Dick Coulson’s Rebuttal to John Tomlinson

First Published: 2011-11-25

In the course of this year Mr. Tomlinson, under the auspices of the Nassau Institute, has given two interesting and provocative presentations about the horrific state of the world economy and how The Bahamas can take steps to avoid the worst of the consequences.

His presentations are essentially divided in three parts.

First, he gives us, quite properly, a pretty gloomy assessment of  what has happened  in recent years. But in certain respects he is guilty of exaggerating the gloom. He tells us that all (his emphasis) sovereign debt is now suspect. In practice, this is hardly true – he is wrongly extrapolating from the situation of Greece, Italy, Spain, and perhaps France, whose bonds are hard to sell and command  high yields because of their high risk. Germany, the dominant country the Eurozone, is having trouble selling its high-rated bonds at lower yields in recent days, but this is not so much the case with the UK and Japan. And the whole world still regards US Treasury securities as the safest investment available in the economic universe: their prices actually rose and yields fell even after the famous Standard & Poor downgrade last August. Of course, Mr. Tomlinson fears that US bonds too will be part of general world-wide collapse. All I can say is, if that apocalypse should befall us, there is no way The Bahamas (or any other country in the dollar zone) can escape collapse, no matter what banking structure or other financial measures we adopt. We must simply face that we cannot shield ourselves from a total economic disaster incurred in the world’s largest economy – we will go down the tubes equally.

Second, Mr. Tomlinson proposes radical restructuring  of our laws and banking practices as a way to attain self-sufficiency and impregnability from credit risks and  foreign pressures. I will return to give this proposal a detailed analysis, as I believe that although well-intentioned it is completely unrealitic.

The third part of his presentation provides a list of steps that both Government and we as citizens must take to assure economic freedom and protect our way of life. They all center around one basic principle: much greater responsibility must be offered to, and assumed by, the private sector rather than the Government. With this view I most heartily agree, and I hope very thinking Bahamian could read and absorb Mr. Tomlinson’s thoughts, which demonstrate that free-market capitalism on the one hand and compassion for human needs on the other hand are not antithetical concepts but in fact bolster each other.

But I have the unfortunate task of focusing on his proposal for our banks, which some may  regard as the keystone of his whole presentation. He starts his analysis with the proposition that when you make a deposit in a bank you no longer own it, the bank does, citing two English legal decision of the 19th century, which he would like to see reversed. I cannot argue the legal position, but as a practical matter a depositor always has the right to withdraw his demand deposit at will and his time deposit at maturity: is this not ownership? What upsets Mr. Tomlinson is that prior to your withdrawal, the bank can combine your money with other deposits and use the pooled funds to make loans over which you have no say-so whatever – in that sense, yes, you have lost control of your money. Of course, that has been the rock-bottom principle of banking from day one. He wants it abolished, on the theory that (1) only you should decide how your money is used, (2) the leverage of using your deposit allows banks to make loans that are inflationary and thus damaging to the economy, and  (3) loans financed  by deposits inevitably make the deposits risky.

The effect of leverage is one of those issues that  have also been debated  since day one. The usual solution has not been to eradicate leverage but for bank management to adopt sound prudential norms in granting loans and for regulators to create and enforce capital-adequacy ratios. These measures do not completely abolish the risk of bank insolvency, but they go a long way. Consider that since the early 20th  century not a single local bank taking Bahamian deposits has gone bust or needed to be bailed out, except for the rogue Arab-owned Gulf Union bank about 15 years ago, and the balance sheets of  our present banks do not give the slightest hint of serious trouble. Probably all of our banks wish they had not lent quite as much mortgage money to enthusiastic home-buyers who are now defaulting; loan-loss reserve have had to be increased affecting profitability, but no huge hits to capital are foreseen.

Mr. Tomlinson is now proposing a novel scheme that he believes would have the marvelous effect of reducing bank risk to zero. An admirable objective, but is it feasible? Let’s look at the details. The principal step would be for each Bahamian bank to separate its demand deposits, now totaling about $1.2 billion, from its savings deposits, about $4.7 billion, and put them in two separate pockets. The demand deposits would remain on the bank’s balance sheet, and would be backed 100% by cash, deposits with the Central Bank, and Government treasury bills – none of the demand deposit funds would be invested in pesky, troublesome, risky loans, and so would carry no risk whatever. Well, yes – that could be done. The bank’s earnings on these deposits, he tells us, would come from a 1% “storage fee”, forex commissions, and “other income” (unspecified).

The big question is, what happens to the .$4.7 billion of savings deposits? Mr. Tomlinson conceives the breathtaking step of taking these off the bank’s balance sheet and immediately placing them in “investments”, separate off-balance sheet funds to be managed by the bank, for a 2% management fee. Consider what this means: each customer who has freely chosen to have a savings account with a fixed term and yield will now be told “here’s your money back from your deposit, we will now invest it for you”.

The administrative difficulties, and even more the public relations issues, will be mind-boggling. A very large portion of  these customers will be furious – they have no interest in replacing what they consider the safety of a fixed deposit with an “investment” managed  or arranged by a brand-new investment department of a commercial bank.

Mr. Tomlinson would have a bank answer this objection by offering a smorgasbord of different funds, one investing in equities, one in preference shares, one in mortgages, one in direct property holdings, one in Government or commercial bonds -altogether creating a vast pool of new capital for supposedly unmet investment needs.

This approach is wildly over-optimistic and I fear betrays Mr. Tomlinson’s ignorance of how our capital markets actually work in practice. It is, and for the foreseeable future will remain, impossible to find several billion dollars of investments that would be attractive to individuals or institutions who have heretofore kept their money in fixed savings deposits. The record shows that  few companies have needed to issue equity or preference shares – probably a maximum of $100 million of  such issues are successfully completed each year, usually much less. Of course there are many “wannabe” enterprises that would like to raise capital, but most of them are not investment grade and will be shunned by any competent investment manager. A venture capital fund is feasible, but is unlikely to need more than $50 or $100 million at most.

As to the mortgage funds, very few of the former bank savers will want to go into. mortgage lending. As for direct property investment, they can do that themselves any time without help from a bank, or else try to invest in our few real estate investment trusts (REITS), that have great difficulty themselves in finding new  properties. As to bond investments, neither the Government nor private companies need to issue billions of new bonds.

In short, we can confidently assume that of the $4.7 billion liquidated  savings deposits,  the savers might agree to invest at most $700 million in the type of investment funds outlined by Mr. Tomlinson.  For the remaining $4 billion, the savers will demand that the banks provide  some other form of investment vehicle,  something roughly equivalent to the savings deposits  they previously held. The banks will have to create   money-market funds (not mentioned by Mr. Tomlinson) similar to those that are popular and widely sold in the US. These funds provide stable value, and liquidity through immediate redemption of their shares, and offer a safe, if unspectacular, yield  similar to bank deposits. (Higher yields can be obtained by restricting redemptions to specific periods – 6 months, 1 year, 5 years, etc.).

For money-market funds to have credibility in the market,  they must disclose a sensible  investment policy,  which in the US means investing mainly in high-rated short- term commercial paper. Here we come to the crux of Mr. Tomlinson’s proposal  and why I believe it is unrealistic and unworkable: since we don’t have commercial paper in The Bahamas, and only a  limited amount of T-bills,  the  $4 billion invested in the money- market funds will have to be re-invested as deposits right back into the Bahamian banks – there’s nowhere else for it to go. And what will the banks do with these funds? Surely not let them sit idle – they would receive no income with which to pay interest on  the deposits placed by the money-market funds. The banks will  have to re-invest the money right back into the same portfolio of mortgages and business and personal loans that Mr. Tomlinson would like  to wipe off their balance sheets!

We would see simply a circular movement of funds out of bank deposits, into money market funds, then back into bank deposits and then back into loans, accomplishing  nothing except confusion and administrative costs. Even the banks’ income would not be helped, as a 2% management fee on money-market funds would  be completely unacceptable. And note that our $50,000 deposit insurance fund applies only to bank deposits, not to investments in money-market funds, so the former savings customers would lose even that protection.

Mr. Tomlinson has tried to create an ingenious “silver bullet” to abolish risk. One of the first lessons of finance is that silver bullets simply do not exist. Risk exists for any use of money. Here the risk to the former deposit saver remains exactly the  same, after all the circular movement of funds. And if the saver is one of the few who choose to put his money not into a money-market fund but into  one of the equity or mortgage funds managed by his bank, he will of  course  be subject to more risk.

There is certainly room for changes in our banking system and in the national financial and economic structure maintained by a succession of spend-thrift governments. But these changes will only come through a series of incremental adjustments  made on many fronts, created from detailed study and supervised by constant vigilance. It is misleading to suggest that a single, radical restructuring of our banks will be a panacea to solve major issues of credit, risk, inflation and economic growth – particularly when, as I hope I have shown, the proposed restructuring is unworkable and illusory.

Nevertheless, the Nassau Institute has performed a valuable service by sponsoring Mr. Tomlinson’s presentations.. His  vigorous exhortations in the final section of his speech  should inspire members of the Institute, and all other individual and corporate citizens,  to use both their time and their wealth to improve our health facilities, our educational offerings, and our support for those too aged or afflicted to support themselves. His key sentences read as follows:

“We can and must ourselves ensure that that those less fortunate receive the help they need, and we must ensure that it is provided within the voluntary or private sector. We must demonstrate that the private sector can and is willing to take care of all the vulnerable people in the world. We can best demonstrate that by doing it here in the Bahamas.”

The Institute continues to play a formidable role in criticizing the failings of the statist intervention and over-regulation imposed by our Government. Now it’s time for the rest of civil society to step forward to support the other side of the equation: the spirit of charity.

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