Queues outside banks that stretched for several streets. Angry depositors who got into scuffles over queue-jumping by those late to realize their savings were in trouble. Banks imposing daily limits on withdrawals and increasing penalties for breaking fixed deposits. Rumors on every street corner concerning the next bank to fail. Central bankers who literally sweat under the spotlight. Government ministers calling up the head of the central bank to appear before an urgent committee where said banker was reprimanded quite severely. Satirical magazines that have steered clear of their usual beat around politics instead to make fun of bankers and depositors.

The above scenes were not from Thailand or Indonesia in 1997 or South Korea and Russia in 1998. Rather, it was in the staid old world of the United Kingdom, where the stiff upper lip apparently gave way to quivering bouts of sentimentality.

The world of Mary Poppins, scones with your afternoon tea and warm beer with your chips appears to exist only for tourist consumption, as locals go around behaving exactly as the much criticized poor people in various emerging markets do from time to time.

England’s sportsmen have had a bad time in various international games this week, ranging from rugby to cricket; perhaps all of them had savings locked up with Northern Rock, the failing English bank that was urgently propped up by the Bank of England barely a week after its governor, Mervyn King, decried the behavior of the US Federal Reserve and the European Central Bank for interrupting the normal functioning of markets by intervening too frequently.

I wrote in a recent column [1] about the dysfunctional nature of Group of Seven (G7) financial systems. Reading that article again, I am myself astounded by how “nice” I was in focusing merely on the interbank system rather than the wider implications for depositors. When G7 countries start facing good old-fashioned bank runs, it is the time for every central banker around the world to stand up and take notice.

This is especially true for Asia, which supplies much of the capital that allows G7 governments to rescue their banks from time to time. [2] To state the obvious, the region must not expect similar favors from G7 countries should local financial systems ever lurch into disaster mode. Indeed, we should instead expect to hear the usual homilies about “rigorous market discipline”, “robust checks and balances” and other such reasons any financial crisis is a problem for Asians and not something with which G7 countries should help them.

I don’t want to dwell too much on the obvious hypocrisy of G7 countries that helps them to adopt a holier-than-thou attitude while scrumptiously helping their own banks avoid troubles. The 50-basis-point cut of the US Federal Reserve this week falls into the same category.

What it means for Asia

Last year I wrote about the major financial systems in Asia [3] to highlight the potential dangers lurking below the surface in both China and India. The summary of those observations was that banks had increased their exposure to low-quality US financial assets to boost their overall income. Their balance sheets are stretched by loans to highly risky but politically connected borrowers in their respective operating areas. Chinese banks enjoy substantial liquidity but make poor investment and loan decisions all too often. While Indian banks are nominally better managed, their liquidity constraints are higher.

What helps the two systems is the substantial increase in the deposit base over the past 10 years as a natural consequence of economic growth. This has allowed banks in the two countries to expand their branch networks, increase their investment books and generally adopt more automation (although Indian trade unions have prevented state-owned banks from going too far down this route).

This economic growth allows a number of risky borrowers to avoid defaults, as their business environment remains robust, thereby keeping them honest – that is, it costs them more to default than to stay in business, and thus they choose to repay the banks, albeit with loans from other banks in most cases.

The growth in retail lending is hamstrung by poor legislation. It is a fairly lengthy process for banks in China and India to repossess homes of delinquent mortgage borrowers, for example. This difficulty in turn encourages slightly more risky behavior by some borrowers, although cultural factors such as the social stigma attached to being bankrupt helps keep such risks on the lower side overall.

Additionally, there are not a lot of avenues for banks in China and India to sell their risks. The use of financial derivatives to diminish risk on the asset side of their balance sheets is quite low, even as the banks are themselves enthusiastic buyers of similar instruments originated in the US and Europe. I blame both the absence of securities regulations and the lack of investor education for this state of affairs. Granted that these are broadly the same category of financial derivatives that got US and European banks into trouble, their use is however justified by the sheer scale of risk being handled by banks in China and India relative to their capital bases.

Last comes the issue of supervision. Asian central bankers are in general less sophisticated than the dictates of modern financial systems. I rate the Reserve Bank of India ahead of the People’s Bank of China in this respect, but that’s like saying Josef Stalin was a better human being than Adolf Hitler. The central banks have a poor understanding of financial derivatives and their ability to distribute risk, as well as the benefits of rigorous risk analysis. Overall staffing levels are actually too low for their remit, and all too often officers are promoted for political rather than reasons of merit.

What to do

Rather than let all these issues simmer below the surface, Asian central banks must act immediately. I suggest the following measures to be adopted with great urgency by governments as well as central banks.

First, merge small and medium-sized banking entities into larger operations. Risks are often too localized when banks concentrate on specific regions. Examples of this can be found across the southern Chinese coast, where a number of banks quite literally only serve a single region and are therefore overexposed to certain industrial sectors. Merging these banks with those operating in different environments would be mutually beneficial.

Second, all public banks must be listed on the stock exchange, with foreigners allowed to own shares. While this is not in any way to suggest that foreigners are smarter than Asians at assessing risks, they do demand higher disclosures and transparency. Additionally, the insights of various dedicated fund managers specializing in bank stocks cannot but be good for the system as a whole – witness for example the improvements brought about in Japan by foreign-owned companies.

Third, securities legislation must incorporate new classes of financial derivatives and provide incentives for banks to sell down their risks (bank regulation). This would allow the development of proper bond markets across China and India that could help increase the flexibility of Chinese and Indian banks in terms of trimming their balance-sheet exposures to some assets while providing themselves with additional sources of liquidity.

Fourth, central banks must increase their supervision standards. In the case of Northern Rock, one of the key failures appears to be that the bank was maintaining low cash balances with the central bank to take advantage of the “averaging” of cash balances. Using averages is pretty dumb for banks – central banks must monitor variance and step in whenever balances fall, say, 20% below the required amount. This requires improved systems and better supervision.

Last, government-mandated limits on bank lending must be scrapped. These limits force banks in China and India to lend to specific sectors and regions because of the “priority” focus of the central government. That is a matter of fiscal rather than commercial intervention; therefore the direct responsibility for such loans must remain with the government rather than individual commercial banks.

Conclusion

China and India are well-positioned now to undertake serious structural reforms. They should not wait for a crisis of the Northern Rock magnitude to force their hands, but rather act immediately. My suggestions above only represent a start for the sector. Forget air-conditioning the branches and providing free tea to the people visiting them; more urgent work beckons behind the scenes.

Notes
1. In gold we trust, Asia Times Online, September 8, 2007.
2. Asia and the vicious cycle of bank bailouts, ATol, August 11, 2007.
3. Chinese, Indian banks plunge at different rates, ATol, August 3, 2007.

https://web.archive.org/web/20100114122711/http://www.atimes.com/atimes/Asian_Economy/II22Dk01.html

https://web.archive.org/web/20100105174004/http://www.atimes.com/atimes/Asian_Economy/II22Dk02.html