Be Prepared: The Game Has Changed8th April 2013

Spring is in the air, and my daffodil bank has been having a terrific year, indeed the best for some time. Bulbs are clever things, storing their energy to create an annual flush of pleasure, before quietly regrouping, replenishing their reserves in preparation for the next, even stronger, annual flush. But away from nature, mankind has been playing, and carefree economics is causing casualties, as we forget to replenish our reserves. Spring carried a bitter economic twist for Cypriots.

For regular readers following my thinking, the economic debacle in Cyprus was entirely expected, and just a natural consequence of the flawed policies pursued by politicians and bankers around the globe as public and private credit has been deliberately interwoven and driven to extremes. We have seen how banks leveraged at 30:1 in weak economies need not just one bail-out to replace their capital, but two, three … followed by many, many more. In Cyprus this has swept up shareholders, bondholders and depositors bringing a real reminder to the meaning of risk.

The reality …

So what happened? The initial plan involved an unpleasant “haircut” for all. But within a week that had transformed. The Central Bank guarantee for those with less than €100,000 in their bank accounts held, albeit at the expense of larger depositors losing almost everything, depending upon where they banked.

But if smaller depositors felt good about this let-off, trying to use those funds which are now subject to withdrawal restrictions and capital export controls means that those wishing to take a little as €2,000 out of the country must now take half in cash, and spend the rest on airport cigarettes, or whisky, or perfume, hoping to sell them at face value when they get to their destination to make their money back!

If you sold your house the day before the bank holiday, and the purchase of your next house was delayed until the following week, keeping the funds in the bank would have seemed a natural thing to do. But you have just become a victim in a game of musical chairs as the music stopped at the wrong time. Your money has been seized. You have lost not just the money in the bank, and most likely the deposit you had paid on what was to be your next home, and quite possibly all hope of that most basic of wants, shelter.

For businesses, money passing through the bank is a lifeblood, representing not “surplus” or “profit” but the full value of transactions on which they only make a margin, and sales taxes. Yet these proceeds of turnover have been seized, whilst their loan repayments, their creditors, taxes and wages still need to be paid. Imagine getting credit terms for your next batch of goods now. Many “essential” public sector organisations (for whom the deposit insurance scheme never applied) have been spared, but at the cost of even more pain for the private sector.

Just ponder how you would react in a similar situation.

In many ways bad banks are businesses that must be allowed to fail, in order to encourage renewal and the reallocation of scarce resources to better businesses performing an outcome that society wants, and is willing to pay for, to the benefit of capital and labour. But the arbitrary preference shown in Cyprus to certain bank creditors over others means this is far from a capitalist solution, and the dividing line between solvency risk and liquidity risk has also been blurred. The unfairness of it all will be argued over for generations.

Cyprus now faces enormous deflationary forces, yet still has huge public debts. For the people of Cyprus, there will be much more pain to contemplate over the coming years. (Sorry, if this is too much to take, for a rather more light-hearted view of how Europe got itself tangled in knots, see A Parable for Europe, The Tower of Babel here).

So where does this leave “money?” …

This is not the functional monetary system we have become used to. I have said before, and it is important to repeat, that Cyprus found itself between a rock and a hard place because it was a currency user, rather than a currency issuer. The UK is a currency issuer, and as long as there is the political will, the solvency and liquidity needs of our banks can be met in full.

We should remind ourselves what money really is. Whilst Aristotle was teaching Alexander the Great, he took time off to define the four characteristics of money as:

1)    Durability, in that it can’t fade or corrode

2)    Portability, in that you can take it with you

3)    Divisibility, in that smaller denominations can be used

4)    Intrinsic value, in that it has other valuable uses or is scarce and desirable in its own right

The Cyprus Euro now fails to meet these requirements. Aristotle also demonstrated that money operates as a store of value, and as a medium of exchange. This isn’t an investment blog, so we will leave money as a store of value well alone (although you should read The Trouble with Inflation, here), and look at the implications for all of us of bank “bail-ins” and how that can affect money used for exchange in our day to day transactions.

Please don’t get despondent. Whilst a few people may have invested in mattresses and safes, many more know that investment in innovation, and mankind’s thirst for progress, is where the real future opportunities continue to lie.

So what are the risks? …

Sir Mervyn King said that it was not rational to start a bank run, but rational to participate in it once it was underway. So where do we find one?

There is a sudden interest in countries with large banking sectors, and large banks within those sectors, compared to the size of their economies. Think what happened in Iceland (10x), Ireland (5.5x), Cyprus (8x) … and increasingly the focus is on countries like Luxembourg (21x), Switzerland (7x), the UK (6x), with the Netherlands not far behind. Even Asian countries are not immune, with Singapore (7x) and Hong Kong (6x), although their governments are in a much better position to step in if ever required.

Beyond bank accounts, there is a huge derivative bubble. Even in 2008 the value of derivatives in existence exceeded world GDP by 10x. And unlike quoted stocks and shares, there is no major exchange to net down and establish who finally holds the asset and the liability, so the system is potentially chock-full of counter-party risk.

Can states really bail their banks out should the need arise, or are depositor “bail-ins” to become the way of the future? Will states realize that they can’t guarantee bank deposits, as the very existence of those guarantees, whilst initially suppressing the likelihood of bank runs, actually increases the ultimate risk of default? Will laws just be changed in an arbitrary fashion to suit the mood of the time?

Until bank leverage ratios fall to traditional levels (a century ago 4:1 or 5:1 was more typical), and governments stop piling their own debt onto banks, major systemic risks in our monetary system will remain. So the risks of being in the wrong place when the music stops are real.

New Zealand (where there is currently no depositor guarantee) has moved to adopt a policy that permits “bail-ins” with the harmless sounding “Open Bank Resolution Policy”[1] In Ottawa the recent budget set hearts racing with the words “The Government will consult stakeholders on how best to implement a bail-in regime in Canada”, although the powers that be have since sought to reassure that this won’t include depositors. In Europe there has been confusion over what was or was not said about Cyprus being a template for future bank resolutions.

Last week Mervyn King announced that UK banks need to raise another £25bn of capital before the end of the year. That’s £400 for every man, woman and child in the country, which sounds huge, but is modest compared to the figures we reviewed for Laiki bank a few weeks ago (Surprised by Cyprus? You shouldn’t be here). So that’s OK, provided the bank’s assets perform. Which is a risk.

But if the taxpayer won’t do a bail-out, what is the alternative to a bail-in? Current laws really are no guide. Just as we saw legislation being written on the hoof in Cyprus, with or without the approval of the Cypriot government or rule of law, these things are resolved in arbitrary ways, in the heat of the moment, whilst bank accounts are frozen and depositors looks on helplessly.

We should be reassured that the Bank of England has it covered. Yes, back in September 2012 the Director of their “Special Resolutions Unit” gave a speech on the very subject of “bail-ins” as a tool.[2] You really ought to read this document, the link is in the footnotes below. Be reassured that there is a hierarchy of creditors here, so bail-ins are not necessarily intended to involve depositors, and forward planning often helpfully avoids or reduces the problem in the first place. Indeed, if the Eurozone had considered points from this speech it may have handled Cyprus is a much better manner.

But bank leverage does create risks for depositors, and as the Bank of England is talking about it, we owe it to ourselves to do the same.

So how should business react to this transactional risk? …

Many businesses are used to hedging their assets and liabilities, from interest-rates to exchange rates, although that often hasn’t gone so well. Now we need to look at some way of reducing transactional risks. Large multinationals already do this, often moving surplus funds into short-dated US Treasury bills, the traditional safe-haven to park money in times of crisis, which is why these bills have at times even traded at negative interest rates, such has been the demand.

Consider the salutary lessons from some of the losers in Cyprus:

  • Those who had deposits in the bank, but also had a loan that could have been repaid, are now left with the loan.
  • Those who had provided cash security for other debts, e.g. subsidiaries.
  • Those who locked up funds in term deposits at their bank, so when rumours of a bail-in started to circulate they were unable to respond.
  • Those who drew funding from other sources (like invoice discounting) a few days before it was needed to meet outgoings.
  • Those who held more than the government guaranteed amount on deposit, but could have spread that between different accounts at different banks.
  • Those whose funds were held on client account by others, particularly if with the same bank, which could equally apply to lawyers and letting agents.
  • Those who thought they were safe by diversifying amongst different currencies, but with the same bank.

So diversifying transaction balances and surplus balances between banks may be a good idea. Diversifying into overseas banks may also be considered, if that picks up a different deposit protection scheme, although Cyprus was heavily undone by the distaste of the regulators for overseas-owned balances. If cash is safe to hold, keep some of that in hand, but be aware that insurance limits for retaining cash on the premises, or in transit, or by staff are generally very low.

We all need to retain up to date paper records of transactions and balances rather than rely on the availability of electronic records, and take particular care to do so, and to diversify balances, just before weekends and especially bank holiday weekends. Even the Bank of England refers to “resolution weekends”.

What else? Well you need to be able to continue to trade outside of the banking system if necessary. Most Cyprus businesses were only willing to trade with cash, and as there wasn’t a lot of it, business was slow. Bitcoin is suddenly in the news, but to receive it, hold it and pay with it, and certainly to any decent level of value, you need to set up the facilities before the event. For the time being Bitcoin’s pricing is volatile, and the exchanges dealing in it too subject to disruption, but as an alternative transactional monetary platform it has much to commend it. The early adopters of Bitcoin have certainly done very well for themselves as the value of Bitcoins has rocketed, and it could make the difference between trading and not trading.

Of course the manifestation of money almost since time began has been physical gold and silver, although in the UK the latter is subject to VAT, and security is a major issue. But then wads of banknotes aren’t particularly safe either.

In the event of a deposit insurance claim being necessary, where do businesses stand? The current link to the Financial Services Compensation Scheme is set out below[3]. You’ll notice that the FSCS use phrases like “may” and “can” rather than “will” which is somewhat perturbing. You need to study the detail, but in summary the FSCS protects individuals and smaller companies only to £85,000. Companies must currently meet two of the following criteria (as set out in section 247 of the Companies Act 1985 or section 382 of the Companies Act 2006 as applicable):

Turnover: not more than £6.5 million

Balance sheet total: not more than £3.26 million

Total number of employees: not more than 50

Those who should review their plans now include professionals who hold client funds. As the Law Society states in its note for Deposit protection for client accounts, “the law in this area has not been tested and is currently uncertain”… ”it is unlikely that you will be held liable in negligence if money is lost following the collapse of a deposit-taking institution…” although “any express undertakings you have made to pay money must be honoured, even if the institution with which they were deposited has collapsed”. Which in plain English suggests that you don’t want to be sitting on the money when the music stops. Policies really should be reviewed, now.

I am not saying that these issues will ever reach the UK’s shores. I very much hope not, and as a currency issuer there is no need for the UK to get into such a mess … and I also have many good decent friends in the banking industry who don’t deserve any of this. But those pesky politicians already love to debate wealth taxes, which is a mere hop, skip and jump away from bank deposit sequestration. Like Cyprus, and throughout business life, those who stand the best opportunity of surviving are those who apply some forethought to likely or worst case-scenarios, and have the flexibility to react accordingly if the game really has changed.

[2] Andrew Gracie speech to the British Bankers Association  http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech600.pdf