In order to enhance public understanding of national and global financial issues and institutions and the various ways in which they impact on society, Stabroek Business has asked Hand-in-Hand Group CEO Keith Evelyn to contribute a series of articles on these issues.
In this issue of the Stabroek Business, we publish the second in that series of articles.
In the previous instalment we learned that financial intermediaries like banks channel funds between borrowers and lenders. We appreciated that risk rules the world of investment. Risk gives financial reward; the more risk we take the higher the reward and of course the higher the probability of losing our investment. We give our money to professional investors to invest for us because we believe that they can make safer investments than we do. Insurers spread our individual risks among us all. We understood that professional investors manage risk in order to make safer investments than we can through the spreading of risk over all their customers’ money and diversifying investments over different types of investments, economies and geographical areas.
We also discussed a few basic financial terms like liquidity and solvency; liquidity meaning cash resources and solvency indicating a company’s ability to meet its long-term financial commitments and grow.
We began to examine systemic risk and we learned that systemic risk is the risk of sudden large scale events, such as disasters, occurring that could disrupt financial intermediation. When these happen, industry is destroyed and income flows are disrupted so that borrowers are unable to pay their bank loans. Depositors who at this time really need their money call on the banks but the banks have lent most of it out and therefore face a liquidity crisis.
Such events affect all banks and us all in a big way. We therefore all must do our utmost to manage systemic risk. We can imagine there would be man made systemic risks, like war. However, there are other types of systemic risks and one really important one has to do with confidence in a financial system.
Global Financial Crisis
I stated earlier that systemic risk ‘used to be’ specific to geographic location. You can imagine that even if a big natural disaster affected more than one country say on a particular continent, then there would still be other countries on other continents that would be safe. If you really diversified your investments in many countries you would theoretically be safer.
However what if something happens that affects the whole world. You may think of a world war or some great disaster.
Well, something unprecedented did happen on a global scale in finance, particularly banking. Over the years technologies and communication systems became so advanced that risks were easy to spread globally. Complicated investment instruments called derivatives allowed banks and insurance companies to spread risk so widely that they thought that their banks could take on riskier or sub-prime loans. Banks and investors virtually placed bets that a portfolio of mortgages would either do well or fail. However, because these risk transfer instruments were so complicated and spread so thinly, banks became unaware of how much of these risks they were really exposed to.
Seemingly protected by these risk management instruments, banks were lending riskier and riskier loans in the USA thinking that they were not too exposed. The bubble eventually burst and the loans went into default. When the banks went to collect on the other banks and insurance companies with whom they had shared the risks they found that they too were inundated with claims that they could not meet. This spread throughout the world and led to major banking collapses globally and serious economic decline. When banks collapsed those that were still alive tightened on their lending, this in turn made businesses run out of bank funding and end up in liquidity problems and insolvency.
Thankfully, Guyana’s banks were not directly exposed to those complicated risk transfer instruments that all went wrong. We were insulated maybe by our own lack of sophistication but mostly because our own bank supervision stuck to simple rules that made us follow a less risky path.
Bailout
You must have read the big debates about bailouts. If these banks and companies were in trouble why not let them fail? The answer, you may have guessed by now is because their individual failure would greatly increase systemic risk and threaten total systemic collapse. Leaders of countries recognised that it would be better to use the accumulated reserves of the country to stem the collapse than to try to recover from it. They were managing systemic risk. Like I said, in the first part of this article it’s all about risk.
Banking panics
Banking panics are considered a manifestation of systemic risk. Here’s why. Banks invest depositors’ money in both short and long term investments. If for some reason depositors feel insecure, panic and rush to withdraw their deposits, then the bank would not have the liquidity to meet all the cash withdrawals and end up running out of cash or failing. If one bank fails then depositors at other banks may worry that their deposits may be unsafe and this creates a snowball effect which may bring down many banks and cripple the whole economy. This snowball effect is called contagion.
When the majority of depositors rush on a bank in this manner it is called a bank run. A bank can avoid a bank run, but it cannot withstand one.
Runs on insurance companies are quite similar. If everyone rushes to cash in their insurance policies, particularly investment type policies, then there will be a similar liquidity crisis which could lead to systemic financial meltdown (to use a familiar term). Sometimes, this may happen to banks and insurance companies simultaneously.
You will now appreciate how equally and absolutely important it is for governments and regulators to manage systemic risk and to ensure that banks and insurance companies do survive bank runs.
You will understand too that everyone, particularly the media, has a stake in ensuring that panics do not occur. Equally you would understand that we all have a grave responsibility to ensure that we are not a victim of any person who wishes to create that type of panic for their own personal gain.
How to assess whether your bank is safe
You may think, “Well I better hurry and take my money out of the banking system before anyone else panics and it collapses.” That sounds fine but you risk creating that panic yourself and if the system does fail, your money would not be able to buy much anyhow.
Further, in these unstable times, you can check yourself if your bank is likely to fail. It’s not that hard. There are a few simple assessments that you can do.
First, assess whether the government or regulators seem committed to keeping the banks and banking system alive.
Surprised? You might have been thinking that you would first check whether the bank has lots of extra money. No, government and regulatory commitment to a stable banking system is the first priority because no bank without the help of the government can withstand a bank run. I repeat; no bank in the whole world can withstand a bank run without government support. I use the word, ‘government’ in its widest sense to include the entire policymaking and regulatory mechanism. This is because first no bank is liquid enough to immediately meet all its deposits in cash. Second, depositors will immediately look towards the government for some signal as to whether their bank is considered safe. Third, the banks would hardly be able to raise the needed liquidity from another bank. Remember, a bank run is a systemic risk issue so the other banks would look at the same signals the government is giving. If the government does not see a bank as safe enough to support then they would not support it. Last, the other banks would want to keep as much cash as possible to manage the contagion risk.
So to meet liquidity needs in times of a run, banks that have assets to meet their liabilities would expect the government through the Central Bank first to help either by way of public assurance or financial assistance. Once their assets exceed their liabilities, then the government and other banks should have no problem using their reserves to help the situation. In fact, the government first would be happy to announce that the bank has the resources to meet depositor’s liabilities and allow the bank to attempt to correct the situation, perhaps through asset trades or loans with other banks. Second, the Central Bank would be most willing to help the liquidity troubled financial institution with its own reserves because the bank would have assets that the central bank can acquire in exchange for the needed cash. Third and most importantly any responsible government would have a vested interest in the stability of the system.
You would have read of the CLICO Investment Bank going to the government of Trinidad and Tobago for such assistance. The government may use a lot of methods to help the bank, like transfer the deposits to another bank that has the liquidity.
Some may question whether the government will tell the truth as regards the health of a bank. The answer is that the government has a vested interest in protecting any viable bank and a vested interest in taking over any non-viable bank and protecting depositors’ interests. There is really no reason to be untruthful.
Our government has made several pronouncements on the health of our banking system. Our Central Bank has disclosed that their assessment criteria have been met and exceeded by our banks. Whatever your political views, it cannot be said that our government has not signalled its commitment towards stability of the banking system.
This brings us to the other assessment criteria of a bank. You can now study their financial position, their shareholders’ commitment to its success and the quality, reputation and skills of its managers.
Does size matter?
Of course, it depends on how you use it. On the one hand, one can say that it has been empirically proven by recent events that larger banks tend to be in more trouble. You must have read about all those large global banking institutions that have serious liquidity problems and wondered, “Why not the small banks?” Large banks run the risk of not knowing too well what is going on in their highly complex portfolios. In this banking crisis, a lot of large banks and insurance companies were not even aware of their exposure to sub-prime mortgages. Sub-prime is another word for very risky. The size of the large banks increased their operational risk which ultimately led to their failure.
Further, small banks can run to large banks for liquidity support. It’s called inter-bank lending. If the small bank is in real trouble, it can be acquired by a larger bank. But where do the large banks run? They go to the government; sometimes for a (that now famous word) bailout.
Capital adequacy
The total assets of a company may be considered the money or value its shareholders own (capital) plus the money that the company owes (liabilities).
The assets of a bank would mainly be its shareholders value plus its depositors’ money. In the case of an insurance company it would be the shareholders’ value plus the money put aside to pay claims.
The more shareholders’ money or worth there is, the better the bank can cushion losses before the depositors’ value or money can be threatened. Think of it as the more money you have personally as compared to how much you owe, the better you can pay your debts.
Looking back at the risk situation, given that the main risk of a bank is how much money it has lent out and invested, the more capital it has compared to how much money it has lent out and invested would be a good thing because it can better cover losses that might happen if the loans or investments go bad. Its loans would be an asset of the bank since people owe the bank the amount it lent out, but loans are risky assets because people may not be able to pay back their loans.
To assess their riskiness regulators take all the assets of a bank and revalue them based on their riskiness. This they call risk-weighted assets. They then compare the capital of the bank to these risk-weighted assets. They use a little arithmetic to arrive at a ratio called the Capital Adequacy ratio which indicates how much capital a bank has against its assets after catering for risk.
An acceptable minimum ratio is 8%. All the financial intermediaries in Guyana have healthy Capital Adequacy ratios. This means that they are less risky to the depositors. From this the regulators can assess the riskiness of a financial institution and make pronouncements on its state of health.
If a bank’s capital adequacy is affected, the bank is required to present a strategy to the regulators to solve the problem, if it cannot resolve the issue then the government through its regulators will intervene in order to correct the situation. In extreme cases the regulator may order the winding-up of the bank where it takes over and dissolves the bank. Whoever is left in charge of the bank then attempts to sell off or liquidate the assets of the bank to pay its depositors as much as it can. That’s why, that person is called a liquidator.
Shareholder Commitment
Next you have to assess its shareholders’ commitment. This is because shareholders stand to lose their investment when a bank fails. They have an interest in keeping it alive. If the shareholders are willing to reinvest in the bank to keep its capital adequacy ratio healthy, then that is the best indicator of their commitment.
Is the bank part of a bigger brand name that would be damaged should the bank fail? Shareholders would be very committed to preserving a valuable brand name. This is one argument in favour of size. The more capital the shareholders have invested in the bank, the more they have to lose and hence, the more committed they will be to see the bank survive.
Management capability
Earlier we saw that large banks failed to assess their exposure to sub-prime mortgages. I mentioned that they had failed to manage their operational risk because they were unaware of how exposed they were to these risky loans. Operational risk concerns the business processes and the people who are in charge of the business process. These processes include well defined business policies and effective performance monitoring. Critical to this is effective communication and the support of professionals.
You need to know who runs your bank; how skilled are they? Are they highly respected business persons? How well do they communicate with you? Does their website have all relevant information? Can you meet them if you needed to? If answer to these questions is yes then your bank is much safer.
So, in assessing whether your bank is safe, you have to first assess the willingness of the government to prevent a bank run that would lead to failure and contagion, Next you have to assess the banks financial solidity or solvency and a good measure of this is its Capital adequacy ratio. You also look at management capability.
In other words, when you have finished you would have assessed the systemic risk factor of regulatory support, and the non-systemic risk factors of the banks’ brand name, and its human and financial resources.
Keith Evelyn BA (Hons.), BSc, MBA, FCII, ACIB, Chartered Insurer has been CEO of the Hand-in-Hand Group of Companies for the past fifteen years. He is also a Past President of the Insurance Association of Guyana. He is the chairman of the Small Business Council of Guyana, and holds directorships of the Berbice Bridge Company, E-Networks (Guyana’s leading triple-play internet service providers), and Prestige Motors (the official BMW dealer in Guyana).
He has degrees in banking insurance and finance from Sheffield Hallam University and Manchester University in the UK. He is also an Associate of the Chartered Institute of Bankers, UK; a Fellow of the Chartered Insurance Institute (UK) and a Chartered insurer (UK). He holds a Masters degree in Business Administration from the University of Liverpool (UK).