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Rewriting Gresham's law!

Nironjan Roy   | Published: September 17, 2019 20:43:56


Hundreds of job cuts are expected at Deutsche Bank's London office.                  —Photo: Reuters

As students of Economics and Commerce Faculty during 1980s, most of us had to come across the important monetary principle: "Bad money drives good money out of circulation". Now this scribe, as a banker, has been learning a new monetary situation where dirty money is driving clean money out of banking channel.

GOOD MONEY VS BAD MONEY: The famous monetary principle referred to above was developed by renowned economist Sir Thomas Gresham. During that time the value of British currency was eroding and the market was abundant with inferior currency causing great concern for the authorities. In order to overcome the situation, the monetary authority circulated superior currency in the market in anticipation that better quality monetary unit will drive inferior currency out of circulation. After a certain period it was observed that the inferior quality monetary unit remained in the circulation while superior currency had disappeared from circulation. Sir Thomas Gresham was tasked to find out the reason for the new currency disappearing from the market. After investigation and research, Gresham concluded that if both bad and good money simultaneously remain in circulation, bad money eventually drives good money out of circulation. In support of his observation, Gresham justified that people by nature prefer to hold good money and spend bad money because in the longer term, the value of bad money will erode, while good money will appreciate although both currencies may enjoy equal value and liquidity in the current market place.

Initially Gresham's law was based on mint coin but subsequently its application was found effective in all currency standards including gold standard and dollar standard. Gresham's law has clearly distinguished good money from bad money. In principle, the currency or monetary unit generating higher exchange value than its face value is termed good money. On the other hand, monetary unit producing less exchange value than its face value is categorised as bad money. As per Gresham's law, people always prefer to retain good money and spend bad money in anticipation that the value of good money will rise while that will decline for bad money in the long run. Although Gresham's law is based on monetary behaviour, people's psychological preference has put tremendous influence on this theory because people by nature prefer to retain good stuff and dispose of the bad stuff. No economic theory is out of criticism, so Gresham's law was also criticised by many economists and monetary theorists. The US central bank, Fed (Federal Reserve Bank) came up with their own statistics to prove that Gresham's law does not equally apply to many currencies, particularly the US currency. However, nobody rejected this monetary principle, rather accepted it with some modifications. US Fed after long analysis and research also endorsed Gresham's law with some modifications that states: Bad money drives good money out of circulation only when the cost of using the good money at a premium is significant. 

NEW DEFINITION OF GOOD AND BAD MONEY: World trade, commerce, economy and monetary structure have undergone revolutionary changes in the last fifty years. In determining currency value, gold standard has been discontinued long ago, and even the widely accepted dollar standard has already started losing its effectiveness. Each country's own economy and monetary structure have strengthened to such a great extent that the intrinsic value of its own currency is mostly determined by domestic demand and supply. Now a days, exchange rate with foreign currency has no or minimum impact in determining the value of domestic currency. Exchange rate in respect of foreign currency now mostly applies in settling cross-border trade. So, in the present monetary system, Gresham's law may apparently seem to have lost its importance and effectiveness, but this is not true.

In fact, importance and application of this law is not only still equally valid but has also intensified in many respects, particularly in compliance perspective. The only difference is that the definition of good money and bad money has changed. Now money or monetary unit is identified as good or bad depending on fulfilling compliance standard. In categorising money as good or bad, compliance has connection with financial activity related to money laundering, terrorist financing, drug or arms dealing, sanctions violation and money derived from illegal means (i.e. bribe, corruption, fraud etc). The terms good and bad money have now been renamed as clean money and dirty money respectively. With a view to distinguishing them from Gresham's good and bad money, the new terms dirty money and clean money are used from compliance perspective.

COMPLIANCE MENACE -- A THRERAT TO BANKING SYSTEM: Now compliance has become a great concern among banks and financial institutions across the world because of the stringent policies to prevent flow of dirty money through banking channel. Many large global banks in the world have recently been the worst victims of compliance failure as they had to pay huge penalty because of compliance failure. From JP Morgan to Deutsche bank, many large banks have paid more than twenty-six billion dollars as penalty during the last eight years for their alleged involvement in undertaking transactions of dirty money having connections with money laundering, drug dealing and sanctions violation. World's strongest bank, Deutsche Bank has been striving hard to survive due to the payment of enormous penalty.

Banks have become so scared of the compliance issues that they fear to undertake any new transaction. Whenever a customer submits any deposit over three thousand dollars, banks seem to smell a rat, i.e., dirty money. Banks are now massively investing for ensuring strict compliance, purchasing new technology one after another, hiring thousands of people in compliance department. Deutsche Bank is a good example here. They are going to hire four thousand new people in the compliance department while few months back, they decided to close some of their operations that would have hurt eighteen thousand jobs.

In spite of many stringent measures undertaken by banks, it has become difficult to make their compliance foolproof.  As soon as a new policy and technology is put into place, another comes up. Initially KYC (Know Your Customer) and DD (Due Diligence) were good enough to ensure compliance. Thereafter, KYCC (Know Your Customer's Customer) and EDD (Enhanced Due Diligence) have been introduced as new measures that banks are struggling to implement. These new measures seem to be difficult to implement because bank may identify its own customer but it is very difficult to identify the customer's customer. So, there will be likely scope of compliance failure as relying on third party is always a risky approach. With respect to cross-border trade and correspondent banking, onboarding of bank's headquarter was good enough but now a new requirement has been introduced to complete onboarding of each and every branch of transacting bank. For example, previously if onboarding of ABC Bank was completed, then LC issued or outbound remittance processed by its Chattogram branch could be easily undertaken by its foreign correspondent bank. Now it is not possible under the new rule because onboarding of ABC Bank is not good enough as onboarding of its Chattogram branch which will also be required. So, this new regulation will substantially reduce inter-bank transaction as it is not possible to bring innumerable branches of each bank under onboarding process. As a result of this new policy, all large global banks will resort to massive de-risking by terminating correspondent relationship that will adversely affect cross-border trade globally. In this situation, banks of emerging markets will be badly affected. 

Too much compliance requirement will keep many legitimate customers away from banks as they are now finding alternative opportunities to banking facility. As a result, private investment fund, investment in capital market and other less regulated opportunities are rapidly flourishing. So, Gresham's law is still valid but in a different perspective where dirty money is driving clean money out of banking channel.

Nironjan Roy is a banker based in Toronto, Canada. 

nironjankumar_roy@yahoo.com

 

 

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