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CIAO DATE: 2/00
Promoting Banking System Reform
Conference on Crisis & Credit: Restructuring Asia’s Financial Sector Asia Society
October 1, 1999, New York
This is a Federalist paper: a “constitutional” suggestion based on a pessimistic view of human nature.
Let’s start with an awkward truth: banks fail. What they do is difficult. They lend money to businesses whose credit is not impeccable, or is hard to evaluate. And they do it without immediate feedback. So they only discover they are doing it wrong when they are in pretty deep.
That said, more banks than necessary seem to fail. Why? Generally speaking, there are four causes:
Access to credit confers wealth. Easy access to credit is wonderful. So ambitious people will always try to capture a country’s credit-granting function. You will hear people say that countries would be better off, and the world a safer place, if there were sounder banks, if they were more transparent, with better governance, and so forth.
These are not totally helpful statements. They are approximately equivalent to saying that government would work better if power never got abused. The whole problem with banks is that they are not transparent, that their unsoundness is easy to disguise, at least for a while. And while you can get rich by owning a bank, you can get mega-rich by lending to yourself. Or mega-powerful by lending to your allies, or your patrons, or their dreams.
Successful public policy around the world incorporates two lines of defense against these ever-present dangers. The first is to insulate the credit-granting function from corrupting influences. Examples would be the laws and traditions in some countries that separate banking and commerce; strict rules about lending to affiliated companies; simply not allowing the government to control a bank; and the quaint British notion that only “fit and proper persons” should be permitted to become bank officers.
The second strategy is to shorten the feedback loop, so that when bad judgement (or worse) leads a bank astray, it gets discovered sooner. Techniques include thorough examinations, mark-to-market accounting, tighter definitions and better disclosure of non-performing loans, and rules that force banks to endure the scrutiny of the capital markets on a regular basis.
When the financial crisis swept over Asia two years ago, the IMF and the World Bank saw the situation as an opportunity to upgrade the banking systems of the affected countries. They conditioned assistance on a mixture of subtle and violent measures to advance the two strategies described above. Some of this worked, and some of it didn’t. As the economies of the crisis countries recover, people are now asking whether reform will be aborted. It is too early to answer that question. But it is not too early to observe that reform is harder than many people imagined.
Bank reform is not engineering; it’s politics. The way a country’s banking system grants credit is part of that country’s unwritten constitution. Changing a constitution is a profound undertaking. Building a fence around the credit-granting function may be good public policy, but it will not happen without a struggle. Those who currently have access to the wealth-and-power-creating machinery are not going to just nod their heads and say, “Oh yes, now I see. It would be better if I turned over the keys.”
Anyone interested in banking system reform must do politics. And that “anyone” needs to be local. Building consensus for change cannot be done by a supranational assistance mission. And without that consensus, the most wonderful programs will fail.
Since reform has natural enemies, and cannot be imposed—but is needed—we must find a strategy for insinuating best practices into the unwritten constitutions of more and more countries. We need a regulator able to be independent, to whose authority individual banks will gradually, voluntarily submit themselves.
How can that be done? By making the regulator a world deposit insurance corporation.
Note that I am not advocating deposit insurance. Governments already implicitly guaranty most deposits at most banks. The stability deposit insurance was created to provide largely exists. The benefits of a “WDIC” would be (a) the existence of a fund, and (b) the pressure it would put on institutions to qualify and join.
When banks fails, it is the people of the country who pay the cost. Once upon a time, they paid in their capacity as depositors. Today they more often pay in their capacity as taxpayers. The problem is that when a lot of banks fail, the cost is too much for the government to face, or for the budget to absorb.
Deposit insurance is a tax you pay in advance. The money is there already. The machinery for resolving failed banks is in place. So banks that run amok get dealt with quickly, which reduces the ultimate cost. This is quite important. Not facing the music is absolutely natural—and absolutely ruinous.
Look at America. The reason our S&L crisis was a crisis rather than just a spell of indigestion was that that industry’s deposit insurance fund became insolvent. Congress did not want to take this bad news to the voters. Five years of dithering was very expensive.
When the government did start to deal with all the insolvent institutions, the fact that the cost was spread across the country buffered the pain. Eight of the ten largest banks in Texas failed, and one other would have done so if it hadn’t been acquired. Had Texas been a country, it would have been Thailand. For small, inherently volatile economies, a multi-national program makes a lot of sense.
If such a program did exist, the organization that administered it would be able to insist that banks who joined adhered to certain standards: honest accounting, examinations, proper governance. A WDIC would be a more independent regulator than many countries can muster on their own. But because membership would be voluntary, “face” and national pride would be lesser issues. Ministries of finance would growl and whine. But banks would want to join.
Joining the WDIC would be like getting a credit rating: painful, but good business. Members’ funding costs would go down by a few basis points. Their reputations would improve a bit. Customers would wonder about banks that claimed they didn’t need the WDIC’s seal of approval. And investors would assign a lower risk premium to those who had it. Bank would see it in the price of their stock.
Creating a new organization, to which governments surrender a bit of sovereignty, is very hard. Then again, a lot of countries have created central banks, which amounts to the same thing. Insulating the credit-granting function is not all that different from insulating the money-creating function.
All we need is agreement on the concept from the G-20, several billion dollars from the World Bank to get the fund established, and a couple of years of hard work.
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