The regulator’s emergency liquidity assistance– a gift or a loan?

The Central Bank
Bank of Ghana

A single page article in a newspaper can never suffice in explaining the critical role of the central bank in a nation’s economic development. Recent developments in the country’s financial landscape have however forced me to attempt to highlight the profound importance of the regulator in sanitizing the banking system according to law on a single page.

Some say behind every stable, resilient banking and financial system is a strong, independent and focused central bank. I want to add that in front, in the centre and behind any efficient financial system is an independent, focused and responsive central bank.

This redefinition is designed to amplify the central bank’s critical role as the originator, monitor and reviewer of the plethora of regulations that are aimed at ensuring the sanctity of the financial system, especially the contemporary need to hold adequate liquid reserves as enshrined in Basel 3.

The central bank can be likened to an impartial, responsible and knowledgeable referee in a football game. The referee’s prime objective (if it has not been tainted by corruption) is to ensure that all players and officials play according to pre-agreed set of rules to make the game interesting and to elicit the desired patronage of fans and other stakeholders.

That is why it becomes disastrous when the referee consciously or otherwise ignores bad tackles and other glaring infractions that destroy the beauty of the football game or allow an undeserving team to win, lose or draw in a game. The events of 9th May, 2001 at the Accra Sports Stadium   in Ghana is a profound reminder of how everybody loses from biased or bad football officiating; just as the entire financial system would suffer immensely from bad regulatory practices.

Like many Ghanaian students of economics, I used to chew and pour the functions of the central bank during examinations. A function that I liked to explain in-depth is the concept of the central bank acting as a lender of last resort. Later in my role as the head of treasury back office operations and subsequently an Asset and Liability Manager I learnt to appreciate the criticality of money market operations, particularly the central role of the regulator in stabilizing liquidity, credit expansion and interest rate dynamics.

In the wake of the current financial crisis, therefore, I find myself re-visiting the regulator’s function as lender of last resort and asking   myself questions that some of my current students with critical minds would be asking me shortly.

The key question that jumps at me is whether the emergency liquidity assistance that the central bank used to prop up the then ailing banks which are now defunct was a gift or a loan to the respective recipient banks?

This cannot be termed a rhetorical question because it is based on the reason(s) that the regulator offered the assistance initially plus the corresponding conditions.  Under normal circumstances, when one offers a gift to another, the giver would not ordinarily be concerned with how the gift (in this case colossal amounts of tax payers’ money) would be utilized. The recipient would be at liberty to determine how the funds are applied.

Even with gifts, sometimes the giver may be interested and possibly determine the secondary recipients and the general purpose for which the funds are applied. This is to ensure that the mode of application of the gift is congruent to the original intentions of the primary giver.

Emergency liquidity assistance in the realm of financial market stabilization cannot by any definition be termed as a gift to the beneficiary bank. It is designed primarily to support banks in temporary liquidity stress so that they do not renege on their traditional promises to meet customers’ withdrawals on demand. The disbursement is by all intents and purposes, a loan facility, albeit for a short period, against defined objectives and pre-conditions set by the central bank.

First of all, a bank in liquidity stress would approach their counterparts in the money market for temporary accommodation, usually on overnight placement basis. When a particular bank persistently borrows on the money market, other market participants begin to be wary of the consistent borrower.

A diligent ALCO team in a bank may even alert the Treasurer to suspend dealings with the bank in distress or demand additional easily realisable collateral. The situation becomes even perilous when the borrowing bank begins to offer significantly above market rates for their borrowing needs. That itself is a signal of the depth of distress and would arise when the central bank pushes the ailing bank to source the latter’s needs from the market instead of relying on the regulator. This measure would be a means to ensure that the appropriate market rates prevail.

When it becomes obvious to the regulator that the distressed bank cannot find counterpart borrowing from the money market, the central bank steps in as a lender of last resort to assist the ailing back. The central bank’s principal reason for assisting the ailing bank is to avoid contagion effects where the ailing bank’s inability to service debts owed to other universal banks can trigger unforeseen consequences in the entire financial system.

It is obvious from the above that the emergency liquidity assistance (a fruit of the central bank’s lender of last resort function) is a loan by all definitions and not a gift to be dispensed capriciously by the recipient banks.

Following from this therefore, one would expect that the canons (principles) of commercial bank lending must come into play in determining why the borrowing bank needs the assistance in the first place.  This includes evaluating the profile of the borrower, the purpose and duration of the facility, pre- and post-disbursement conditions and the repayment source. The borrower’s capacity to repay the facility from mainstream operations is crucial, as also is the collateral.

Other critical issues that come into the evaluation of the borrowing request are the causal factors for the temporary or hard-core illiquidity and the reasons for the sudden loan expansion, if that was the remote or immediate cause of the liquidity crunch.

Early warning indicators should have been perceived in the ailing bank’s deteriorating capital adequacy ratios by the central bank.  It could also mean that the bank was suffering low deposit mobilization as a result of some reputational backlash or inappropriate expansion in fixed assets. Invariably, mass customer withdrawals would follow such adverse perceptions.

It would be highly expected that the ailing bank’s relationship officer at the Banking Supervision Department or an established team would have identified signs of distress beforehand from the reports submitted by the banks.

Even where the figures were cooked, suspicions should ordinarily lead to an examination of the ailing bank’s assets and liability portfolios respectively.

When liquidity shortages persist, they are often symptoms of deeper problems pla­guing the bank concerned. Chances are that the bank is facing high non-performing loans ratio which is depressing their liquidity and profitability. It could also mean that there is a massive mis-match between assets and liabilities where the universal bank has used short term deposits to fund long term assets, like the alleged equity investments in other banks or a multitude of subsidiaries which has drained its liquidity.

To qualify for such emergency liquidity support, therefore, the central bank would have determined that any pre-conditions for the grant of the facility have been met or are likely to be met sooner or within a prescribed time frame. As in the granting of Special Dispensation Authority by which the regulator waives the mandatory 10% liquidity ratio for a period, one would expect effective monitoring to ensure that the beneficiary of the dispensation would meet all the conditions set prior to the approval of the SDA, or waiver

It comes as a surprise therefore that a bank on life support would itself share its oxygen with other siblings or grandchildren and the central bank could not detect such infractions of the related party rules before things degenerated.  Some of these infractions border on mischevious machinations to avoid detection until all the packs were blown off by the Asset Quality Review, rather belatedly.

Sadly, a TV commentator is heard lamenting during a panel discussion on the emergency liquidity assistance “since when did the Bank of Ghana arrogate to itself who a universal bank lends to?”. I gasped for breath, bewildered that banking students would listen to such effusions ignorantly, particularly so when the emergency liquidity assistance is a direct lending facility from the central bank.

To require such assistance in itself   is an admission that the borrower is laboring under fundamental issues causing the liquidity shortage. Under current liberal dispensation, a commercial bank is not restricted as to who it lends to, provided the purpose of the lending is legal and the bank would not breach their single obligor limit, connected part y considerations or mandatory capital adequacy ratio.

The key question however, is which universal bank would lend without being interested in how the funds are subsequently applied and to whom? Why should the regulator itself (a lender) not be interested in how its EMERGENCY FUNDS are applied? Failure to monitor such loan application would amount to irresponsibility.

What appears to compound the issues is that the central bank holds the major clearing accounts of the respective banks. It is not clear whether the funds were credited to the defunct banks’ accounts in tranches or as lump sums and subsequently transferred to other parties without the central bank’s knowledge, seeing how the clearing system functions through each bank’s current account with the regulator.

Can we safely surmise that the central bank failed to identify the funds flow on these specific clearing accounts of the fallen banks? Who was in charge of monitoring how the emergency funds were disbursed? Were the affected banks respecting the conditions for the repayment of the emergency funding. or there were no conditions or criteria for usage and repayment at all?

Any diligent and smart relationship manager in a universal bank would be expected to ensure that a borrowing client is using the loan funds disbursed   according to the purpose of the loan. This person must gauge the ultimate beneficiaries of the customer’s cheques passing through the account. Why could the regulator not do similarly to ensure that the liquidity assistance was ring fenced and not dissipated capriciously as we are now being told.?

Granted that some of the funds were used to set up subsidiary companies even outside the country, how were these funds transferred to the affected foreign subsidiaries and was due process followed in respect of the outward direct foreign investment?

Another irony that is difficult to fathom is the length of time it took for the decay to be unearthed, seeing that all these infractions in the respective banks did not just spring up like an Indonesian volcano.

Can we say that all the respective relationship managers in the Banking Supervision Department failed to identify and report these infractions that are now causing heartaches for thousands of shareholders and the affected staff of the erstwhile banks? Or self-interest made the referee turn a blind eye to the rough tactics for the game to turn chaotic and detrimental to all stakeholders?

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