Banking in developing countries

Conventional wisdom would have it that one of the important obstacles to surmounting poverty is lack of access to formal banking services. It is assumed that once people are given access to bank accounts, they will manage their finances more efficiently, save more, and also leverage it to raise capital for their self-employment and other entrepreneurial needs.

However, as I have already written here, this may only be a partial interpretation. There is mounting evidence to show that conditional on access to a bank account, the majority of people use their bank accounts sub-optimally, most often as a mere storage for their cash balances. The Economist, which points to a newly released World Bank report (pdf here) on banking services usage across the world, writes,

The vast majority of people in developing countries - 88% - say they use banks solely for personal use. The commonest reason for taking out a loan, for example, is to pay for family emergencies (typically someone falling ill). That is followed by school fees, home construction and the expenses of a wedding or funeral. In Africa, 38% of those with bank accounts say they use them to receive remittances from family members abroad. One particularly important reason for having an account in Europe, Central Asia and Latin America is to bank money from the government, either salaries or benefits. In comparison, banks do not seem to be used so much for what seems like a basic purpose: saving money. More than a third (36%) of adults said they had saved some money last year. But only a fifth (22%) said they used a bank or other formal financial institution to do it; 29% saved, but not at a bank (presumably they put the money under the mattress or used it to buy jewellery).

 A few graphics from the report highlights these findings. Accounts penetration is very low in South Asia.



Even among those saving money, banks have not been able to marginalize the informal sources.

Further, a majority of those with bank accounts did not save.

Loans were mostly drawn for personal consumption than for business purposes. 

 Purchases of insurance products for health and agriculture is minuscule.
 

The last-mile challenge in banking for the poor

It has always been thought that lack of access to formal bank accounts prevented poor people from saving more and once accounts were opened they would be able to more optimally manage their finances. But now that we have made some progress, albeit tiny (only 5.5% of 650,000 Indian villages have bank branches and half the adults in the country do not have access to bank accounts), with access through the campaign for total financial inclusion (TFI), have the desired outcomes been achieved for those people?

Surprisingly, it does appear that having a bank account does not automatically translate into its use, much less efficient management of personal finances. Livemint points to a study by Skoch Development Foundation which found that only 11% of 25.1 million no-frills accounts opened between April 2007 and May 2009 are operational mostly because of the high costs.

India Development Blog points to an IFMR study of the impact of TFI campaign in Gulbarga District of Karnataka (claimed to have achieved 100% financial inclusion), which found that 36% of sample households remained without access to formal and semi-formal savings mechanisms and more importantly, access to bank accounts did not translate into bank account usage. It was found that the accounts were used mostly to manage NREGS payments or SHG transactions. Critical to the lesser than expected account usage is the high transaction costs, especially by way of travel costs.

I am inclined to believe that even if access to formal banking systems, by way of opening a bank account, is increased, actual usage is likely to remain low unless bridge the last mile gap and take banking to the door-step of the people, especially in rural areas. The recent decision by the Reserve Bank of India to approve the deployment of mobile bank business correspondents, equipped with electronic terminals, to transact at the sub-branch level is certain to increase the quality of access. This will ensure that, unlike now, rural account holders are more likely to actively transact using their accounts.   

In this context, mobile phones have the potential to revolutionize banking and increase utilization dramatically. Mobile phones-based technologies offer the attraction of directly placing the bank account in the hands of the customer, thereby lowering transaction costs and increasing the likelihood of account usage. It may therefore be tempting to get carried away by this possibility, coupled with a campaign to increase financial literacy, and assume that it will ensure account usage.

However, dovetailing NREGS and other government cash transfers through TFI accounts, extensive use of business correspondents and mobile phone-bassed technologies, and financial literacy, while necessary are not sufficient conditions to ensure optimal account usage.In fact, unless complemented with other initiatives, mere increase in access to banking accounts, could be counter-productive. It could just as easily enable access to debt and other less than desirable financial products, whose extensive adoption could be detrimental to the interests of the poor people.

Behavioural science teaches us that even with access to their accounts and adequate financial literacy, human beings are cognitively constrained. This in turn means that despite firm commitment to save or spend on certain things, people tend to renege and fall short on achievement. People discount the value of later rewards by a factor that increases with the length of the delay. They are therefore tempted to spend on immediate needs as opposed to save for important long-term requirements. Further, drawing from theories of "mental accounting", it has also been found that people tend to save optimally when they they know what they are saving for.  

It is therefore necessary that the bank accounts are structured to address these cognitive biases. This assumes importance since we need to bear in mind that the ultimate objective is not to merely enable access to bank account, but to enable poor people with systems to more effectively manage their scarce finances. What can be done to ensure that poor people save more, optimize on their interest returns, manage their long-term needs like health care, children's education and pensions, make more effective purchase decisions, and so on? In simple terms, how do we ensure that people not only manage their finances effectively, but also overcome their cognitive urges which are often determental to their interests?

I have written about several examples of how innovative financial products can overcome such cognitive biases and increase the likelihood of optimal outcomes for poor people with management of their finances. In fact, bank savings accounts and financial products, with subtle commitment features, have the potential to dramatically increase not only usage but also effective usage of bank accounts. I have bloggged earlier about Save More Tomorrow, default pension savings, lottery savings products, products to increase fertilizer consumption, multi-tier accounts (also here), and budgeting family expenditures. See also this and this.

In this context, there is a big window of opportunity. Bill and Melinda Gates Foundation have just pledged $500 million to helping poor people learn to save money. They propose to fund research and project interventions in this area to emulate the examples like the hugely successful mobile banking for the poor — via cellphone in Kenya and Bangladesh and smart card in Mexico. Spurred on by the low domestic savings rate, this area has been the focus of considerable interest in the US too. It is appropriate that some part of this be leveraged into experimenting with financial products and structured accounts that help overcome cognitive biases.

It needs to be borne in mind that TFI and optimal utilization of bank accounts by the poor needs to go beyond mere door-step acceess to bank accounts.

The return of Iceland?

Amidst all the gloom surrounding Europe, Iceland's apparent recovery from the depths of despair should be a cause for some celebration.The FT has a nice story that chronicles the Icelandic saga over the past five years.

Iceland's story till its meltdown in 2008 is classic Bubble Economics 101. The aggressive financial deregulation of early 2000s led to massive capital inflows and over-leveraged local banks. Asset prices inflated, construction activity boomed, businesses borrwed heavily in foreign currency and purchased assets abroad. Then the music stopped and the bubble burst, leaving the banks heavily leveraged, especially with foreign loans.

Iceland's recipe for restoring normalcy was to let its banks collapse and default on their loans. In contrast to countries like US, UK, and Ireland which injected billions to prop up their too-big-to-fail banks, Iceland let its inflated banking sector collapse. In 2008, the three biggest banks by assets – Kaupthing, Landsbanki and Glitnir - defaulted on $85bn of debt. This led directly to the collapse of the currency, the government and much of the economy. While the domestic assets of Iceland’s lenders were protected – costing the state 20% of GDP, according to the IMF – the lion’s share of the collapse was borne by foreign creditors.

Capital controls were introduced to prevent money leaving the country. The kroner underwent over 50% devaluation against the euro in 2007-08, which contributed towards restoration of national competitiveness. A rebound in tourism and fishing exports, boosted by the devaluation, have been critical drivers of the recovery. 

Iceland's economic recovery has been slow but unmistakable. As Paul Krugman has pointed out, the contrast with Latvia, which followed the orthodox prescription of fiscal consolidation and austerity, is stark.

On every parameter, the Icelandic economy has been making slow progress. In February, Iceland’s debt was upgraded from “junk” to investment grade by Fitch, the rating agency.

The FT article writes approvingly,

In August, Iceland completed a three-year IMF-supported restructuring programme, including loans of $10bn, and has started borrowing again on global credit markets. It has been held up by the IMF as a model of crisis management. GDP is set to expand by a respectable 2.5 per cent this year – which, added to last year’s 2.5 per cent, solidifies the sense of a country on the mend. The figures contrast with the 0.3 per cent contraction the European Commission expects in the eurozone this year.

But normalcy is still some distance away. The households and business balance sheets remain over-leveraged and it will be sometime before consumption and business investment will return to normalcy.  

The average household has suffered a 30 per cent fall in purchasing power since 2008. The private sector remains heavily indebted, with household debt levels exceeding 200 per cent of disposable income and corporate debt 210 per cent of GDP, according to Fitch. Partly because of this, domestic companies are reluctant to invest.

Market failure in the US Banking sector

NYT has an excellent graphic that illustrates the enormity of the huge concentration of market power in the US banking industry. Of the more than 8000 banks in the US, the top 3 have 44% of market share while the top 20 take 92%.



The Times article is spot on its assessment of the US banking sector in the aftermath of the sub-prime mortgage crisis,

Failure is as important to healthy capitalism as success. The nation’s handful of huge banks, however, are spared the indignity of failure... It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

In this context, more often than not, regulatory expansion will favor the existing entrenched big firms. In fact, even the current credit squeeze, by hurting the smaller firms disproportionately and also subsidizing the bigger firms, will only amplify the market power of the latter. This is a classic market failure, with potentially catastrophic systemic risk consequences (the TBTF moral hazard), crying out for policy intervention. The only way out of this systemic risk gridlock is to break-up the larger firms and disaggregate the concentration of market power and thereby risk.

In light of both the obvious danger of systemic risk caused by a few large firms and the fresh memory of the banking sector trends in the aftermath of the sub-prime crisis, one can only assume that policy makers are being deliberately obtuse if they can't get round to pulling the plug on the banking behemoths.

The banking sector bailout debate resurfaces

In a recent post, Felix Salmon had a bleak assessment of the Eurozone crisis,

"In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse."

As the increasing bond yields and CDS spreads indicate, the European credit markets are pretty much freezing up. As reflected in the dismal response in recent auction, even the Teutonic credibility of the German bund has taken a dent. Governments are finding that debt refinancing has become very expensive. Banks, with heavy sovereign debt exposures, have become averse to lending anymore, not only to sovereigns but also to each other. Further, they also face rising margin calls due to heightened sovereign debt default risks. The risk of assets turning sour and demand for increased capital requirement (from margin calls), is turning an initial liquidity crisis into a solvency crisis for the banking sector.

In the circumstances, there are two options. The interventionists advocate aggressive measures to restore credit markets (through rate cuts, liquidity injections, credit guarantees, and asset purchases) and bank recapitalization with stringent conditions attached. This is effectively a call to the central bank to step in as a lender, buyer, and insurer of last resort. It would also involve governments taking stakes in banks. Felix Salmon too prefers intervention. His prognosis about the fate of Eurozone is based on this assumption. He believes that the ECB's intransigence and failure to act has driven away the confidence fairy.

The sceptics counter that such measures are likely to be futile. They oppose such bailouts as rewarding reckless and greedy bankers. They also argue that it would merely postpone the hard decisions and belt tightening that are necessary to remove the excesses and distortions created by the skewed pre-crisis growth. Finally, they associate it with trying to restore growth in the aftermath of an asset bubble by inflating another bubble. They point out that the extraordinary monetary easing and liquidity support has the potential to amplify distortions and destablize global financial markets. It would also come in the way of the much needed croeconomic rebalancing among economies of the developed and emerging world.

In this context, as Christina Romer points out, the nature of the response matters critically with any interventionist approach. She points to the contrasting experiences of Sweden in 1991 and Japan in 1992 after their respective banking crises. The former nationalized its banks, recapitalized with public funds, and then returned to private control, with the result that the country returned to its pre-crisis trend within three years. In contrast, Japan refused to clean up its banks, rolling over loans to failing companies, with the result that it continues to grapple with anemic growth and deflation for almost two decades.

It is difficult to make a satisfactory enough judgement call on either position from merely theoretical principles or historical experiences. Both sides could be right and wrong in different ways. In simple terms of a cost-benefit analysis, which option generates higher net benefits? Alternatively, which option would generate the least costs or the less worse set of distortions? Unfortunately, these questions do not have convincing enough answers.

But it is undoubtedly true that bailouts generate moral hazard by taking away the biggest disciplining factor of capitalism. And, as the recent evidence has shown, such bailouts, perversely enough, end up concentrating risk by making the TBTF institutions even bigger.

Update 1 (21/12/2011)

In its role as lender of last resort to banks, the ECB allocated 489.2 billion euros, or $644 billion, to 523 institutions through its longer-term refinancing operations, or LTROs. The loans are for three years and will be at the benchmark 1% interest rate. This is the largest amount ever allocated in a single ECB liquidity operation and first time ECB has extended loans for maturities beyond one year. ECB had started the liquidity operations in the aftermath of the Lehman collapse. It announced that another LTRO will be held in February 2012.

The three-year loans are designed to compensate for a dearth of longer-term market funding, at a time when banks are facing the need to roll over an extraordinarily high amount of their own debt. Banks in the euro zone must raise more than 200 billion euros in the first three months of 2012.

The cheap loans issued by the ECB may also indirectly help governments like Spain and Italy that have faced higher borrowing costs. Spain paid sharply lower interest on debt it auctioned early this week, as banks appeared to use cheap ECB money to buy the bonds, profiting from the difference in interest rates. However, the proceeds could also be used to re-finance existing assets as they become due in the months ahead.

The ECB, as part of its effort to prevent a credit crunch, also broadened the collateral it will accept in return for loans. It is even accepting outstanding loans as security, a measure designed to help smaller community banks that may lack conventional forms of collateral like bonds.

The "mother of all bailouts" unmasked!

A Bloomberg investigation has revealed the stunning magnitude of the post-Lehman financial market bailout. Hitherto information about only the $700 bn Troubled Assets Relief Program (TARP) was made public and the details of the liquidity injection facilities were withheld on grounds that it would stigmatize borrowers and thereby destabilize market confidence. However, it now emerges that the Fed's liquidity infusion support dwarfs the TARP and should rightly assume the moniker of the "mother of all bailouts"!

As the crisis deepened, the Fed had to expand its traditional discount window to provide liquidity support to the frozen credit markets. By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources. Such credit support involved reduced credit standards and collateral requirements.

The report finds,

Add up guarantees and lending limits (to direct lending), and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the US that year... The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy.

While TARP credit had some strings attached, the liquidity injections came without any conditions attached and was a virtual doleout. And these banks, including foreign ones, profited by atleast $13 bn from the Fed's below market lending rates. It is no wonder that the Fed and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. The report writes that the witholding of this information helped the banks ward off pressures for greater regulatory oversight,

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse... While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.

The hypocrisy of concealing the fact of being under life-support while at the same time publicly claiming stability and strength is captured in the report,

"On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed 'one of the strongest and most stable major banks in the world'. He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day."

On Sept. 21, 2008, a week after Lehman went bankrupt, Goldman Sachs converted to a bank holding company, gaining access to the Federal Reserve's last-resort lending program for banks, the discount window. While it took only $50 million from the window, New York-based Goldman Sachs had been borrowing from the central bank for six months from two temporary programs for broker-dealers: the Term Securities Lending Facility and the single-tranche open market operations, or ST OMO. On Dec. 31, 2008, Goldman Sachs had $34.5 billion of loans from ST OMO, some of it at an interest rate of 0.01 percent. "We weren't relying on those mechanisms", Goldman CEO Lloyd Blankfein told the Financial Crisis Inquiry Commission in January 2010.



The exposures of the six biggest financial institutions were staggering. The six biggest US banks, received $160 billion of TARP funds and borrowed as much as $460 billion from the Fed (measured by peak daily debt), and accounted for 63% of the average daily debt to the Fed by all publicly traded US banks, money managers and investment-services firms.



See the interactive graphic here.

Rating agencies are back in focus

Rating agencies continue to make news, for all the wrong reasons. Over the past few days, there have been three illustrations of how decisions of rating agencies have contributed towards their declining credibility.

Just before the market close on Thursday last week, the Standard & Poor’s (S&P) erroneously sent out an e-mail suggesting that it had lowered the rating on France’s sovereign debt. The mail shook the markets and forced up French bond yields,

"In a statement, S&P attributed the message to "a technical error" and affirmed that the rating was unchanged. But the yield for France’s 10-year benchmark bond jumped more than a quarter point, to 3.48 percent, and the spread between French and German bonds of that duration reached 1.7 percentage points, a euro-era record... The erroneous S.&P. message went out shortly before 4 p.m. Paris time, and the correction was issued almost two hours later, after most European markets had closed."

Simultaneously, in India, Moody's Investors Service revised its outlook for India's banking system to negative from stable. It attributed the downgrade to increasingly challenging operating environment that will adversely affect asset quality, capitalisation, and profitability of Indian banks; high inflation; monetary tightening and rising interest rates; and the crowding out effect of government's massive borrowing program.

Just a day after the Moody's downgrade, S&P went the opposite direction and upgraded the sector from group '6' to group '5', the same as the other similar economies. Its argument

"Dependence on stable bank deposits due to an extensive branch network and limited dependence on external borrowing made India's banking system low-risk on system-wide funding... In our view, banking regulations in India are in line with international standards and the regulator ( RBI) has a moderately successful track record".

So what do we make of these contrasting ratings signals? Do investors and financial market actors go by the fact that since S&P is larger entity, its ratings should be given greater credence? In this context, The Gold Standard has an excellent post where it compares the Moody's decision on India's banking sector with that on China's similarly troubled banking sector. He wrote,

"The price India has paid for its relative transparency on its problems is a negative outlook. The more opaque it is, the higher the rating. That is why these agencies gave AAA ratings to CDOs, CDO-squared and to CDOs on CDOs...

Its giant neighbour to the North has an entirely State dominated banking system and an economy with even greater financial repression. It systematically under-counts and under-reports its bad debts. Those who dare to raise their voice are forced to withdraw their reports.

Banks have large exposure to local governments who are dependent on land banks sales for their revenues. Banks have exposure to developers who want the prices of land banks to decline. Their apartment prices are dropping and transactions are plunging. So, we have no idea of the true health of Chinese banks or, for that matter, the whole economy. We will never have one. Yet, on November 8th, Moody’s reaffirmed its ‘stable’ outlook for Chinese banks."

It is hard not to be baffled by the clear inconsistency in these rating decisions. In fact, during the ongoing European debt crisis, on several occasions ratings downgrade decisions by one or the other of the three big rating agencies have triggered market downslides. There is a strong and credible enough view that the decisions of ratings agencies could contribute towards turning a liquidity crunch into a solvency crisis. It is therefore no surprise that a growing number of opinion makers hold the view that the ratings agencies hold disproportionate power, whose exercise has, as numerous events of the past four years have shown, been questionable.

The emergence of corporate monopolies in the US

Nancy Folbre points to a Monthly Review article which notes that in 1995, the six largest bank-holding companies (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) had assets equal to 17 percent of gross domestic product in the United States. By the third quarter of 2010, this had risen to 64 percent. This graphic from Mother Jones captures the evolution of this concentration of market power over the last decade.



The Monthly Review article points to similar concentration of market power and emergence of monopolies across different industries. The number and percentage of US manufacturing industries that have a four-firm concentration ratio of 50 percent or more have risen dramatically since the 1980s. More and more industries in the manufacturing sector of the economy are tight oligopolistic or quasi-monopolistic markets characterized by a substantial degree of monopoly.



This concentration of market power has been a constant theme across sectors. The graphic below shows the rise in four-firm concentration ratios in six key retail sectors and industries, over the fifteen-year period, 1992-2007. Most remarkable was the rise in concentration in general merchandise stores (symbolized by Wal-Mart), which rose from a four-firm concentration ratio of 47.3 in 1992 to 73.2 percent in 2007; and computer and software stores from a four-firm concentration ratio of 26.2 percent in 1992 to 73.1 percent in 2007.



Another graphic highlights the rising share of the top 200 US corporations as a percentage of total business revenues in the US economy over the 1950-2008 period. The revenue of the top two hundred corporations has risen steeply since the mid-nineties.



In this context, a pathbreaking scientific study of the network of global corporate control by Stefania Vitali, James B. Glattfelder, and Stefano Battiston has thrown up several astounding insights. They mined the Orbis 2007 database of 37 million companies and investors worldwide and mapped the ownership and control networks of all the 43060 trans-national corporations (TNCs). Then they constructed a model of which companies controlled others through shareholding networks, coupled with each company's operating revenues, to map the structure of economic power. They write,

"We find that, despite its small size, the core holds collectively a large fraction of the total network control. In detail, nearly 4/10 of the control over the economic value of TNCs in the world is held, via a complicated web of ownership relations, by a group of 147 TNCs in the core, which has almost full control over itself. The top holders within the core can thus be thought of as an economic "super-entity" in the global network of corporations. A relevant additional fact at this point is that 3/4 of the core are financial intermediaries."

How we got here and what is the way forward with bank reforms

Andrew Haldane, Executive Director at the Bank of England, is one of the leading and credible voices championing financial regulation reforms so as to prevent a recurrence of events that led to the sub-prime mortgage meltdown. His most recent speech, the Wincott Annual Memorial Lecture, is an excellent chronicle of banking industry and summarizes his reform proposals.

He describes the source of a governance fault-line in banking sector,

"Ownership and control rights are exercised by shareholders. But for banks, equity is a vanishingly small fraction of their balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society. This fault-line lies at the heart of the imbalance between privatised returns and socialised risks. Only in banking do control rights and incentive wrongs combine so uncomfortably."

He traces the evolution of the banking sector since the nineteenth century - unlimited liability moved to extended liability and finally to limited liability. Given limited liability, bank managements realized the benefits of excessive risk taking - the downside losses were capped, while the upside gains were all theirs. This meant that volatility with high upside gains increased the returns on equity. Similarly, higher leverage too enabled equity holders to amplify their returns on equity.

With equity holders having increasingly limited skin in the game, the other possible restraint on excessive risk taking, arising from debt holders (who could either have demanded higher returns on their investments or even denied their funds), too started breaking down. The disciplining role that debt holders had exercised on banks started failing for various reasons, the most prominent being the realization that governments will step in and bail out failing banks.

A measure of the too-big-to-fail (TBTF) subsidy of UK and global banks, based on different models, rose dramatically in the build-up to the sub-prime crisis. For the global banks, the TBTF subsidy is worth at least hundreds of billions of dollars per year. This subsidy is also a measure of the risk mispricing by bank debtors, and by implication also the extent of dilution in debtor discipline.



Finally, there is the executive compensation system that rewards short-term equity market gains over more sustainable value addition. Return on equity (ROE), with quarterly periodicity, has become the guiding post on evaluating manager performance and shareholder returns. Haldane describes how the shorter-term investors in bank equities gained from volatility,

"Institutional investors in equities are typically structurally long. They gain and lose symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions. If their timing is right, they can win on both the upswings (when long) and the downswings (when short). For them, the road to riches is a bumpy one – and the bigger the bumps the better. As in Merton’s model, all volatility is good volatility. Perhaps reflecting that, there is evidence of the balance of shareholding having become increasingly short-term over recent years... Average holding periods for US and UK banks fell from around 3 years in 1998 to around 3 months by 2008. Banking became, quite literally, quarterly capitalism. Today, the average bank is owned by an investor with a time-horizon considerably less than a year...

What we have, then, is a set of mutually-reinforcing risk incentives. Investors shorten their horizons. They set ROE targets for management to boost their short-term stake. These targets in turn encourage short-term risk-taking behaviour. That benefits the short-term investor at the expense of the long-term, generating incentives to shorten further horizons. And so the myopia loop continues."

Increased volatility, high leverage, and distorted basis for calculating management compensation and return on shareholder investments favors the short-term investor and the management over all others. All this coupled with the basic "governance fault-line" meant that incentives became badly mis-aligned all round.

He captures the results of all this in a few stunning figures. In the 1880s, total UK bank assets were equal to 5% of GDP. At the bubble peak they were 500%. The assets of the UK’s three biggest banks at the start of the 20th century were 7% of GDP. By the end of it they were 75%, and by 2007 it was 200%. Leverage climbed from 3-4 times in the 19th century to 30 times in the bubble. And return on equity went from modest single figures to 30% at the peak. As to executive compensation among the CEOs of the seven largest US banks, in 1989 it averaged $2.8 million, or almost 100 times the median household income. By 2007, it had risen ten-fold to $26 m, over 500 times the median US household income. Most astonishingly, temporary support for the global banking system during the crisis peaked at around a quarter of global GDP.

Haldane suggests four financial market regulation proposals

1. Higher equity capital. He writes about its benefits

"It would put more skin in the game for equity-holders, thereby reducing their incentives to extract option value. It would reduce leverage directly, thereby reducing banks’ capacity to risk-up. And it would increase banks’ capacity to absorb loss, thereby reducing the probability of official intervention."

He favors much higher capital reserve ratios than that being considered under the Basel III norms. More radically, he favors equalizing the scaales between equity and debt, thereby forcing debt holders to have much greater skin in the game and encourage them to play their traditional disciplining role.

2. Equity-like liabilities

He favors the use of financial instruments which explicitly combine the incentive features of debt and equity, the so-called contingent convertible securities or CoCos. They are debt in good times, but convert to equity in bad, and combines the benefits of unlimited liability without its practical drawbacks.

However, such instruments should be time-consistent (they should kick-in without discretion and expectations of its kicking in should not distort market incentives).
He suggests that the bank management should have no discretion on when and how conversion takes place. Further, conversion needs to take place well ahead of bankruptcy, thereby avoiding the deadweight costs of default which, for too-big-to-fail institutions, are likely to be too large to be tolerable by the authorities.

As a trigger for the conversion, Haldane prefers market-based measures of capital adequacy, like even equity prices. This would be better that regulatory ratios which can be tweaked to suit requirements. Such triggers would expedite pre-emptive recapitalisation of failing institutions and contain the spread of risks.

3. Control rights

Haldane prefers a ownership and control rights model that is a right mixture of the two extremes of a public limited company (rights vested in a small minority and voting rights assigned according to portfolio weights – an equity dictatorship) and the mutually-owned co-operative (rights spread over a wide set of liability-holders, with voting rights unrelated to portfolio weights – a liability democracy). Voting rights could be extended across a wider set of liability stakeholders, with rights allocated on the basis of their deposits, thereby ensuring that governance and control are distributed across the balance sheet - a wealth-weighted democracy.

4. Performance and compensation

he advocates moving over from a system of evaluating performance based on ROE to one based on return on assets (ROA). This covers the whole balance sheet and, because it is not flattered by leverage, does a better job of adjusting for risk. He writes that if the CEOs of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA, by 2007, their compensation would not have grown tenfold but would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times.

The savings rate de-regulation

The decision by the RBI to deregulate bank savings rate in its second quarter monetary policy review is one of the most progressive and efficiency increasing reforms in recent years. All banks are currently mandated to pay an interest of only 4% on savings account deposits.

In one stroke it eliminates one of the last remaining glaring incentive distortions in India's banking sector. With 26% of the total bank deposits (as on June 2011) being in the current and savings bank accounts, banks hitherto benefited hugely from an artificially lower cost of funds.

It is expected to increase depositors’ interest income by around Rs 9000 Cr. The Businessline reports that assuming the savings bank deposit rates of banks rise by 1 percentage point, profits before provisions and taxes will be lower by 9.3 per cent (based on FY-11 profits) if they do not pass on the deposit rate hikes to borrowers.



This decision increases competition, lowers entry barriers, encourages savings, and contributes to strengthening the financial markets and increasing the effectiveness of the monetary policy transmission channels. In simple terms, it is one of the rare policy decisions which aligns incentives of all stakeholders and increases overall efficiency of the system. Here is a summary of its benefits.

1. It will increase competition among banks and thereby increase all round efficiency in the sector. Banks will be forced into raising deposit rates so as to attract depositers and also allocating their lendings into the most profitable avenues.

2. It lowers entry barriers by working to the advantage of smaller banks and newer entrants. They have hitherto suffered from a system where location of branches conferred an unfair first-mover advantage. Now with the freedom to price their depsoit rates, these banks can hope to attract accounts by signalling with more competitive rates. This was evident in the immediate aftermath of the decision, with Yes Bank announcing hiking its deposit rates by 200 basis points.

3. It will force banks into diversifying into other transaction and advisory services which will in turn enhance the breadth of India's financial system. This will be felt with much greater force by the public sector banks who have a higher exposure to low cost savings bank deposits. Hitherto, the ceiling on deposit rates had provided banks with a large easy source of money and comfortable assured profits from it (SBI alone loses Rs 1500 Cr for every 50 basis points increase in deposit rates). To this extent, the incentives were not aligned towards getting banks to search for alternative sources of revenues.

4. On the consumers side, given the dominant role of banks in household savings, especially of savings bank accounts in case of the poorer people, this deregulation will enable them to get higher returns on their deposits. This will in turn boost household savings and also encourage people in rural areas to utilize bank accounts to channel and save their incomes. Banks too are certain to come up with more differentiated savings products.

5. It increases the effectiveness of monetary policy transmission mechanisms. As deposit and lending rates are arrived through a competitive process, any changes in the repo rates will, in normal times, is more likely to be transmitted quickly into the financial system and the economy.

No lessons learnt - The UBS ETF scam

The $2 bn loss incurred by the rogue UBS trader Kweku Adoboli is surely another big blow to the confidence of the embattled European banking sector. It is also a reiteration of the fact that financial market regulators and governments have learnt little from the bitter lessons of the sub-prime mortgage meltdown.

Adoboli headed the Exchange Traded Funds (ETF) trading desk, which packaged ETF-based derivatives and transacted its trades for clients, and which are typically hedged to minimize risks. But Adoboli did not always hedge them, thereby exposing the bank to huge swings.

ETFs track financial indices and its value arises from either directly from an underlying index fund or a derivative with the index fund as the counterparty. It is the later which makes ETF's risky. If the counterparty suffers a huge loss, leaving it without the funds to service the derivative contract, then the ETF owner suffers huge losses.

Further, depending on the complexity of the packaging of the underlying index funds, the risk is dispersed far and widely across, making it difficult to accurately locate and price risk. In recent years, as ETFs have gained popularity, investment banks have even been packaging ETF derivatives to create "synthetic" ETFs (the counterparty is another set of derivatives). In this regard, it is similar to the complex and highly opaque Collateralized Debt Obligations (CDOs) and synthetic CDOs constructed by splicing and dicing and then packaging pools of mortgage loans.

The risks from activities of traders like Adoboli go beyond these. His 'Delta One' trading desk effectively conducted both client and proprietary trading. Investor clients were promised certain benchmark returns, with the excess returns going to the bank (and those in the trading desk), an incentive for the traders to take extra risk, often leveraging their employer's (bank's) balance sheet. Sometimes, even as banks sell ETF's to their clients, they themselves form the derivative counterparty (positions often taken with their proprietary capital), thereby creating the potential for deeply undesirable conflicts of interests.

Adoboli is only the latest in the long history of such rogue traders - Tomonori Tsurumaki of Sumitome, Nick Leeson of Barings, and Jérôme Kerviel of Société Générale - who caused huge losses to their employers and clients. Incidents such as these lend further weight to the argument that even the best monitoring cannot firewall a determined trader who tries to systematically mislead his employer, even over long periods of time. This naturally revives calls about separating commercial and investment banking operations in big financial institutions. An editorial in FT succinctly sums up the need of the hour,

"The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled."

The final report of the Independent Commission on Banking, appointed by the British Government to improve stability and competition in the British banking system, and headed by John Vickers, which was released a few days before, has much the same to say. It calls for ring-fencing investment and deposit taking retail banking and alos higher capital buffers for investment banks to limit systemic risks.

Ring-fencing will limit the taxpayer guarantees to individual and business depositers and will not cover the risks taken by traders within the investment bank. Today, the deposit insurance guarantee within the large universal banks (that combines all activities, not spearated from each other), acts as an effective public subsidy for their private investment banking activity. As Martin Wolf has argued, ring-fencing, and not outright separation (as was the case during the Glass-Steagall era in the US, which was replaced with the Gramm-Leach-Bliley Act in 1998), will retain the benefits of a single management - like an investment bank bailing out its failing retail banking division.

In this context, Matt Taibi raises an important point about inherently risk-taking investment banking traders and the apparent incompatibility of their activities with the need to protect the interests of retail depositers and tax payers. He argues that there is little distinction between rogue traders and most investment bankers, in so far as both have the freedom to take excessive risks with their client's money and bear limited direct and immediate responsibility to their clients' interests. He writes scathingly about the adverse consequences of the legal end to separation of retail and investment banking and the inherent risk-taking nature of investment bankers,

"the brains of investment bankers by nature are not wired for "client-based" thinking... it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts... Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month... investment bankers by nature have huge appetites for risk...

The influx of i-banking types into the once-boring worlds of commercial bank accounts, home mortgages, and consumer credit has helped turn every part of the financial universe into a casino... They’re not "rogue" for the simple reason that making insanely irresponsible decisions with other peoples’ money is exactly the job description of a lot of people on Wall Street... they don’t call these guys "rogue traders" when they make a billion dollars gambling.

The only thing that differentiates a "rogue" trader like Barings villain Nick Leeson from a Lloyd Blankfein, Dick Fuld, John Thain, or someone like AIG’s Joe Cassano, is that those other guys are more senior and their lunatic, catastrophic decisions were authorized... if you're a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book... rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts."

Felix Salmon's makes this excellent case for separating or atleast ring-fencing retail/commercial and investment banking activities,

"When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so."

Moral hazard, systemic risk, and financial markets

It is increasingly evident that the regulators and policymakers have learnt little from the bitter lessons of the sub-prime mortgages meltdown induced global financial market crisis.

As Simon Johnson points out in an excellent post, the numbers of too-big-to-fail banks looks set to grow as more mergers are in the pipeline, despite growing signs of risk build-up. He points to the recent decision of beleaguered Bank of America (BofA) to court and accept $5 bn from America's most credible investor, Warren Buffet, as sure sign of serious troubles at the bank.

The bank is the largest bank-holding company in the United States, with assets at the end of June of more than $2.26 trillion. It services one in five home loans, and with 5,700 branches assembled through decades of mergers, it counts 58 million customers. Investors are worried at BofA's long-term health, despite the roughly $20 billion set aside to atone for its mortgage misdeeds at the height of the housing bubble, in light of the $ 9bn in losses suffered by the bank over the past 18 months.

He also points to an interesting NBER working paper by Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh who highlight the distortions in the price of put options for the financial sector stock index relative to put options on individual banks' stocks. Put options, which are effectively an insurance against price collapses, are cheaper if investors percieve less risk of such eventualities. They write,

"Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks... The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis."

The authors find that index puts were a lot cheaper than the appropriately weighted sum of put options on individual bank stocks, especially during the recent financial crisis. They argue that because "investors price in substantial government bailout guarantees for the financial sector as a whole", they find little need to insure privately against overall collapse. This disproportionately benefits the TBTF institutions (over smaller institutions), since any problems individually affecting each of them will translate into a risk for the financial sector as a whole.

In simple terms, the moral hazard created by the sub-prime bailouts and the the resultant market expectations have had the effect of lowering the price of risk for the TBTF institutions. The cause of this risk reduction being the effective bailout guarantee for TBTF institutions that governments provide. The handful of TBTF institutions are so large that they have become proxies for the financial market itself. As Simon Johnson writes, "No other sector in the United States economy gets anything like this kind of insurance". I would call it subsidy.

Incentivizing savings habit among the poor

The government of India have initiated a Total Financial Inclusion (TFI) program to ease formal institutional credit constraints and expand their ability to manage their finances more optimally. However, while the policies under implementation may achieve success with the former, the later remains a much more formidable challenge.



The prevailing set of policies, revolving around the TFI program and door-step banking through business correspondents, will deliver a savings bank account to every citizen. It is also being suggested that the Aadhaar number and Aadhaar-linked savings bank bank accounts could provide the ideal platform to implement the proposed cash transfer schemes to deliver subsidies. All these will still not address the ultimate objective of getting people to optimally utilize their savings bank account to manage their finances efficiently. The challenge will be all the more bigger in promotion of savings among those poor who are more acutely present-biased (or have greater self-control problems).



Promotion of savings habit among the poor has been an area of interesting research in recent years, driven mostly by trends and developments in behavioural economics. Economists like Sendhil Mullainathan have expanded on Richard Thaler's mental accounting framework to explain how people's subliminal predisposition to categorize and evaluate savings and spending decisions can be invoked to nudge people into managing their finances more optimally.



I had blogged earlier about the merits of a system which divides income into separate, end-use based mental accounts.

"It helps people manage their finances more effectively in two ways. One, people are inclined to save if they are aware of what they are saving for. For example, a "car account" is a strong nudge to get people to save for purchasing a car. Two, separation of expenditure heads with pre-defined allocations help in effective management of expenditures."

Based on the mental accounting framework, I have also blogged about the merits of use-directed multi-tier accounts to nudge people into saving for specific purposes.



In this context, the most recent research paper (pdf here) on incentivizing savings among the poor come from an experiment among the rotating savings and credit associations (ROSCAs) of Kenya by Pascaline Dupas and Jonathan Robinson. They provided members of 113 ROSCAs in Kenya with different household and ROSCA savings instruments (like individual lock and key boxes and ROSCA health pot) to save for health and other contingencies and found that it could "substantially increase investment in preventative health, reduce vulnerability to health shocks, and help people meet their savings goals".



They also found that providing people with a designated safe place to keep money was sufficient to overcome the common barriers to savings - transfers to other people and "unplanned expenditures" on temptation goods - through a mental accounting effect ("The money put into the box was seen by respondents as 'for savings' and was therefore less likely to be spent on luxuries or given away to others").



The find strong evidence that use-directed commitment savings products can be effective in promoting savings even among the more present-biased individuals. The ROSCA health pot was a commitment savings approach wherein a sub-group in a ROSCA could agree on a health product and provide additional contribution (over and above their ROSCA contribution), which could be redeemed each month to purchase the particular health product for one member at a time. They write about the present-biased members of the ROSCA,

"The enthusiasm that led them to sign up for the Health Pot tied their hands not only to spend the money a certain way, but also to continue to save on a regular basis (i.e., at each ROSCA meeting). This strong social commitment feature is the only one that enabled present-biased individuals in our sample to overcome their barriers to savings."

They point to an earlier study by the same authors from the same area in Kenya which found that providing simple bank accounts to wmone who run small vending businesses had substantial savings impact only on about 40% of them. They write,

"Since the bank accounts did not provide any form of earmarking or a strong commitment feature, their primary function was likely to provide a designated place to save. The present study suggests that more sophisticated devices that include stronger commitment features might be better suited for some of those individuals who did not use the simple savings account. For others, it appears that a less sophisticated but more easily accessible device such as a Safe Box would be better suited to save small sums on a regular basis."

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

Iceland Vs Ireland?

Almost alone among those who faced the depths of the financial crisis, Iceland refused to bailout its financial institutions. It placed its biggest lenders in receivership and chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion (11 times GDP). In other words, the creditors, not the taxpayers, shouldered the losses of banks.

The krona lost 58% of its value by the end of November 2008, inflation spiked to 19% in January 2009 and GDP contracted by 7% that year. The Prime Minister Geir H. Haarde resigned after nationwide protests.

As a Bloomberg report argues, if early signs are any indicator (with economy projected to grow 3% in 2011), then Iceland’s decision to let the banks fail is looking smart and may provide important lessons for others. The GDP grew for the first time in two years in the third quarter, by 1.2%, inflation is down to 1.8%, the cost of insuring government debt has tumbled 80%, and banks have bounced back into the profitability.

The three biggest Icelandic banks - Kaupthing Bank hf, Landsbanki Islands hf and Glitnir - who had indulged in the spectacular lending spree at home and overseas were seized by regulators on October 6, 2008. The Bloomberg report writes,

"The government negotiated with the creditors, almost all of them outside the country, including mutual funds and hedge funds in the US and the UK and European banks and pension funds. Kaupthing’s creditors agreed to take an 87% stake in Arion, and Glitnir’s creditors now own 95% of Islandsbanki. Glitnir’s biggest creditor as of June was Dublin- based Burlington Loan Management Ltd., followed by Royal Bank of Scotland and DekaBank Deutsche Girozentrale, the fund manager for Germany’s state-owned savings banks.

Glitnir’s 8,500 creditors and Kaupthing’s 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks’ debt and asset valuations by the resolution committees. About half of Kaupthing’s creditors are German depositors who had Internet accounts, have gotten their principal back and are seeking interest payments.

Landsbanki’s creditors opted for a promissory note from successor NBI hf instead of a stake in the new bank. Landsbanki had collected about $5 billion of overseas deposits through branches in the U.K. and the Netherlands. Iceland didn’t guarantee those deposits at the time it seized the bank, as it did for domestic customers, leading to a dispute with the British and Dutch governments. In December, Iceland agreed to compensate the U.K. and the Netherlands in full for their payments to Icesave depositors, as the Landsbanki accounts were known. Payment, including interest of about 3 percent, will be made over 35 years."

In contrast, Ireland guaranteed all the liabilities of its banks when they ran into trouble and has so far injected 46 billion euros ($64 billion) as capital so far to prop up these banks. The result is an unsustainable debt burden that could swell to twice its GDP, up from 94% now and the near certainty of a sovereign debt default. It is a widely held feeling in Icleand that if it had guaranteed all the banks’ liabilities, they would have been in the same situation as Ireland.

See this Vanity Fair article by Micheal Lewis on Ireland. Micheal Mandel has an excellent series of graphics that puts the role of external sector, exports/imports and financial profit repatriations, on Ireland's economic fortunes in perspective.