Fall of BCCI May Aid Reform Effort
Hardly anyone believes that the failure of the shadowy Bank of Credit and Commerce International was a good thing. After all, BCCI had offices in 69 countries, assets of about $20 billion, and hundreds of thousands of depositors.
No one knows what the price tag for the bank's closure will be. Knowledgeable insiders are betting that the losses will total at least $5 billion and might go as high as $15 billion.
Yet in the long run, the BCCI affair may prove a blessing in disguise, a watershed event in international finance that could clear the way for a much sounder banking system.
BCCI was shot full of selfdealing and fraud, a haven for drug money, and a vehicle for illegal international arms transactions. While fresh details concerning BCCI's operations have poured out since the bank was shut down by a multinational strike force on July 5, the gist of the story has been public for years.
Getting Out the Word
With a series of judicious leaks about its questionable dealings, banking agencies put financial markets on notice that BCCI was rotten to the core. The association of former Secretary of Defense Clark Clifford with First American Bankshares, which the Federal Reserve maintains is one of BCCI's U.S. holdings, has long been a cause celebre in Washington. (First American's subsidiaries were not included in the BCCI shutdown.)
Despite such ample notice, market players continued to do business with BCCI's many affiliates, presumably on the ground that the bank was simply "too big to fail" - that with or without insurance, depositors would be protected by governments. In the end, financial institutions had billions in deposits and trading contracts outstanding with BCCI when the bank authorities swooped down.
It is to be hoped that the financial pain and suffering that will follow in the wake of the BCCI failure will provide a definitive object lesson for the banking community. Big banks, as well as little ones, can go down the tubes. When they do, somebody will lose money.
If this statement seems self-evident, rest assured that it is not. Starting with the failure of Franklin National Bank in 1974 (then the 20th-largest bank in the nation), regulators in the United States and overseas lulled market participants into believing that while big depositors at small banks sometimes lose money, big depositors at big banks are safe.
If the collapse of BCCI finally disabuses participants in world financial markets of the pernicious notion of "too big to fail," it will be well worth every penny that it costs.
"Too big to fail" is, in fact, a key issue in the debate over the reform of U.S. banking statues.
In its massive study of financial reform, the Bush administration recognized that "overextended deposit insurance has. . . removed market discipline that should have constrained the increased riskiness of weak banks."
The report added: "Depositors should have shifted funds away from unprofitable, under-capitalized, and risky banks, forcing them to shrink or decrease risk. But with expanded federal insurance and no risk of loss, depositors have been more than willing to supply funds to weaker banks engaged in activities that produce inadequate returns and excessive risk.
Illusion of Safety
"With so little to lose, these weak, undercapitalized banks have had a perverse incentive to take excessive risk - the |moral hazard problem' - exposing the taxpayer to even greater losses."
The administration focused its analysis, naturally enough, on the domestic banking system. Even so, these conclusions apply equally well to BCCI and large multinational banks. If regulators had not convinced depositors and creditors of BCCI that somehow they would be protected against loss, the bank could never have grown to the size that it did.
The study asked the right question and came to the right judgment. However, the administration was too timid to follow the logic of its own analysis.
"In a given case," the study said, "the presence of systemic risk could require a decision to protect uninsured depositors."
"Accordingly, the administration recommends that (1) any determination to protect uninsured depositors on the basis of systemic risk should be made jointly by the Federal Reserve and Treasury Department; (2) the extra cost incurred from protecting uninsured depostors should be advanced to the Federal Deposit Insurance Corp. by the Federal Reserve; and (3) the FDIC should repay the advance with industry funds."
Watchdog Agency Concurs
The General Accounting Office, the congressional watchdog agency, echoed this approach in separate report on banking reform:
"It would also be beneficial to pursue policies which have as their ultimate goal the ability to make de facto protection much less predictable for uninsured depositors. In pursing this goal, however, the ability of Federal Reserve and FDIC officials to take whatever actions are needed to stop destabilizing bank runs must not be compromised."
Such hybrid suggestions are not likely to stabilize world financial markets. They recognize that market discipline must play a key role in keeping wayward bankers in check, but only as long as it is convenient to do so.
The BCCI affair made it clear that this approach is too cautious. BCCI failed without bringing down any other institutions, despite the huge losses involved.
If participants in world financial markets are to remember the real lesson of the BCCI collapse, depositors and creditors must know that they will lose money if a bank fails. That is the only way to protect the overall financial system from the misdeeds of an individual banker.
