Citation(2008) 20 SAcLJ 316
Date01 December 2008
Published date01 December 2008

This article explores the subject of banking crises, paying particular attention to the recent banking crisis in the UK, and attempts to provide some guidance as to what lessons can be learned from this. The crisis involved the Northern Rock bank, a leading mortgage provider, which found itself in financial difficulties in the late summer of 2007. The article provides an examination of the following: why banks deserve special treatment; the use of the financial sector safety net; regulation and supervision of banks; the protection of depositors; a legal framework for dealing with insolvent banks. It then sets out the Northern Rock story before considering the position in Singapore.

“A bank lives on credit. Till it is trusted it is nothing; and when it ceases to be trusted it turns to nothing.”1

I. Introduction

1 Banking crises involving bank failure, often on a massive scale, have been relatively common across the globe in the last 30 or so years. These events have affected developed as well as developing countries and in the last ten years banks have failed in at least 50 countries.2 To minimise the economic and social damage that can be caused by failing banks, it is important that individual countries have in place a financial sector safety net which comprises a system of regulation and supervision. In many jurisdictions, there is now an additional component to the safety net, a scheme which will provide some degree of protection for depositors in the event of a bank failure.

2 It is generally thought that it would be virtually impossible to eliminate entirely the failure of individual banks and the purpose of the financial sector safety net is not to attempt the complete avoidance of insolvent banks. This is something which has been recognised in Singapore and in London.

3 The Monetary Authority of Singapore (“MAS”) in its Annual Report of 2006/2007 has stated that “a ‘zero-failure’ regime is neither feasible nor desirable as it leads to considerable moral hazard for the regulator and places excessive regulatory burden on financial institutions”.3 In the UK, Howard Davies, the former Chair of the Financial Services Authority (“FSA”), has stated that “risk taking is an essential element in dynamic financial markets, and it would be both unrealistic and wrong to aim for a zero-failure regime. Regulators should, however, target a low level of failures which bring losses to retail savers and investors”.4 These views are both realistic and represent the generally prevailing international position. However, the recent problems in the UK as a result of a troubled bank, Northern Rock, demonstrated a clear reluctance by the UK authorities to even consider the possibility of allowing this bank to fail. The events surrounding the Northern Rock crisis and the efficacy or otherwise of the UK’s financial sector safety net will be discussed in this article.

4 The principal aim of this article is to consider two relevant aspects of financial sector safety nets, paying attention in particular to the problems faced in the UK by the Northern Rock crisis. These are bank insolvency law and depositor protection schemes5 although other aspects will be discussed where relevant.

5 It is hoped that by doing this some degree of guidance for the future for other jurisdictions in general, and Singapore in particular, will be provided.

II. Why do banks deserve special treatment?

6 In most countries, banks are treated differently in some respects to other types of businesses. The taking of deposits from the public is one reason and this is coupled with the role banks play in the payments system. These two factors single banks out for some degree of special treatment.6 A further issue is the possibility of “systemic risk” which can lead to problems at one bank 7spreading to other banks and, in a sufficiently serious crisis, to the entire banking system. The banking system tends to be far more fragile than is generally realised and a healthy system depends on confidence. Why is this? According to Goodhart, “Fractional reserve banking is inherently a confidence trick, and, should confidence be lost, as is bound to happen from time to time, the house of cards is prone to tumble down.”8 Banks, instead of safekeeping the savings of depositors stored away safely in a vault,9 will use the money deposited for the purpose of carrying on their business, and the business of banks tends to carry with it certain risks. From the legal perspective, the depositor has lent the money to the bank and has become an unsecured creditor.10 The bank will then seek to use these funds to obtain a better rate of return than it is paying to the depositors and this inevitably involves some degree of risk.11 The main risk is that borrowers may default and if this happens in sufficient numbers the bank may find itself in difficulties.

7 Another aspect of the business of banking which increases risk is that banks invariably operate on the basis of fractional reserves. This means that they will seek to use as much of their capital as possible for potentially profit-making business. Traditionally, this has been mostly

by way of loans. Typically, they will seek to keep as little capital as possible in cash or near cash form. In most countries, there will be a regulatory minimum level of required capital.12 This means that should there be exceptionally high demand from depositors for repayment, the bank may find itself without sufficient liquidity to meet these demands. This risk is increased hugely by another aspect of traditional banking business. This is the idea of “borrowing short and lending long”. This makes banks particularly susceptible to risk as they typically lend on the basis of term loans which are made for a fixed period of time. From a legal contractual perspective, the bank will have no right to attempt to accelerate repayment of these loans unless there has been an act of default by the borrower which would permit such action by the lender.13 Deposits, on the other hand, are normally repayable either on demand or on relatively short notice. This creates a maturity mis-match which can be potentially problematic. However, these risks can be minimised by ensuring adequate liquidity to deal with normal day-to-day business and by the availability of an interbank market coupled with the ability of the central bank to provide liquidity in certain circumstances. Where a bank is dependent on sources of funds from a more concentrated base, as was the case with Northern Rock, the business model can become extremely high risk and this should be a matter of concern for the banking regulator.

8 Perhaps the most important aspect of the business of banking is the need for the public to have confidence in its banks. It is of singular importance that confidence is not lost as this may not only affect a single bank but may also have systemic implications. It is, in fact, the systemic aspect which is most important to bank regulators and central banks. The banking crises in Mexico in 1995 and East Asia in 1997 demonstrated the extent and speed with which a systemic crisis can develop when confidence is lost.14

9 For these reasons, it is vital that countries develop a financial sector safety net to ensure the safety of individual banks and to protect

bank depositors. In the next part of this article, the components of a financial sector safety net will be examined.

III. The financial sector safety net

10 Most countries have introduced a financial sector safety net which typically involves the central bank as provider of emergency liquidity assistance (which may or may not also be responsible for the regulation and supervision of individual banks), the banking regulator (where this role is undertaken by a separate body) and the Ministry of Finance. In addition, in many jurisdictions, there will also be a deposit insurance scheme in place and this means that the role of the deposit insurance agency will also be a relevant part of the financial sector safety net. As noted above, the aim of a financial sector safety net will not be to prevent all bank failure and because of this there will be a need for a legal framework which is capable of dealing effectively with insolvent banks.

A. Regulation and supervision

11 The major technique used to reduce the likelihood of failing banks is an effective system of regulation and supervision.15 The responsibility for undertaking the task of supervision is most commonly given to the central bank, but there is an increasing tendency towards giving this task to a separate body and, in some countries, this has resulted in a “super regulator” which has responsibility, not just for the banking sector, but for the entire financial services sector. This is the position, for example, in the UK where the FSA is the body which has been established for this purpose. Prior to the establishment of the FSA, the Bank of England, which is the central bank of the UK, had responsibility for bank regulation and supervision. It now has responsibility for the overall health of the financial system but no longer has any role to play in the prudential regulation of individual banks.16

12 The regulatory process for banks involves the concept of licensing, or prior approval, of both banks and those who own and manage them. This is something that is recognised by the Basel Committee on Banking Supervision in its Core Principles for Effective Banking Supervision17 and virtually all jurisdictions use a licensing system for banks. It is important to realise that, while a licensing system can ensure that the appropriate standards are being met at the time the licence is granted,18 the role of the supervisor must involve the continuous oversight of the licensed body to ensure continuing compliance. This will involve ensuring that such matters as minimum capital requirements are maintained and also that those responsible for...

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