On August 30 in these columns (https://tinyurl.com/y966zm8k), I had pointed out the perils of bank privatisation advocated by Arvind Panagariya and his ilk in the US. The fact is that there are frequent failures of private banks all over the world. So what happens when a private bank fails?
The short answer is that the bank gets bailed out by the regulator/government, with hardly any consequence for the management of the banks. Often the tax payer picks up the tab, and the attendant risk.
Aftermath of a bank failure
Let us look at four cases of bank failure, two from India and two international.
Silicon Valley Bank: The bank collapsed in March 2023. Auditor KPMG gave this bank clean bill of health just weeks before. As the failure unfolded, as reported by the American Economic Liberties Project, an organisation that advocates corporate accountability legislation, “a variety of influential men argued that the collapse of this bank would lead to economy-wide consequences. They argued that the nation would face ‘contagion’.”
Silicon Valley Bank catered mostly to affluent people. Over 95 per cent of its deposits were not covered by Deposit Insurance.
The regulators invoked emergency authority to undertake a full bailout of SVB’s uninsured depositors. While the shareholders and bondholders lost their investment, all deposits were made good.
In a step with wider ramification, the Federal Reserve, offered loans at below-market rates to any other bank that needed funds, backstopped by $25 billion of taxpayer funds. It was deemed necessary to protect the banking system.
Credit Suisse: One of Switzerland’s leading financial institutions founded in 1856, Credit Suisse was among a group of 30 banks known as globally systemically important. At the end of 2021, employing over 50,000 people, Credit Suisse had assets under management (AUM) of 1.6 trillion CHF ($1.75 trillion), making it the second-largest bank in Switzerland after UBS.
A year later, at the end of 2022, Credit Suisse’s AUM had dropped to about 1.3 trillion CHF ($1.4 trillion). The bank was hit by a spying scandal, collapse of two private capital companies leading to $1 billion in losses and a management shakeup. With rumours circulating that Credit Suisse faced an impending failure, clients pulled out $119 billion in funds in the last quarter of 2022.
When it failed in 2023, the Swiss Financial Market Supervisory Authority moved swiftly. They pushed through a deal by which UBS Group AG agreed to buy Credit Suisse for CHF 3 billion ($3.2 billion).
Credit Suisse’s convertible bondholders lost CHF 16 billion ($17 billion) as part of the takeover. The Swiss provided CHF 100 billion ($108.4 billion) to ensure the completion of the deal. Depositors were protected from losses. There was no shareholder approval of either entity; it was not even sought.
YES Bank: The case of YES Bank, arguably the largest bank to be bailed out in Indian banking history is recent. The fall was triggered by aggressive growth leading to large loans being written off, coupled with revelations of fraud and gross financial misdealing by its co-founder.
In March 2020, the RBI and the government implemented the YES Bank restructuring scheme through which State Bank of India invested in YES Bank equity worth ₹7,250 crore. Other lenders too joined the rescue act.
Additional tier-bonds worth ₹8,400 crore were written off, causing a full loss to the bondholders. Equity shareholders lost as the bank’s shares tanked. Reportedly, the RBI extended a 3-month special liquidity amounting to ₹50,000 crore to help YES Bank recover the deposit shortfall. Depositors did not lose any money.
Lakshmi Vilas Bank: In a swift action, this 94-year old institution was shut down by the RBI and the government in October 2020, and handed over to the DBS Bank, Singapore’s largest lender.
In yet another instance of a private bank losing heavily with loans turning sour, Lakshmi Vilas Bank faced serious erosion of its capital. The bank had 566 branches and 918 ATMs. With over two million bank accounts, LVB had over ₹20,000 crore deposits.
The entire paid-up share capital, reserves and surpluses of LVB were written off. The shareholders were wiped out. DBS was expected to infuse a fresh capital of ₹2,500 crore into its India arm, to strengthen its balance sheet. With LVB ceasing to exist, its deposits were taken on the books of the India unit of DBS. The interests of depositors was protected.
What private banking?
The pattern in private bank failures is clear. Public interest is affected. Political fallout is high. Hence regulators clean it up. The most important stakeholder, the depositor, is protected. The protection shows that banking is not a private business, but a public franchise from the state.
Pure shareholder capitalism in banks can take undue risks to maximise profit. Economists define moral hazard as a situation where a party lacks the incentive to guard against a financial risk because it is being protected from potential consequences.
In banking, this is the obvious case.
Wanted: A statutory warning
There is an implicit protection to private banks. No other private business is protected like this. Such protection should be removed by making it abundantly clear to bank customers. Every private bank should communicate the following clearly: “Your bank deposits are subject to investment risks taken by the bank. The deposits are protected to the extent of deposit insurance of ₹5 lakh in India. All deposits above this run the risk of not getting returned. The government is not protecting your deposit.”
Mutual Funds issue a statutory warning to investors. So should private banks issue a warning to its customers.
The writer is Group CEO, R K SWAMY HANSA. Views expressed are personal.