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Northern Rock: Time for protection of SA depositors?

25 October 2007 Werner Behrens, Knowles Husain Lindsay

Although logic dictates that banks, who are there to make money for their shareholders, should be allowed to fail through bad decision-making, especially if they engage in unusually risky practices, it's not as simple at that.

A banks protection lies in "the preservation of the stability of the financial system/banking sector" and "the protection of depositors". Indeed, the bigger and more wide-spread the mess, the more likely the chance of state intervention. Shareholders mostly lose value but not all when the state intervenes, as was the case with Northern Rock in the UK.

But, questions Werner Behrens of legal specialist Knowles Husain Lindsay, can South African banking shareholders bank this?

"Banks depend on the inter-bank lending market for their liquidity requirements and also take a credit view on one another. In the case of a mortgage lender, as its liabilities are short term yet assets are long term, it is hugely dependent on the inter-bank market," explains Behrens.  "A negative sentiment about a bank can cause many depositors to withdraw at once, causing a liquidity shortage and by this time the bank is usually not able to access the inter-bank market."

He compares UK's Northern Rock (still standing) with SA's Saambou (demised) as a case in point.

Northern Rock started out as a small regional bank, but in recent years has grown to become one of the UKs largest mortgage lenders. The crisis in the US sub-prime mortgage market (which could probably be defined as a risky practice) created a huge strain in the London inter-bank market, as the banks did not know one anothers exposure to this fall-out.

"Northern Rock was the victim. Unlike its counterparts in the US and Europe, who injected liquidity into those markets, the Bank of England initially failed to do so, and when it finally did, this in itself caused a depositors run on Northern Rock. Eventually the Chancellor of the Exchequer stabilised the situation by agreeing to guarantee all deposits held by Northern Rock.  And Northern Rock continues."

In South Africa, Unifer (a subsidiary of ABSA) failed in January 2002, and Saambou was placed under curatorship a month later. As at Northern Rock, mortgages formed a large part of the business of Saambou.

Behrens explains that a sustained fall in its share price coupled with persistent rumours on irresponsible lending in the micro lending market caused Saambou's downfall. Here, however, Treasury refused to come to its assistance, albeit rumoured to be against the advice of the Reserve Bank, apparently because of their concern about systemic risk. Indeed, the banking system did take strain.

"The biggest casualty was BoE which, notwithstanding a sound asset base, ran into liquidity problems due to the resultant discrimination by the big banks against the smaller (so-called A2) banks in the inter-bank lending market. However, Government then came in with support in this instance."

He points out that following this, government did put in quite a blunt marker bank shareholders cannot assume that a bail-out will happen.

After Saambou, a number of things happened.

"The A2 banks all but disappeared off the scene resulting in SARB's banking supervision having fewer headaches to deal with. In addition, banking supervision also sharpened its pencils, in itself a comforting tool at the prevention level," comments Behrens.  "Securitisation of loan books took off, spreading retail risk in the market place. Basel II caused the banks to become much more sophisticated in their credit analysis -the irony of course is that it ostensibly did not prevent the huge boom in the sub-prime mortgage market."

He says a big risk for government is the concentration in the banking sector, which is largely off-set by the even bigger majority shareholders of most of the banks, who can be called to the party if needed, as is the case when Old Mutual underwrote the rights issue of Nedbank when its capital came under strain..

"The seemingly limited impact of the US sub prime market crisis bodes well for the local banks if it is a measure of their risk appetite," believes Behrens.

The National Credit Act also impacts on financial institutions. The Act aims to promote responsible credit granting and use, which should mean that banks cannot lend money to people who cannot afford to repay the loan. In contrast, the UK banking sector is highly deregulated and the general secretary of the OECD commented recently that not only will over-regulation stifle innovation, but he doubts that it will work.

Behrens says in the aftermath of Saambou, the introduction of an explicit deposit insurance scheme, to protect depositors from losses arising from the failure of a bank, was also mooted but nothing happened.

Governor Mboweni again raised it as a financially regulatory challenge' at the SARB annual general meeting in September 2007. In the UK, where such a scheme (albeit limited) exists, an overhaul is also being considered. It is worth noting that (at least) no retail depositors lost money in the Saambou debacle. This did however cause serious hardships as access to these deposits were frozen for a period of time, coupled with a period of uncertainty on whether these deposits were in fact safe.

"A deposit insurance scheme can be of great value in improving confidence and reducing the likelihood of a run on a technically solvent bank. Deposit insurance schemes are mostly aimed at protecting only small depositors up to a certain amount.  This is the customer that most probably deserves protection, as bigger and institutional depositors can manage their exposures by spreading their risk between the banks and shareholders should take shareholder risk.  Such a scheme will largely take the emotion out of a bank failure," concludes Behrens.

Werner Behrens from specialist legal firm Knowles Husain Lindsay


 

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