THE UNANSWERED QUESTIONS ABOUT BANKS THAT ARE ‘TOO BIG TO FAIL’

The recent announcement by the Bank of Thailand instructing the country’s five biggest banks to beef up their capital reserves caused a minor panic among some of my elderly relatives. Who can blame them when regulators use jargon that sounds like ancient Greek to most people? Basel III, D-SIBs, Tier-1 capital ratio, just to name a few.

My eight-year old son asked me who “Basel the 3rd” was. So I told him to put down his Henry VIII book and go ask his mother who is a banker. After 20 minutes, even she struggled to come up with a simple explanation that an eight-year-old could understand about how banks are regulated.

But to be perfectly honest, many of my banker friends are just as clueless about the set of international banking regulations developed by the Bank for International Settlements in order to promote stability in the international financial system.

In a nutshell, the purpose of the Basel

III rule is to reduce the ability of banks to damage the overall economy by taking on excessive risk. And the scary part is that most of my banker friends do not read the rules, some read the rules but do not understand them and, worst of all, some try the bend the rules when the going gets tough.

So let me try to explain in layman’s terms how banks are regulated and what will happen to your savings if they go belly-up. Banks by their very nature are in the business of leveraging other people’s money to make a living. Let’s say a bank has an asset worth 100 baht. Regulations require the bank to put up 12 baht of its own money, and the 88 baht can be borrowed. This is known as the capital adequacy ratio (CAR), which is the core of a bank’s financial strength. Generally, a bank with a high CAR is considered safe and likely to meet its financial obligations.

Domestic “systemically important banks”, or D-SIBs, are banks that the public sector is unable, without incurring prohibitive costs, to let fail. Simply put, they are too big to fail. This is still a hotly debated issue among regulators and politicians alike. Let’s not forget that the losses incurred in bailing out failed banks and finance companies from the 1997 crisis — 327 billion baht — are still on the books of the Financial Institutions Development Fund (FIDF).

Twenty years after the Asian financial crisis, which started in Thailand, can we sleep any better at night knowing that our bank deposits are safe in the event of another crisis? All I can say is be afraid, be very afraid. Banks have been required to pay 0.47% of their deposits into the Deposit Protection Agency (DPA) but thus far the DPA has accumulated only 80 billion baht, a mere drop in the bucket and far from enough should there be another crisis. The reason is that out of the 0.47% deducted from banks, only 0.01% goes to protect deposits and the other 0.46% is used to pay off the debt incurred in 1997.

So how should we go about protecting our banks? Let’s suppose that the too-big-to-fail banks do exist, would it be wise to define them in advance and not wait for the next crisis? Should these institutions be subject to higher capital requirements, greater disclosure rules and stronger supervision, with detailed guidelines on what to do if they do fail?

The counter-argument would be that if the banks on this list are “too big to fail”, why should they have more capital when their owners will be guaranteed against losses anyway? Moreover, should banks with SIB status contribute more to deposit insurance or should such insurance be better used to protect deposits in banks that can fail?

The financial crisis in the past has demonstrated that regulators often fail to recognise systemic risk until the very last moment. So why should things be any different in the future? Or can it be that a bank that is too big to fail is simply too big? And this still does not answer the question of what is “big” or “too big” from the perspective of the next crisis. Nor does it answer the question of whether breaking up a SIB wouldn’t ultimately mean that instead of rescuing one large bank, a government would have to rescue 20 small banks instead.

I think most banks would not want to be on such a SIB list, as it would mean higher costs and greater regulatory uncertainty. The ideal situation is to avoid being a listed SIB, but nevertheless to be treated as one when bad times come.

In the name of the national interest, I would argue against the concept of SIBs. It sends banks the wrong message. Intentionally or not, the assertion of too big to fail and passing artificial stress tests may actually generate exactly the opposite incentive for large banks to continue taking risks with depositors’ money.

In fact, using data of more than 200 banks in 45 countries, a New York Fed paper found that banks classified by ratings agencies as more likely to receive government support engaged in more risk-taking. The authors also showed that riskier banks were more likely to take advantage of potential government support.

Political decisions made in the heat of a crisis usually diverge from pre-prepared solutions, treaties and agreements. In an uncertain market, why should any institution feel certain that it will live forever? It’s only fair that only the strong survive and the weak be taken over.

The economy will be better off in the long run when bankers know that there is no safety net when they fall. Depositors will be smarter, too, in choosing which banks they want to do business with now that they are being weaned off across-the-board deposit guarantees.

Teera Phutrakul CFP® is a certified financial planner professional and a fellow member of the Institute of Directors.