Survival strategies

The shock to the global financial system last year triggered waves of panic about the safety of savings and investments. Specialist financial centres have been exposed to the problem – and to the solution.

The ‘confidence’ trick
Banking is, in the nicest sense, a confidence trick. Banks live and die by customer sentiment, and death can come on very rapidly once it is lost. In the fourth quarter of 2008 we saw some examples that highlight the delicate balance of reality and perception in financial markets.
Take Northern Rock. The bank has been reviled as an ‘irresponsible mortgage lender’ and a catalyst of the collapse. Arguably its problems were not as catastrophic as its implosion might suggest, but that is not an argument that would have reassured Northern Rock depositors at the time of the panic. That is the nature of a run on a bank. We see others withdrawing their money and assume that there must be something wrong, so some of us do the same. Now there is definitely something wrong: a dwindling deposit base. Then we all try to get out – and jam in the door.

Once one institution is tainted, the fear can spread.

Don’t panic!
Containing panic was a major challenge for governments last year. One of the measures adopted was to quickly bolster depositor protection arrangements.

Responding to the loss of confidence in banks on the part of investors, Ireland announced in October 2008 that it would provide 100 per cent protection for all retail and commercial deposits until the end of 2010. In isolation the step was effective – in fact, rather too effective, as funds started to move into Irish banks from other jurisdictions.

What followed was a flurry of activity from competitor nations. First came criticism, but soon after there were ‘political commitments’ (as opposed to legislative change) made by Germany and Greece to provide the same level of protection. Criticism of these ‘commitments’ led to them being watered down. More tangibly, other mainland financial centres bolstered their existing regimes. For example, the UK increased the amount of protection for individuals from £20,000 to £50,000, and similar moves were made across the EU.

As an exercise in reducing volatility of bank deposits it was successful. However, it was perhaps more a PR triumph rather than a considered compensation policy. There is substantial variation in the levels of protection, the scope of schemes and the details of eligibility. The capacity, even of major economies, to underwrite losses and protect investors has been strained, which undermines the credibility of guarantees. However, for now the panic has been contained.

What now?
Smaller economies that specialise in servicing the financial sector – the ‘offshore’ jurisdictions – have faced particular problems. The Organisation for Economic Cooperation and Development definition of ‘offshore’ specifically refers to disproportion in the size of the finance sector compared with the rest of the jurisdiction’s economy. Obviously in that circumstance, there is a proportionately smaller ‘buffer’ to absorb shocks in the financial sector and less capacity should a large deposit-taking institution fail.
Most deposit protection schemes are funded in the first instance by the finance industry, which is perfectly adequate to deal with the consequences of a defaulting institution in normal times. Under current circumstances the backing of a guarantor of last resort is required, and that at a time when onshore governments have been raising the threshold of protection. That makes the problem political.
For small, financially focused economies and their communities, dealing with the ­consequences of institutional failure and loss is commercially critical and emotionally charged. The moral hazard invited by generous ad hoc compensation (as offered in some onshore jurisdictions) stores up future problems for all. A hard-nosed attitude invites immediate condemnation.

There have been various suggestions to mitigate financial exposure and deal with political issues, in particular:

• limiting protection to resident depositors;
• limiting recourse to individual rather than commercial deposits; and
• putting a cap on the protection provided.

Given the importance of non-resident depositors, a residence-based limit has been almost uniformly rejected. Where that approach has been followed (Jersey for example has given a political commitment to protect resident depositors) it is expected that protection will be extended to non-residents.

Caps on protection effectively reinforce the formal limitation of schemes to individuals, preferentially protecting smaller (assumed to be more vulnerable) investors. Schemes may also prudently limit the aggregate exposure of individual jurisdictions. Despite the differences of schemes in this respect, that does not appear to have been the dominant factor in depositors’ minds since the initial panic. We have not seen mass flight of deposits from specialist financial centres. Indeed, deposits in Guernsey as of December
2008 stood at £157bn – up 32 per cent year-on-year.

Offshore economies specialising in finance cannot isolate themselves from shocks in the global system. Their dependence on the financial sector creates a higher exposure. However, such jurisdictions are not generically unsound and in fact have good reason to control risks more tightly than their onshore equivalents.

Measures taken since last year have bolstered depositor protection. This has maintained confidence and the competitiveness of specialist financial centres. There are limits to such protection in all jurisdictions. Clear communication of those limits by the finance industry of each jurisdiction on the one hand, and the recovery of normal prudence on the part of investors on the other, should protect against another damaging cycle.

On this issue, as elsewhere, reports of the imminent death of ‘offshore’ have been greatly exaggerated. However, the events of the past year provide salutary lessons for economies that choose to specialise in finance about the risks they run and the demands this places on their regulatory and political infrastructures.

Paul Wilkes is a senior associate at Collas Day