Understanding bank runs and why the CBK dropped the ball

To avert panic, Central Banks should lend early and freely (without limit), to solvent firms, against good collateral, and at ‘high rates”.

This prescription, known as “Bagehot’s Dictum,” is one of the most enduring pieces of economic policy wisdom.

It comes from an 1893 classic, Lombard Street: A Description of the Money Markets by Walter Bagehot, a prolific polymath and editor of The Economist magazine.

This particular rendition is by Paul Tucker, a former Deputy Governor of the Bank of England.

What explains the dictum’s longevity? Why are banking crises still a regular occurrence?

These questions were illuminated by Douglas Diamond and Phillip Dybvig in a seminal 1983 paper titled: ‘Bank Runs, Deposit Insurance and Liquidity,’ in which they developed a model of bank intermediation that has become economists’ workhorse for analysing banking crisis.

DIAMOND-DYBVIG MODEL

As is often the case, the most remarkable intellectual insights appear painfully obvious after the fact (why did I not think of that?). And so it is with the Diamond-Dybvig model.

The model’s basic insight is that deposit-taking banks are essentially in the insurance business. They provide “liquidity insurance”.

To illustrate, you have Sh50,000 saved for a rainy day. You could lend it to cousin Mary, who runs a matatu.

Cousin Mary is actually completely honest and dependable, but it may just happen that you may need the money urgently just when cousin Mary’s matatu needs major repairs. If she pays you, she will not be able to fix her matatu.

Deposit banking enables you to finance cousin Mary indirectly with your rainy day savings instead of putting it under the mattress (where you could succumb to the temptation to consume it), and cousin Mary also does not have to worry that she may not have your money when you need it.

The business model works on the law of large numbers - the expectation that only a small fraction of depositors will suffer liquidity shocks (rainy days) at any point in time, and only a few loans will be defaulted on - that only a few cousin Marys will suffer engine knocks at any point in time.

DEPOSIT-BANKING "VALUE PROPOSITION"

Thus, deposit-banking’s “value proposition” to society is that it converts rainy day savings into capital.

The liquidity insurance property derives from the fact that bank deposits are available at face value plus interest earned on demand, on a first come first served basis.

No other financial asset offers both liquidity and certain value (stocks are liquid but value is volatile).

But this comes at a price. Individual banks can and do run into trouble. The economy also generates systemic liquidity shocks.

If, for instance, there is a natural disaster, floods or an earthquake, many depositors will need their money all at once, and many borrowers will have been ruined and in effect unable to pay their loans.

When a problem is suspected, the sensible thing to do is to run to the bank to be first on the withdrawal queue.

In economic lingo, we say that deposit banking exhibits “multiple equilibria” namely, a good equilibrium (stability) and a bad equilibrium (bank run).

As the title to the paper suggests, Diamond-Dybvig demonstrate that government intervention by way of deposit insurance is an effective way of mitigating bank runs. Deposit insurance can be explicit or implicit.

The Central Banks’ lender of last resort and government bail-outs of vulnerable banks are both implicit deposit insurance schemes.

Implicit insurance insure banks against liquidity shocks generally, that is, they mitigate bank failure.

"SUSPENSION OF CONVERTIBILITY"

Explicit deposit insurance guarantees depositors that they will get their money back (up to the insured limit) when banks fail.

The alternative to deposit insurance is “suspension of convertibility”, which is a technically elegant way of saying suspending withdrawals on demand.

The most recent example of suspension of convertibility was the closure of Greek banks for three weeks mid last year, and imposition of ATM withdraws to 60 Euros a day.

In the run-up to the closure, Greeks were withdrawing over a billion Euro a day.

During the 2001 currency crisis that culminated in her most recent debt default, Argentina imposed a year-long suspension of convertibility nicknamed corralito (small corral), unleashing in turn a political tsunami that saw the country go through four presidents in a month.

There is a large interesting literature on the efficacy of deposit insurance vis a vis suspension of convertibility.

In theory, suspension of convertibility is a more effective way of pre-empting bank runs.

If people know that a bank run will trigger automatic suspension, then it does not make sense to run on the bank.

The drawback is that it is indiscriminate as no distinction is made between genuine need like to buy medicine and panic withdrawals.

Consequently, the draconian suspension required lacks credibility because people expect governments to succumb to public pressure or courts to intervene - economists call this a “time consistency” problem.

The main drawback of deposit insurance is “moral hazard”, of which the “too big to fail” phenomenon is the most problematic.

One of Bernie Sanders campaign pledges is to break up the “too big to fail” US banks.

TENTATIVE HALF MEASURES

But the worst of all possible worlds is tentative half measures.

The continued insistence by the Central Bank that failure of three banks in the space of nine months is a stretch.

But even if it had been an isolated problem, this ceased to be once Imperial Bank closed.

I was with a CEO friend on the day Chase Bank closed, who intimated that his company had completed liquidating huge deposits the week before.

How did you know, I asked? They did not know, but they have money locked up in Imperial too. This is called contagion.

The first order of business when dealing with a troubled bank is damage control, not retribution.

The first best option is to keep the bank open, whether it is discovered that the bank is actually run by the Mafia is immaterial at this point.

The only bank that arguably posed minimal contagion risk is Dubai Bank. Imperial Bank could and should have been kept open.

The run on Chase Bank was not caused by dodgy insider lending. It was caused by panic withdrawals.

Once it closed Imperial Bank, the CBK should have anticipated contagion risk.

Adverse information had been coming out of Chase Bank, including the Youth Fund deposit scandal.

In the circumstances, the ousting of the chairman and Group CEO and restatement of accounts in rapid succession was as sure a trigger for a full blown run as you can get.

Tales of emergency all night meetings trying to wring cash out of the shareholders in the aftermath of these developments suggests people who are out of their depth.

Where did the CBK expect the shareholders to get the cash from? Even if they could, who would put money in a sinking bank?

The time wasted with shareholders would have been infinitely better spent working out the bailout as has been done subsequently while keeping the bank open, a la Bagehot’s dictum.

GOVERNMENT IN FINANCIAL DISTRESS

The mishandling of the two cases, Imperial and Chase, has done serious damage to confidence, which has two consequences, namely “flight to quality” and “liquidity preference.”

“Flight to quality” simply means that people will move their money to the banks that they consider either absolutely safe or “too big to fail.”

Liquidity preference means that banks, more so those that perceive themselves as vulnerable, will shun longer term or risky loans because the rational response to panic withdrawals is to keep money in cash and near cash assets, precipitating in turn a credit squeeze whose brunt will be borne by SMEs.

The timing could not possibly be worse. It is an open secret that the government is in financial distress. It is living from hand to mouth.

Late last year, it took a $750 million commercial loan to plug a cash crunch. The money is gone.

The Treasury has disclosed that it is arranging another $600 million emergency loan from China to plug the budget deficit.

Unscheduled commercial borrowing to $1.35 billion within the financial year - the equivalent of four Thika highways - is distress borrowing.

This notwithstanding, the government is not paying its bills. Some bills have been pending for more than a year. These unpaid suppliers owe banks money.

PROFIT WARNINGS

A record 20 listed companies have issued profit warnings. I have seen an expanded list that has more than 50 prominent companies, which reported adverse performance last year.

But the government and its Washington cheerleaders continue to insist that the economy is in good health, in fact, one of the best-performing in Africa.

The result is policy schizophrenia. A Treasury in denial continues to insist that revenue shortfalls are nothing to do with a flailing economy, that it is Kenya Revenue Authority sleeping on the job.

The Central Bank issues rules for better provision for bad and doubtful loans, KRA rejects them for tax purposes because higher provisions will reduce taxable profit.

But it is far from evident that KRA is underperforming. Revenue collection to the third quarter of the financial year is up 12 per cent compared to same period last year.

That is above par given the weak underlying economy, besides the profit warnings, tourism has been on a losing streak for three years.

KRA is a scapegoat for the unravelling of Jubilee administration’s incompetence and plunder.

The real problem and present danger is the continued denial by the Jubilee administration that the wheels came off its hare-brained ‘get-rich quick’ economic agenda a long time ago.

The administration needs to sober up - I mean this metaphorically.

BAILOUTS

In the wake of the cash crunch late last year, I argued that the Jubilee administration should seek an International Monetary Fund bailout.

Perish the thought! But a few months down the road, it is taking a Chinese emergency loan for the same purpose.

These London and China bank loans are more expensive but they are preferred because they have no strings attached, that is, the financial discipline an IMF bailout would impose.

We are going to pay for political egos. Pride comes before a fall.

Sobriety is required at CBK as well. The “bandit economy” is not a figment of Chief Justice Mutunga’s imagination.

The trouble at Dubai and Imperial was related to money laundering. The operation has not closed shop.

It has migrated elsewhere, just as it migrated into Dubai and Imperial from elsewhere.

We are reputed as one of the major money laundering hubs in this part of the world.

Add domestic corruption proceeds and we are talking 10 to 20 per cent of the money in our banking system that cannot survive basic KYC (know-your-customer) scrutiny. Food for thought.

Argentina’s meltdown brought to an abrupt painful end of a decade long false prosperity bubble build on the quicksand of an overvalued currency (the exchange rate was fixed at one-to-one to the US dollar) and reckless foreign borrowing.

Jubilee administration’s false prosperity bubble will not be the first, or the last, to be busted by a financial unravelling.

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