When ‘taking the flak’ has no meaning – Financial Sector Laws Amendment Bill

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This thorough assessment of what is a complicated bill that bestows sweeping powers on Reserve Bank bureaucrats should a financial institution fail has one problem – they are currently unable to take the flac – simply because it doesn’t yet exist. Translated, ‘flac’ means financial loss absorbing capability, an investment instrument still to be designed. A recent evaluation by a committee of global central bankers and supervisors of the effects of current too-big-to-fail reforms, concluded that obstacles to resolvability of systemically important banks remain, and that improvements should be made to the implementation of flac instruments, of resolution funding, of the valuation of bank assets in resolution, and of continuity of operations and access to financial-market infrastructure during resolution. Taxpayer support for failing banks therefore continues and is not avoided by this bill, says Brian Benfield, a retired professor in the Department of Economics at the University of the Witwatersrand. His bottom line? These new powers violate the rule of law. Hello, the courts. – Chris Bateman

Financial Sector Laws Amendment Bill: Another bureaucratic power-grab?

By Brian Benfield* 

It is questionable whether the much-vaunted “too-big-to-fail” benefits of the Financial Sector Laws Amendment Bill now before Parliament justify its far-reaching rule of law impingements, its dubious depositor insurance provisions and its very significant costs, among many other concerns:

The Bill fails to crisply define its principal stratagem, being the “resolution” by employees of the South African Reserve Bank (SARB) of a “systemically important financial institution” (usually a bank) that they in their discretion think may not be able to meet its obligations.

It is claimed that the Bill’s proposed deposit-insurance scheme will “reduce” moral hazard. However, it will not do away with it and could well engender additional moral hazard, as witnessed in several international jurisdictions where similar provisions have been attempted. Moreover, this Bill does not eliminate the possibility of government bail-outs, thereby merely creating another source of moral hazard.

Banks must pay premiums and levies to meet the expense of providing insurance cover for their retail depositors of R100,000 each. (Less than US$7,000.) These charges will of course be passed on to all bank clients, directly and indirectly.

These deposit insurance premiums should not all be levied at the same flat rate for all as the Bill proposes. Fundamental insurance principles dictate that, to avoid risk arbitrage and moral hazard, insurance premiums should depend on the nature and extent of the risk involved, which will vary widely. A flat rate for every bank irrespective of its risk profile leads to additional moral hazard, not less.

The Bill’s proposed “Corporation for Deposit Insurance” will be yet another state owned enterprise. It is intended to be a statutory body, not a registered insurer properly complying with statutory solvency and reinsurance margins, and charging each institution individually assessed premium rates. Could it suffer a similar fate to that of the SA Special Risks Association (SASRIA) in also having ultimately to be bailed out by government using tax-payer money?

The Financial Sector Laws Amendment Bill claims that it will ensure that losses incurred due to failure of an institution will in the first instance be borne by shareholders and creditors “who are able to properly assess their investment risks” and “who had benefited from profits made by the institution as a going concern”. Yet there is no indication in the Bill of how these persons or entities are to be defined. The justification for targeting such creditors will likely prove indefensible.

The Bill aims to “assist” in maintaining financial stability and protecting the interests of depositors through the “orderly resolution” of a financial institution if, in the opinion of SARB employees, it is or will likely be, unable to meet its obligations, whether or not it is solvent. SARB personnel are thus to be endowed with extensive discretionary “resolution functions” and powers. These include the power to cancel or suspend the institution’s existing contracts with outside parties, to force the institution to transfer assets or liabilities, amalgamate or merge, and to cancel shares or issue new ones.

Bestowing such wide-ranging unconstrained powers on bureaucrats violates the fundamental requirements of the Rule of Law.

Despite this wide array of sweeping and discretionary powers, the attempted “resolution” of an institution by SARB staff can still fail. Bureaucratic “moral risk” is then distinctly possible, in that such personnel are also given the power to apply to court for the winding-up of an institution in resolution, on the ground that in effect they themselves have failed to resolve it.

Another concern with this Bill is that the financial loss-absorbing-capacity (so-called flac) investment instruments, which the Bill says banks should hold, are yet to be designed. The characteristics of flac instruments are not yet settled. In May, the Reserve Bank suggested that flac instruments should not be issued by banks but by their holding companies, and that there should not be any requirement to identify ultimate beneficial holders of flac instruments. Instead, designated institutions should “deduct their flac holdings” from “their qualifying flac instruments” (whatever that may mean).

A recent evaluation by the Basel Financial Stability Board (a committee of global central bankers and supervisors) of the effects of current too-big-to-fail reforms, concluded that obstacles to resolvability of systemically-important banks remain, and that improvements should be made to the implementation of flac instruments, of resolution funding, of the valuation of bank assets in resolution, and of continuity of operations and access to financial-market infrastructure during resolution. Tax-payer support for failing banks therefore continues and is not avoided by this Bill.

With these many unsettled and concerning matters, there is considerable doubt whether this Bill could or even should ever be brought into operation.

  • Dr B C Benfield, Retired Professor, Department of Economics, University of the Witwatersrand.
  • The views expressed in this article are the author’s and are not necessarily shared by the members of the Free Market Foundation.

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