Cyprus Mail
Opinion

Recession, bankruptcy, banking, corruption and conflict of interest

By Costas Apostolides

WHEN times are good everyone tends to gain and the overriding attitude is “leave alone and do not rock the boat”. All this changes when recession hits, unemployment rises and acute social, economic and political problems arise. The issues swept under the carpet suddenly seep through, and are laid bare for everyone to see, but this occurs at a time when resources are limited and political instability makes tackling the problems exceptionally difficult.

The current recession and economic crisis in Cyprus is the first to occur owing to economic causes, previous recessions were caused by inter-communal conflict or war (notably the Turkish Invasion which was followed by the rapid recovery owing to the “economic miracle”). Basically the 1974 recovery was achieved by Keynesian economics with good governance, achieved by a good planning and coordination system, and cooperation of all the political parties as well as the freedom of movement of a country with its own currency that was throughout its history in essence a “hard currency”. The recession or stagnation evident today in many parts of Europe, as well as the uncertain recovery in the USA, do not provide a conducive environment for recovery, and in Cyprus the banking system has been hit by the Euro Group decisions, the Cyprus planning system has been weakened, there have been four to five years of poor to bad governance, and there is confrontation in the political system.

In all recessions bankruptcies and company failures bring forth the corruption and the weaknesses of the system, lead to investigations and normally to the application of stricter supervisory and restrictive measures.

The current recession began in the USA, because of excesses and failures in the financial sectors including banking and financial paper of various sorts. The initial cause of the crisis was the contradiction between the growth of the money supply and savings, and the pressure to obtain high returns and profits, encouraged by unjustifiably high bonuses in the financial sector, both at the operating and the management level. When a good, or in this case money, is available in excessive quantities this leads to lower returns to factors of production. Assuming money is a factor in the financial sector at least, the aims of banks and financial houses were incompatible under good banking practices, and therefore the boards and management of banks and financial houses took increasing risks to achieve target profits. These risks were taken against the savings and deposits of the public and companies held with deposit taking institutions primarily banks. Financial institutions, therefore, turned to a form of gambling which was most obviously shown by the repeated rogue trader scandals where agents playing the markets showed losses running into billions (Societe General, UBS, Morgan and others).

Banks should not be involved in risk taking outside of good banking practice. More specifically banks and all deposit taking institutions should maintain good practices and not try to maximise returns, but achieve reasonable returns while at the same time moderating and diversifying their risks. This was one of the major findings of the investigations into the 1929 stock exchange crash, which is considered to have been the initial catalyst for the great depression in the 1930s. The depression in turn resulted in great and catastrophic social, economic and political change in the whole world.

Yet pressure from the banks led to a relaxation of the restrictions imposed over time and banks became huge conglomerates dealing with risks, including insurance, stockbroking, and all sorts of new financial instruments many of which are impossible to understand. In addition, new financial entities were created such as hedge funds, offering higher returns and putting more pressure on banks by competing for deposits. All of which drove banks into a cycle of higher risk and higher bonuses and increasingly into a form of gambling, because the whole system was based on high returns under conditions that could not be sustained (i.e. excess supply of funds).

The problem is that when there is strong economic growth and inflation is under control (more or less) such a system increases wealth and makes those in the game better off (it is clear now that it exaggerates income and wealth disparities for the benefits are not shared). But when things go wrong and recession sets in banks have problems and may need to be supported to prevent collapse. In the current crisis this occurred most notably in the USA and the UK, where banks too big to fail were supported by the state. In Cyprus the contagion arrived through the expansion of Cyprus banks as branches into Greece, and the recession in Greece.

One of the side effects of recession is that all the failures, corrupt and criminal practices and weaknesses come to the fore and investigations are undertaken to try to limit or exclude the recurrence of such activity. The report of the High Level Expert Group led by the Chairman of the Bank of Finland on behalf of the European Commission, as well as other studies, identified these failings. But their recommendations were more in line with establishing a firewall around deposits rather than shaking up the banking sector and forcing the banks to sell off their insurance, stockbroking and development banking subsidiaries. At the same time the Group recommended that in the case of banks too big to fail, they should bail in funds by grabbing deposits, something which is totally against the basic psychology of banking that is confidence in the system.

If the above analysis is accepted then the following policies require serious consideration:

  1. There should be strict controls on all deposit taking institutions, including Hedge Funds.
  2. Banking (deposit taking) should be totally separated from insurance and stockbroking, and banks should not be involved in playing the market.
  3. Banking supervision should be undertaken in greater detail, and should be focused more on diversification of risk, and corrective measures effectively enforced.
  4. The links between banks and politics should be broken, by prohibiting banks to fund political parties or political candidates.
  5. The concept of conflict of interest should be applied in the financial sector and all supervising bodies. In this respect it should be noted that staff of the Central Bank of Cyprus were allowed to hold shares in banks they supervised (it is unclear whether that is still the case).
  6. The bonuses in the banking sector should be moderated in line with the new EU policy, and should not be paid when the company has losses.
  7. Supervising institutions should be strengthened and should be able to enter detailed bank data sources and check on a sample basis that regulations are upheld and the loans and accounts of all major bank clients should be checked regularly to ensure the diversification principle is upheld.
  8. Big banks should not be subject to confidence destroying bail ins, and deposits should be protected, instead Central bank and Government support should instead be provided and flexibility be shown to coax such problematic large banks back into good practice.

 

Costas Apostolides in Chairman of EMS Economic Management Ltd ([email protected])

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