From time to time, we hear losses of deposits and investments of various persons, rich and poor. We also hear financial crises from countries or regions or world that destroy economies of both rich and poor. The Asian currency crisis 1997/98 and the last global financial crisis 2007/09 are the most recent crises. It takes decades to recover from such catastrophes. Nobody can predict them even after early symptoms hit.
The fundamental cause of such losses and crises is the existence of risky financial systems in modern monetary economies. From time to time, the financial systems expand in bubbles with too much risks and fictitious confidence and burst suddenly due to bankruptcies if the bubble is too large beyond limits considered as prudent. Such bursts could be highly contagious across various layers of the financial system due to their inter-connectedness and various concentrations/excesses.
No one can practically escape from the financial system and live its life. However, we can minimize our losses/risks possible from the bursts if we know the design-features and risky nature of the financial system.
Design features of the Sri Lankan Financial System
In modern monetary economies, the financial system is a combination of several layers, possibly built/operated in form of a pyramid. I outline them in four in view of their different business profiles.
First - Central Bank
The first layer is the Central Bank. The Central Bank issues/prints currency as a liability of the government to facilitate transactions in the economy. The purchase of foreign currency (i.e., foreign assets) and grant of credit (domestic assets), both with banks and government, are the dominant means of printing money. Therefore, the accounting balance sheet of the Central Bank is the money printing ledger in the system. As at end of 2017, the Central Bank balance sheet was Rs 1.6 trillion with foreign currency assets constituting 83% which backed the money printing to that magnitude.
Therefore, foreign currency is the core pillar of the financial system. The main risk confronted by this layer is the possible difficulty to return or redeem foreign currency back to the system in emergency. In that context, the purchase of foreign currency is also credit grated by the Central Bank against the collaterals of foreign currency. The present tensions of excessive currency depreciation (exchange rate over-shooting) also could be an early symptom of default on foreign currency-based credit eventually by the Central. The greatest risk of possible default on currency is the collapse of currency systems during inflation crises as a result of reckless macroeconomic management as many countries have confronted in the past (Zimbabwe) and present (Venezuela).
Second - Banking
The second layer is the banking. A part of the money printed by the Central Bank remains as currency with the public and the other part reaches the banking system. Banks raise short-term funds (liquid liabilities) and lend long-term (non-liquid assets). In this business, more money is created in bank books on the top of the money printed by the Central Bank. Therefore, the total balance sheet of the banking system as at end of 2017 was Rs. 10.3 trillion, i.e., 6 times the Central Bank balance sheet. Banks keep only a small portion of currency/cash reserves to repay depositors and lend the majority to earn profits. Therefore, the core risk confronted at the banking layer is the possible default by borrowers on loans and by banks on deposits.
Third - Financial Markets
The third layer is the financial markets where savings are traded in financial securities/assets such as equities, government securities and private debt. In advanced market economies, this layer is very wide covering equites, bonds, hedge funds, exchange traded funds and derivatives. A part of printed and created money is transmitted to financial markets to buy financial securities. Therefore, the securities trade also is nothing but creation of money in books of those borrowers and investors. This is the layer that mostly mobilises foreign currency from participants/investors in the financial systems of other countries. The total of investments in the stocks and government securities was Rs. 10.2 trillion as at end of 2017. The risk confronted at this layer is the possible losses due to market slums (price collapses) and default by bankrupt borrowers.
Fourth - Shadow Banking
The fourth layer is the shadow banking. It contains a diverse set of institutions and persons who mobilize funds for lending and investment in various businesses. Financial intermediaries such as finance companies, leasing companies, thrift institutions, insurance companies, investment companies and pension/retirement funds are some of formal business players.
There is a large network of private businesses which canvas funds through various devices by promising attractive returns. Some operate in pyramidal forms prohibited under the Banking Act. Various businesses which recruit members by collecting various fees or contributions with high promises to provide valuable services through a network of profit-frenzied parties also are pyramidal operators. Microfinance appears to be an emerging social menace. One can count many such business/service networks operating to steal money cunningly from the public.
These business operators are de-factor deposit-takers and/or prohibited schemes without the approval of the Central Bank and they eventually end up in scams. A lot of black money (unlawful earnings and tax-evaded money) is parked or used in this part of the financial system until such money is cleaned up.
This whole layer is globally known as shadow banking as they in aggregate are tantamount to banking. A part of money gets transmitted to this layer which also creates further money in books. The total balance sheet of the approved shadow banking sector was Rs. 5.2 trillion as at end of 2017. The information on a large network of operators is not available to quantify the true size and spread of this layer. Globally, this is the riskiest layer. The last global financial crisis 2007/09 had strong links to the shadow banking. See graphic and Table
Inherent Risks and Returns
Returns
In normal times, almost all participants at the financial system earn profits/returns at various rates. The Central Bank also earns profit or losses or even may confront accounting bankruptcies as some analysts interpret. The greatest return the Central Bank can earn is the economic and price stability and financial system stability which provide the confidence to all participants in the system. The financial system provides unmeasurable benefits to the public by providing services of money to make payments, save and invest.
Inherent Risks
Financial systems have several inherently risky fundamentals. First, all layers exist on the general public trust that all funds/money in books in the system can be recovered in currency/legal tender, if necessary, although it is not so. Second, all layers are inter-connected to different extents through credit flows and their real businesses where some participants operate in several layers simultaneously. Third, the risk of default prevails in all corners as the system is built on credit. The mismanagement of credit/finance is the cause of the default. The losses and collapses we frequently hear are nothing but such defaults.
The Golden Key Credit Card Company which boomed on masked-security deposits taken to provide credit cards service was a large shadow bank that led to a wide contagion across the financial system in 2008. The Central Bank promptly and strategically defused its contagion on the banking layer. Although its contagion on the shadow banking layer was reduced, its resolution still remains unattended even after a decade.
Fourth, in general, all financial assets of participants are financial liabilities of some other participants. All attempt to maximise returns with different risk appetites. The general financial rule of thumb in normal times (when the general public trust remains strong) is; higher the return, the higher is the risk. The interest rate is the mostly seen risk-return indicator as the public do not have the financial know-how to assess and understand the risks and returns from readings of financial disclosures made by bigger participants.
Fifth, the excessive creation of money or leverage in the system is the major root of the risk of default and financial crises. At end of 2017, the leverage in the system (Rs. Rs. 27.3 trillion) was 17 times the Central Bank balance sheet (or money printing).
What if it rises to 34? Further, the total system was twice the country’s total annual income. Then, our dependence on credit and the financial system would be double in a big bubble calling for crises. We will live on too much credit with non-exiting value of financial wealth that can erode in few days.
The current exchange rate tensions also could be early warnings of a risky credit bubble built on foreign currency. The foreign currency is the conduit that connects financial systems and economies across the countries and transmit country bubbles. Already, the bottom of the system is too heavy towards foreign currency credit. This design-risks can cause currency and economic crises in the event the Central Bank defaults on redemption of foreign currency due to insufficient foreign reserve. Similarly, there can be several other points in the system that are burning under the ashes. Some raise grave concerns on heavy public debt stock. Therefore, we need to be mindful of early warnings of risky bubbles and control them if we are to escape from catastrophes.
Safety Nets and Risk Management
There are some forms of government safety nets such as regulations to protect the stability of the system. The Central Bank is the authority responsible to keep the system stable. It has the monetary policy and regulation with a big policy weaponry to control credit and enforce prudence. However, no governments can be prepared to subsidize all risks everybody takes as none is prepared to bear the cost of subsidy. The Central Bank cannot print money without limit to bail-out the system (Rs. 27.3 trillion) which is already 16 times greater than the Central Bank balance sheet (Rs. 1.6 trillion). The government also cannot borrow to bail-out because the system is nearly 3 times greater than the government’s already high level of market debt (Rs. 7.3 trillion). Both may be able to pump only few billions of fresh money and interim guarantees to boost the confidence and calm-down panics.
The fact of the matter is that we all live on too much risky credit. Therefore, we all have to manage credit at prudent levels consistent with the current level or potential of the real economy if we are to avoid bursts of credit bubbles and economic catastrophes. In that context, it is our responsibility to understand where we are in the financial system, how much risks are involved, whether the risks are greater than what we would normally like to take and what early warnings are available. Then, we need to stay away from the complacence and control both risk and greed. In respect of the wider financial system, it is the public duty of the Central Bank to do this which will eliminate a lot of excessively risky business operators and make the system safe and sound. This is not a rocket science or a statistical model-based exercise, but a conscious, continuous and consistent act based upon already available real-world lessons and ample best practices.
(The writer is a recently retired public servant as a Deputy Governor of the Central Bank supervising the financial sector and a chairman and a member of several Public Boards. He also served as the Director of Bank Supervision and the Secretary to the Monetary Board in the Central Bank. He has authored several economics and financial books and articles covering this topic.)
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