Banking System: Overcoming Its Inherent Risk

 

Banking system is a part of economic activities of a country. But its operational framework is different from other economic works.  Economic activities bring outputs in the form of goods and services. The output is the result from combined operations of different components such as capital, labor, infrastructure, technology, management, etc. Of the items, capital consists of owners’ fund and borrowed fund. The later fund may come from different sources, banks work as a source. As usual, banks start operations with owners’ fund, a part of which is basically used for capital expenditure of banks like procurement of immovable and immovable assets. Its lending function is performed by money from mass people and economic entities.

As we know that money was born to replace barter system. There were problems in barter of mismatch between demand and supply. Unless coincidence between demand and supply was matched, transactions could not be executed. But money as a medium of transactions solves the problems. Market system, outcome of medium of transactions, facilitates exchange of goods and services by money. Monetary system is basically run by way of banking and payment operations regulated through legal framework.

Money system phased out barter system. In the same way, bilateral interaction for lending and borrowing was replaced by financial intermediaries - banking system. Banks are not run by capital injected by owners; rather savers of the economy keep their savings with banks which use the same for lending business. There is a beauty of banking business - fractional banking. A part of deposits is retained as safety, the remainder is lent out. The lending proceeds are credited in deposit accounts of borrowers, which are again lent out under fractional banking system. Lending activities are basically of two types - short term working capital loans and long term loans. Banks’ deposits short term in nature arranged from domestic or foreign sources are fit for short term loans which are used to grease the business activities. On completion of sales, the loan comes back to banks along with margin. But long term loan does not bring repayment and interest income. Such lending brings maturity mismatch considering tenure of deposits.

It is well known that Medici bank faced closure in 1494. In recent time, banking industry underwent different crises. During late 80s and early 90s of last century, the sector went  through a period of great stress and turmoil in different countries all over the world like Brazil, Chile, Indonesia, Mexico, several Nordic countries, Venezuela and USA, etc. In USA, more than 1600 commercial and savings banks insured by the Federal Deposit Insurance Corporation (FDIC) were either closed or given FDIC financial assistance during this period.

In 1997, Asian financial crisis affected the economies of several East Asian countries. The crisis began in July 1997 when the Thai government abandoned its pegged exchange rate with the US dollar, causing the Thai baht to depreciate sharply. This affected other Asian currencies, such as the Indonesian rupiah, Malaysian ringgit, and South Korean won. The crisis was fueled by a number of factors, including high levels of short term debt from external sources to promote rapid economic growth which became unsustainable. As the crisis deepened, it spread to other countries outside of Asia, including Russia and Brazil. Asian financial crisis had a significant impact on the affected economies, resulting in high levels of unemployment, bankruptcies, and social unrest. However, it also led to important reforms in many of these countries, including greater transparency in financial systems, improved regulatory frameworks, and more sustainable economic policies.

 Different crises led to the search for appropriate supervisory strategies to avoid bank failures as they can have a destabilizing effect on the economy. For this very reason, medium or large banks are rarely closed and the governments try to keep them afloat. In both industrial and emerging market economies, bank rescues and mergers are more common than outright closure of the banks. If banks are not to be allowed to fail, it is essential that corrective action is taken well in time when they still have adequate cushion of capital so as to minimize the cost of bailout in the event of a forced liquidation. In view of the situation, it is suggested that supervisory action can be at two levels: early recognition of problems and corrective actions, and supervision and monitoring of troubled banks. Identifying problem banks early is one of the responsibilities of banks regulators. The other responsibility is to initiate corrective action in an attempt either to prevent failure or to limit losses.  

 Maturity mismatch between deposits and lending is major issue to lead banks in facing crisis. In the current century, financial crisis of 2008-2009 was a global economic crisis that began in the banking system of the US and quickly spread to other parts of the world. The crisis was triggered by the bursting of the housing bubble, which had been fueled by a combination of easy credit, low interest rates, and investments without observing credit parameters. As housing prices began to fall, homeowners defaulted on their mortgages and the value of mortgage-backed securities declined. This led to a wave of bankruptcies and financial institutions found themselves holding large amounts of toxic assets, which were difficult to sell. The crisis deepened as major financial institutions, such as Lehman Brothers, AIG, and Bear Stearns, began to fail. This led to a loss of confidence in the financial and banking system and a freeze in credit markets, which threatened to bring down the entire global financial system.

In response, governments and central banks around the world took aggressive action to stabilize the financial system and prevent a complete economic collapse. The US implemented a number of programs, including the Troubled Asset Relief Program, which provided funds to banks and other financial institutions, and the American Recovery and Reinvestment Act, which provided fiscal stimulus to the economy. The crisis led to a prolonged period of economic stagnation, with high levels of unemployment and slow economic growth. The effects of the crisis were felt around the world, and many countries implemented austerity measures in response to the economic downturn. The crisis also led to increased regulation of the financial sector like Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States and other similar measures in other countries.

According to Hyman P Minsky, there are three types of financing, as classified by  (a) hedge finance, interest and principal of which is settled by income flows; (b) speculative finance, interest of which is covered from income flows; and (c) ponzi finance, where inflows are insufficient to cover interest and principals, requiring new loans to support the repayments. Type (a) above is possible for short term lending. Other cases may appear provided that proper business scenarios are not assessed taking adequate cash generation cycle into consideration. Otherwise, lending by banks may face troubles.

As banks deal with public money, their activities need to be close monitored by regulators. There are different types of patients in real life, some of whom requires ventilation. Similarly banking industry needs to be diagnosed by framework of corrective actions which contain some criteria such as capital position, net non-performing assets, and profitability. It is observed that there are some banks in ill-health for which observers are appointed by central bank of our country. Memorandum of understanding is also available with some banks made by central bank. In addition, there needs a framework to quick assessment of banking health so as to take prompt corrective measures with regards to the aspects of inadequate capital, unexpected non-performing assets, and low level of profitability.
 

Mehdi Rahman works in
the development sector.