Is banking industry heading for a crisis?

In June 2007, the collapse of Bear Stearns, a New York-based global investment Bank, signalled start of what now we now call the Global Financial Crisis (GFC). In the weeks following the collapse - again, what we call, the contagion effect - took grip over the banking industry. The list included almost all who's who of the global banking industry like JP Morgan, Chase, Lehman Brothers and many other banks around the world.

Before the crisis it was widely believed that these banks are "too big to fail'' and the financial system would stay afloat. Such a belief is founded on the theoretical premise propounded by the Chicago School that financial markets are always self-correcting. This view was articulated by the "Efficient Market Hypothesis' (EMH) developed by Eugene Fama. In effect, EMH provided the theoretical foundation for the deregulation of the banking industry in the 1990s onward which allowed investment banks also to get involved in commercial/retail banking. EMH is consistent with the neo-liberal ideological orientation embraced by all major political parties in all leading democracies in the West and also the multilateral institutions like the World Bank (WB) and the International Monetary Fund (IMF).

Frederick Hayek added further impetus to increased neo-liberal hold on economic policy development since the early 1980s in most advanced economies. Hayek claimed that any public ownership or regulation is, ipso facto, a step towards totalitarianism. Since early 1980s, we have seen rapid deregulation and privatisation of industries including the banking industry and state-owned natural monopolies like telecommunication, electricity and water.  In the USA, the New Deal regulations (e.g. Glass-Steagall Act, 1933) were gradually dismantled. The result is not only the disappearance of distinction between retail/commercial banks and investment banks but also development of close interconnectedness between, finance, insurance and real estate which further extended to natural resources and newly privatised natural monopolies. Underlying assumption is bankers will pursue honest dealing in their self-interest than fraud, because customers will shun fraudulent bankers. Acquisition of increased financial wealth is considered to be the most efficient means to enhance both individual and societal welfare. In other words, the objective is to get rich by purely financial means and not working through the real economy.

Banks are generally in the business of accepting deposits and lending them; in doing so they mobilise savings and channel them to investment by creating credit. The credit creation is where the inherent weakness of the banking system lies. If depositors lose confidence in banks, there will be a run on banks resulting in a liquidity crisis which, in turn, feeds into solvency crisis. Then they start to feed into one another creating a cycle. While credit creation enables the real economy to function and grow, the economy as a whole finds itself continually in a state of crisis. This causes imposition of new regulations, removal of existing regulations, bail-out and bail-ins, even outright state take-over of banks.

The banking industry, now largely self-regulated, has embarked on a very innovative products development and the most innovative of them is securitisation where banks can have repackaged loans to secure liquidity, and the next bank do the likewise. This increases the credit multiplier and can go on unchecked with the same monetary base. This renders the central bank incapable of having control on money supply because securitisation does not break the central bank rule on the monetary base.  Such activities also increase co-dependence between banks. So, when a bank gets into troubles, that set on a chain reaction affecting other banks.

Such innovations in financial product development enable banks to earn huge profits. A large chunk of this profit is used to buying back bank shares causing the share prices to rise. Also, corporate tax cuts enable banks to buy back their shares rather than flowing as investment into the real economy.

Now, banks in a deregulated (but self-regulated by banks) environment moved into financial markets and accumulated a vast panoply of financial assets making their balance sheets very vulnerable to bubbles and crashes which are the distinguishing features of financial markets. As quick profits are made by pushing stock market prices up, the risks inherent in their new ventures are overlooked. This was the situation that marked the US Stock Market immediate one year preceding the Global Financial Crisis (GFC). The GFC, according many observers, opened up an opportunity for captains of the banking industry to further reinforce their grip on elected governments and markets.

In the wake of the GFC, leaving aside bailouts and quantitative easing (QE), some new regulatory measures have been introduced (e.g. Frank-Dodd Act) in the USA and other advanced economies, but measures proposed are marginally better than what existed at the time of the crisis which failed to prevent the crisis in the first place. At the global level, Basel III (an internationally agreed set of measures in response to the GFC, introduced by the Basel Committee on Banking Supervision) reforms were designed to withstand shocks by increasing the capital ratio five times and increasing transparency to forestall any major bank failures. But the Basel approach in mitigating any banking crisis is premised on the assumption that financial markets are efficient and calculate risks on that basis to come to the required capital ratio to minimise risks. Basel III, in essence, tinkered with the post-GFC reforms. Once again, the power of the banking industry has prevailed.

Almost a decade of easy money has now created an unprecedented global government bond bubble with historically very low interest rates. Once again, asset prices have risen to a new height which will inflate the bubble, tax cuts have further added fuel to asset prices as more money goes into buying shares or real estates. Even developing countries such as Argentina with a long record of loan defaults and many others are placing bonds on the international market but the surprise is they are oversubscribed. In fact, the world is much more indebted now than it was on the eve of the GFC. All these will eventually come to an end, and when that happens, the picture would not very pleasant to look at.

But the banking crisis in Bangladesh as a developing economy has taken a completely different dimension. The banking crisis in the country is a liquidity crisis, primarily arising out of rising bank loan defaults, which are described as non-performing loans, causing unexpected need for cash for banks to run their day-to-day business. There is a widespread belief that these loans are non-performing in the sense that they are no longer performing in the business enterprises they were borrowed for, as reflected in non-payment of interest and principal, but more likely, in many instance, monies borrowed, moved into some benami business enterprises or property or even moved out of the country.

According to Bangladesh Bank,  non-performing loans amounted to TK1.31 trillion by the end of June this year and the number of loan defaulters stood at 230,658 during the same period. It is estimated that 60 per cent or more of the default loans are owed to eight state-owned banks and financial institutions. People knowledgeable about the banking industry in Bangladesh attribute the crisis facing the industry to corruption, cronyism, poor governance and lack of accountability and transparency. Even the country's central bank (Bangladesh Bank) was robbed early this year using the electronic cash transfer mechanism. The liquidity crisis can lead to a run on a bank, and even resulting in insolvency. In the absence of a well-functioning capital market (again attributed to widespread corruption and insider trading), banks remain the principal source of credit for business enterprises in the country. The liquidity crisis facing the industry has serious implications for business enterprises in the country with the flow-on impact on the economy as a whole.

Muhammad Mahmood is an independent economic and political analyst.

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