What is the Central Bank & its Governor Doing?

Moral Hazard, Systemic Risk, Central Banking and Prudential Supervision

Nobel Prize winning economist Paul Krugman described moral hazard as: “…any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” In other words, where a person is faced with interests competing with his own personal interest, a conflict of interest, he will tend to do what benefits him the most if he has an incentive to do so notwithstanding the moral implications of his actions.

Banks are prone to engage in moral hazard behavior. Typically, a bank makes its money from lending. In order to lend, it must have funds to lend. A bank gets its funds primarily through deposits from the public and capital (in the form of cash) from its shareholders. In a basic model of a bank, Deposits + Capital = Loans + Reserves. Given that loans generally earn a higher rate of return than reserves, some reserves earning as little as 0% when held with the Central Bank, reserves tend to zero except as otherwise required by statute while loans tend to 100% of deposit and capital net of statutory reserves. This is borne out in the June 2010 quarterly financial statements published by the Central Bank as follows:

In most banks, whether in Belize or elsewhere, deposits comprise the super‐majority of the funds a bank has to lend. In lending funds comprised mostly of deposits, most of the funds at risk on a loan are not the shareholders’ own funds (capital) but instead are the depositors’ money.

In Belize, using the June 2010 quarterly financial statements, capital represents 19% of total deposits in the banking system, with Heritage having the lowest ratio at 7% and Scotiabank having the highest at almost 26%; Atlantic Bank, Belize Bank and First Caribbean Bank each having ratios of 11%, 21% and 20% respectively. In other words, for every $1.00 raised in deposits from the public, the entire banking system raises only 19 cents from its shareholders.

It is this type of dis‐proportionality that gives rise to one form of moral hazard in banking. Banks can either invest in a prudent loan yielding high expected returns or gamble on a risky loan that can yield high private returns for the bank if the gamble pays off, but imposes costs on depositors if the gamble fails, especially as the ratio of capital to deposits approaches zero. That is, the lower the ratio of capital to deposits, the higher is the propensity to gamble for resurrection. Furthermore, if markets are sufficiently competitive, the bank earns relatively little from prudent investment but the bank can always capture short term high yielding returns from gambling. Thus increased competition tends to promote gambling in the banking sector. Some form of prudential regulation is then necessary to protect the interests of depositors vis‐à‐vis banks’ managers and shareholders and to induce banks to invest prudently. This has been referred to as micro‐prudential policy, a primary tool for which is the mandating of minimum capital requirements. A minimum capital requirement sufficient to dis‐incentivize gambling and instead to promote investment in a prudent loan in equilibrium combined with effective monitoring of banks by a central regulator has been shown to form an effective basis for micro‐prudential regulation of banks.

A second identified purpose necessitating prudential regulation of banks is macro‐prudential policy, that is, the fostering of financial stability and the protection of the banking system as a whole from systemic risk. Systemic risk is the risk that the failure of a large institution whether by way of a bank run or otherwise might spread to the rest of the banking system. In Belize, all of our domestic banks are large, the smallest being Heritage Bank representing 7% in market share of deposits and the largest being Belize Bank representing 38%. Although financial stability may be recognized as a public good, the total willingness of individual banks to pay for financial stability is less than the social value of this financial stability. It is in the interest of each individual bank to free‐ride on the willingness of others to pay for financial stability. Macro‐prudential regulation therefore becomes necessary for maintaining the public good of financial stability.

The Central Bank of Belize is tasked with effecting both these regulatory policies. Under the Central Bank of Belize Act, “within the context of the economic policy of the Government, the Bank shall be guided in all of its actions by the objectives of fostering monetary stability, especially as regards stability of the exchange rate, and promoting credit and exchange conditions conducive to the growth of the economy of Belize.” Under the Banks & Financial Institutions Act, the Central Bank is also vested with broad powers to examine, audit and otherwise regulate banks including powers to issue orders and directives and seize management and control of a bank with a view to restricting, prohibiting, remedying, or correcting courses of actions taken by banks which may be detrimental to the interest of their depositors. At the same time, to support the achievement of these objectives, and in particular, to ensure financial stability, the Central Bank is also a lender of last resort to banks. It can control interest rates, control credit and vary the amount of liquid asset reserves a bank must hold including the amount of cash reserves it must hold with the Central Bank.

Recent events call into question whether the Central Bank has been effectively discharging its duties as a prudential regulator or whether it has become derelict in its duties and is instead recklessly fanning the flames of systemic risk and moral hazard in the banking system.

In a claim before the Supreme Court, the Belize Bank and its parent company BCB Holdings has brought proceedings against the Central Bank to restrain enforcement of a directive by the Central Bank requiring the Belize Bank to de‐recognize its $20million Venezuelan claim against the Government as a receivable or asset on its balance sheet and restate its financial statements accordingly. This necessarily meant a one‐time extraordinary expense of not less than $20million against the net income of the Bank. In opposing the application on behalf of the Central Bank, the Governor of the Central Bank, Glenford Ysaguirre, swore to an affidavit in which he seeks to justify the issuance of the directive. In essence, the Central Bank’s action seems to be a valid exercise of micro‐prudential regulation.

He then continues further however to address other matters not materially connected to the directive or to the application. He continues on to speak of the Bank’s ratio of non‐performing loans and to speculate about the stability of the Bank. This is particularly alarming given the non‐performing loan ratios of other banks with substantially less capital than the Belize Bank, whether on an absolute basis or on a percentage basis. In light of such numbers, one is left to naturally speculate – does that mean that such other banks are even more unstable? What happened to the Central Bank’s role as a macro‐prudential regulator?

While the status of a bank’s non‐performing loans must be evaluated very closely, having regard to the financial stability of not only a bank but to the financial stability of an entire banking system, a regulator must choose his words very carefully so as not to scare the public into an unwarranted contagious confidence panic. Knowing that financial analysts, investors, politicians and others hinge on every word that they may say and that financial markets may rally or may plunge depending on what they say, Ben Bernanke, Chairman of the U.S.A.’s central bank, the Federal Reserve, and his predecessor, Alan Greenspan, are always very careful in their choice of language. With fractional reserve banking, loss of confidence by the public can quickly lead to a systemic banking crisis.

With recent reports in the media about the financial details of individual borrowers, there is also growing concern of leakage of confidential information and reports coming directly from the Central Bank and/or banks which it regulates. It is not clear whether such illegal leakages are intended or unintended but, in any event, what is the Central Bank doing to stop any such leakages and to bring the persons responsible to account for such illegal actions? How do these leakages foster financial stability?

While the Central Bank may be seeking to uphold its duties as a micro‐prudential regulator to protect the interests of depositors in issuing its directives, for the sake of all of us, it is of paramount importance that the Central Bank seeks to ensure the financial stability of our banking system, avoid systemic risk and absolutely refrain from taking actions inconsistent with such role as a macro‐prudential regulator.

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