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Revisiting liquidity crisis

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Much has been written about the recent liquidity crisis in the Nepali banking system and the bank bashing that has ensued. Given the failure of some of the banks and supervisory function of the central bank, this is understandable; yet it is only fair that we relook at the crisis to uncover the fundamental issues and where we are headed from hereon.



THE ISSUE



For more than a decade, not only Nepal Rastra Bank but the international regulators including the Basel committee had been diligently focusing on the capital adequacy requirement. The liquidity risk issue remained at the back burner supported by the abundant liquidity in the market (both in Nepali and international market) and the linear thinking that there will be uninterrupted supply of liquidity. Ever since the crisis broke out, governments and central bankers around the world have had to save their banks— some provided blank cheques to the banks while some injected capital. While doing so, some of the countries chewed more than what they could bite and underwrote losses of the banks and ended up leading the country at the edge of bankruptcy. The result is the hard austerity measures that have hurt their economy.



Historically, banks have been comfortable dealing with credit, market and operational risk but oddly though liquidity management is one of the prime risk banks face—it had not received the due attention (even globally). Given the complexity and relative concept of liquidity issue, there wasn’t any international liquidity accord and only after the 2008 financial fallout that the Basel III has now included a new liquidity accord. If the world’s leading banks and the regulators failed in the liquidity management, how far can the nascent banking sector of Nepal be punished for this failure?


THE PROBLEM



The problem is fairly simple. Banks typically lend long and borrow short. Since yield curves are typically upward rising, this makes sense. Bank takes short-term deposit (say at 7-8 percent) and lend long term (say at 10-12 percent), the difference being the spread the bank makes. A part of the deposit is held in liquid assets to meet the withdrawals by depositors and banks would like to hold just enough liquid assets since such assets pay little interest. Thus, by this logic, banks are inherently illiquid institution as they have asset-liability mismatch.



From banking perspective, two trends contributed to the liquidity issue. First, due to competition, banks increasingly held less liquid assets and rampantly financed longer-term assets with shorter maturity instruments exposing themselves to excessive funding liquidity mismatch. Reliance on wholesale funding that has different behavior compared to retail depositors further aggravated the liquidity risk. Secondly, decline in lending standards and mispricing of liquidity risk, again as a result of competition. The combination of cheap credit and lower lending standards resulted in the housing frenzy that laid the foundation for the crisis. Fundamentally, this is quite similar to US crisis that snowballed with the housing collapse; the only difference being the US banks used structured finance products like CDO/CLO and securitization to create new asset class and generate liquidity from another market.

There are countries that have evolved more strongly after a crisis and we should strive to be one such country. Notwithstanding the fine line between the liquidity and solvency issues, if the recent crisis in Nepal is a liquidity issue and not a solvency problem, then, indeed, this crisis may be a blessing in disguise.



In response to the global liquidity crisis, central banks in different parts of the world have acted as Lender of Last Resort (LoLR). And NRB responded accordingly providing rescue packages to address the liquidity shortages apart from CRR reduction. NRB’s effort is appreciated; however the two issues arising out of this cannot be overlooked. The first is the moral hazard as it creates expectations of bailouts and stimulates risk-prone behavior. And, secondly, due to information asymmetries, a key concern in the context of Nepal, it is difficult to distinguish between insolvency and illiquidity and this can lead to adverse selection in rescuing a troubled banks. It is up to the central bank to analyze the bank’s financial position to identify that it is illiquidity and not a case of insolvency.



LESSONS



There are many cases of governments supporting their banks for survival during the financial crisis and there are cases of success stories with the banks coming back on their feet. However, this policy failed miserably with the Irish banks to the extent that it almost bankrupted the entire country. There is a lesson to be learned from this. As a LoLR, it is only fair that the central banks support their solvent banks but undue generous offer can be detrimental to the overall economic health of the country. Some of the sovereign debt crisis could have been limited or averted if the government hadn’t been so generous with their banks.



This crisis has exposed the negative consequences of mispricing risk and poor credit and liquidity risk management in the financial system. Liquidity management has gained much more importance in view of the declining funding sources, liquid assets and shift in the consumers’ demand and preference when faced with the volatile environment. A lesson learnt is that funding liquidity risk is inherent in the banking system and thus requires a comprehensive and robust liquidity risk management framework. Another lesson learnt is that pricing an asset should reflect both the actual cost of fund and any contingent risk.



This crisis has also shown the role of media and how yellow journalism can propagate rumors into a name crisis. Even a strongly positioned bank will go down if all the depositors get behind the cash counters. Another lesson: Banks should also have a good name crisis contingency plan.



This crisis has also uncovered the weakness in the governance of the banks and the flaws in the supervisory function of the central bank. This shows that a bank’s capital base alone is not enough to cushion the liquidity difficulties and that the national regulators need to have market-tested diagonistic tools apart from stress testing, quantitative standards and supervisory tools.



The financial turmoil showed that liquidity (and capital) can vanish almost instantly. During 2008-2009 financial crisis, referring to the banking meltdown, a senior banker told me “it is a very interesting time to be working in a bank”. Indeed, crises do happen and it is on to us to learn the lessons from them and build a better framework for us to be prepared for the future downturns. However, every crisis comes with its own specifities aided by evolution of risks and emerging practices.



Even if the regulations and the advanced models are not able to prevent crisis, it should at least give warning signals for the potential stress. There are countries that have evolved more strongly after a crisis and we should strive to be one such country. Notwithstanding the fine line between the liquidity and solvency issues, if the recent crisis in Nepal is a liquidity issue and not a solvency problem, then, indeed, this crisis may be a blessing in disguise.



The writer is the Acting Managing Director, BMI Bank, Qatar Branch



Michael.Siddhi@bmibank.com


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