The blame for financial crisis is not all our own
We need to draw attention to punitive stance on financing of bank resolution, writes Colm McCarthy
Banks are fragile institutions and failures of individual banks, and of whole banking systems, are a regular occurrence around the world. Banks hold assets as much as 20 times their free-risk capital, the amount they can afford to lose. Through lax oversight and the use of off-balance sheet vehicles, many European banks were allowed to hold even less true capital than appeared the case during the recent crisis.
Their principal assets, particularly loans to customers, cannot readily be realised while their deposits can flow away rapidly. A bank forced to write off even one loan in 20 will have no free capital and depositors will flee. If it wishes to restore liquidity, it needs to shrink its balance sheet by large amounts rapidly, restricting credit and exacerbating the decline in the collateral values backing its surviving loans. A banking system with thin capital and illiquid assets, financed with short-term deposits, is an unexploded bomb.
Bank failures can be minor, affecting just one small and poorly managed bank, or they can be systemic, threatening the entire economy. Consequently banks are licensed, regulated and supervised through central banks or specialist financial regulators, whose role is two-fold. The first task is to prevent banking crises, the second to resolve them quickly, and with minimum damage to the rest of the economy.