Economist Brian Easton explains what to do when financial institutions fail

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

In a dynamic economy, businesses are always closing down. Sometimes they crash because they have not enough cash. People suffer – workers, suppliers, purchasers, investors and those who provide them with credit. Over the years, procedures have been developed to deal with such crashes. Some involve try to keep viable part of the businesses working.

The general principles apply to the firms in the financial sector. However they have particular quirks. To simplify, I identify four sorts of financial institutions: finance companies which invest in businesses, finance companies which invest in finance, mainstream commercial (trading) banks, and central banks (such as our Reserve Bank of New Zealand).

Finance companies which invest in businesses

An example might be a company involved in property development. It takes in deposits and uses the cash to fund its activities. Its investments are riskier than a bank, which is why it has to pay higher interest rates to entice depositors. A number of them collapsed in 2007-9. Where there were no government guarantees, the depositors lost some or all of their money.

(The guarantees were implemented in late 2008 during the Global Financial Crisis to prevent ‘runs on the bank’ – more below. At the time it was known that some of the companies were unsound but, in my judgement, the guarantees had to be implemented universally because excluding a finance company would have intensified the runs on it. But they should have been implemented to cover only existing deposits and not new ones. The guarantees to unsound companies cost taxpayers a bomb. For South Canterbury Finance see here.)

Will it happen again? Yes! (That is why they still pay higher interest rates.) Is it likely to happen soon? Who can tell? Is it happening elsewhere? It is happening BIG in China. It is very hard to know what exactly is going on because of the different institutional arrangements. I wrote a little about it here but things have since got worse. I am not optimistic that the eventual outcome will be beneficial to China or the world.

Finance companies which invest in finance

Cryptocurrencies are probably the best example we have of investment which is investing in financial arrangements which have only a tenuous connection with the real world. If you are investing in a property development company, your cash is meant to go into tangible property. If you are investing in bitcoin, your cash goes into intangible bitcoin. The cash is sloshing around from investor to investor but not increasing. Essentially it is gambling.

I wont extend the cryptocurrency example further, other than to reaffirm the standard advice. If you want to have a flutter, don’t punt up more than you can afford to lose, and don’t borrow to punt. It’s the same advice one gives for gambling on Lotto, the pokies or the TAB.

Penrich Global illustrate the underlying process. It was a hedge fund operating ‘in the major developed markets investing primarily in fixed income and foreign exchange’, that is, in other financial assets. It collapsed with a loss of $80m plus; its owner and investment manger, Kelly Tonkin, was convicted of fraud and is serving a sizeable sentence.

The casual might see the words ‘fraud’ and ‘$80m’ in the same sentence, and assume that the money was stolen. It was not. Some of Penrich’s investments lost money. In order to recover the loss Tonkin made more (probably more risky) investments and they kept losing too. Running down the cash reserves, he falsified documents to hide the losses while continuing to try to trade out of the mess. Eventually he could not disguise the loss any further, the firm crashed and he pleaded guilty to the fraud.

So where did the $80m go if it did not end up in Tonkin’s pocket? The short answer is that the deals where he was making a loss involved another side making a profit in what is essentially a zero-sum game. For all we know, dear reader, some of your investment profits are a trickle-through from that $80m. (I suspect that falsifying documents, as firms wrestle with temporary losses, happens a lot more than the cases we see in the courts. Usually a firm has to crash for such fraud to become public.)

Mainstream Commercial Banks

The mainstream banks differ fundamentally from other private financial institutions because they provide the medium of exchange which enables us to pay our bills. (That includes providing the short-term credit which business, and – ahem – many households, need to function for their day-to-day activities.) If the banks went under, hardly anyone could pay their bills and the economy would come to a grinding halt.

Could our banks fail? The last time it happened in New Zealand was in the 1890s. But it has happened more often overseas.

The Irish experience during the 2008 Global Financial Crisis was spectacular. The National Asset Management Agency Act 2009: A Reference Guide by Mark Kennedy, Maire Whelan and Feargus O’Raghallaigh (Feargus is an economist now based in New Zealand) describes how some of their trading banks made sufficient unwise investment to compromise their balance sheets – they had too many loans which would never be repaid. If they had been ordinary financial institutions, they would have collapsed. In order to keep the payments system operating smoothly, their bad debts were separated out into a ‘bad bank’ (the National Asset Management Agency) which unwound the bad debts.

In the 1890s, and also for the Bank of New Zealand in 1990, the threat was met by a ‘recapitalisation’, that is, by an injection of equity. (In the BNZ case by $600m from the government; some of the privately owned commercial banks also had a capital injection from their overseas owners.)

Today the commercial banks are closely monitored both by regular disclosures to the public and by the Reserve Bank. We cannot rule out that one might fall over, but it is very, very unlikely. I could not give you the same assurance for Chinese banks.

A more likely crisis scenario is a ‘run on the bank’. That is when the public lose confidence and withdraw their deposits even though the bank may be sound. Because the bank’s assets (investments) which match its liabilities (deposits) cannot be so easily wound up – typically they are in mortgages and trade credit – the bank’s reserves get compromised.

That happened during the 2008 Global Financial Crisis. Many withdrew their bank deposits for notes (which are essentially deposits in the Reserve Bank). The RBNZ handed more notes over to the banks which passed them on. In return, the RBNZ took security for the notes by taking a lien on the banks’ assets. (At one stage much of New Zealand’s housing mortgages were temporarily ‘owned’ by the RBNZ.) The priority was to keep the payments system intact.

It could happen again if the public were to lose confidence in a bank. The government has an ‘open bank resolution’ (OBR) procedure where if a bank gets into trouble, it would be open the following day, but depositors would be restricted from accessing their deposits; there would also be a government guarantee so that they would not have to rush to remove their funds.

Were the bank’s troubles to arise from too many bad debts, shareholders would lose all their equity and it is possible that depositors could suffer a ‘haircut’ off the value of their deposits. In extreme circumstances there could be a bad bank.

The Reserve Bank of New Zealand

Could the Reserve Bank fail? The answer is no. A central bank can run and operate with negative equity. Think of the central bank as small subsidiary of the government. Any obligation made by the central bank must by meet by the government. A government can default. That is an extremely unlikely scenario. It is very, very very much more likely that a cryptocurrency will fail.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.