How nice it would be if we could actually make two banks stand apart like two lamp posts. But unfortunately, the financial markets of our times are so intertwined that once the fuse of one bank goes off, in all likelihood the fuse of the next bank will also go off, setting off a chain reaction which would plunge the entire financial world in darkness. So handling a new-age banking crisis requires a new set of skills and actions. Let’s find out what options our policymakers have in dealing with a banking failure.
Johnny: I really feel scared when I hear about the failure of a bank. Tell me, Jinny, what are the best ways of dealing with a bank failure?
Jinny: Well, there could be thousands of reasons for a bank to reach the brink of failure but our policymakers have only a dozen or so responses, which could be used in different permutations and combinations, for dealing with the crisis.
The choice of the most suited response to a great extent depends upon the factors responsible for the crisis.
Whether the immediate trigger for the crisis is the loss of depositors’ confidence causing a run on the bank or whether the crisis is due to some other problem in the financial market or macroeconomic factors or whether the crisis is really due to the bank becoming insolvent.
Each banking crisis, therefore, requires its own independent analysis and policy response. If you are interested, I could tell you about some of the most common policy responses.
Johnny: You don’t have to ask me, go ahead.
Jinny: Provision of liquidity support by the central bank of the country to the bank in trouble is the most common policy response. As a lender of last resort, the central bank lends money to the bank in trouble by taking bank’s assets as collateral. This action greatly helps in restoring the confidence of nervous depositors.
However, provision of liquidity support can work in the short-term only, and that too if the bank in trouble is otherwise healthy. In case the bank is really insolvent, then provision of temporary liquidity support only prevents the bank from immediately falling to the ground. It gives policymakers some time to explore other options.
Illustration: Jayachandran / Mint
In such situations, one possible solution could be what is called “lifeboat rescue” in popular banking literature. Lifeboat rescue is a type of arrangement in which the assets and liabilities of the troubled bank are taken over by another, healthy bank. The assumption behind this solution is that with the infusion of new capital and proper management, the troubled assets can be brought back to life. However, this solution can also work only if some suitor is ready to take up the challenge. Policymakers try their best to find a perfect match but many times failing banks have no such suitors.
Johnny: What other options can be used if no suitor is ready to take up the challenge?
Jinny: In such situations, the government may have to intervene directly. The government can rescue troubled banks in several ways. It can extend a guarantee to all depositors in addition to the existing guarantee provided by the deposit insurance. The government can also establish an asset management company for taking over the assets and liabilities of the troubled bank. The government can itself directly take over the troubled bank or else provide it fresh capital.
Any intervention by the government in the rescue of troubled banks has a miraculous effect.
But government intervention imposes the cost of rescue on the general public and, therefore, it must be undertaken only when the benefit of rescuing any particular bank exceeds its costs. So, we should never presume that the government will always intervene no matter. In a worst-case scenario, when none of the aforesaid actions is feasible, then you may actually see a bank going down.
Johnny: Really? You are frightening me once again!
Jinny: There is no need to get frightened. In case you are a small depositor, there is not much to worry. All deposits up to Rs1 lakh are compulsorily protected by deposit insurance in our country. So no matter what happens to your bank, you will get back all your money up to Rs1 lakh. In case you have deposits in excess of Rs1 lakh, then how much you get back ultimately depends on how much money the assets of your bank are able to fetch in the market.
The chances are that you may get back some of your money in excess of Rs1 lakh. But this is only a worst-case scenario. With each banking failure, our policymakers have learnt a lot about how to prevent things from reaching such a pass. So, in all likelihood your worst nightmare may not come true.
Johnny: That’s true, Jinny. Learning from one bank crisis may not completely root out all bank failures in future, but with the experience of each banking crisis our survival instinct becomes stronger.
What: The choice of a response for dealing with a banking crisis depends on many factors.
When: Provision of liquidity support by the central bank produces good results when the bank in trouble is otherwise solvent.
How: “Lifeboat rescue” is carried out by merging the bank in trouble with another bank.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org