For most of us, understanding the global financial market is a bewildering affair. With increases in consumer spending and lending during the festive season, being clued up on exactly how money moves from a central bank, to a commercial bank and to the public purse, becomes essential.
What is a lifeboat?
Let's explore the concept of a Lifeboat, as a form of financial assistance
from a central bank, to a commercial bank and how this relationship potentially affects the financial system and the public sector. The term ‘Lifeboat’ was first incorporated into financial jargon by the Bank of England in 1973. To put it quite simply, according to QFinance, a Lifeboat is “a measure designed to protect or rescue a failing business or fund”.
Fundamental forms of assistance
To help us understand the implications of a Lifeboat as a “lender-of-last-resort activity” within the banking sector, let’s review some key differences between two fundamental forms of assistance available. First up, we have Liquidity Support. This is a short-term loan, with a high interest rate given to a bank which remains solvent, but faces a liquidity problem. Solvency support is the provision of capital to a bank at the shareholders expense with the intention of resolving a solvency crisis. The latter could also involve a grant of public funds through a central bank with the aim of protecting the depositors. The distinction between the two terms becomes important since they have different effects on you and what happens to your hard earned cash.
What are the risks?
A principle condition of Lifeboats is to ensure the support is structured so that any risks fall on the shareholders. A Lifeboat, in the form of liquidity support, needs to ensure the repayment terms are as penal as possible, without leading to a financial collapse that is trying to be avoided. In the form of solvency support, a lifeboat needs to ensure that bank’s depositors are protected while the shareholders remain accountable for interest accrued.
Since most central banks are not well poised for credit assessment, Lifeboats become morally questionable and potentially risky for the public purse once the issue of transparency is brought into question. If they are not transparent and a veil of secrecy is maintained regarding the lending of public funds or funds secured from the central bank then they – the bank and its shareholders – are able to continue operations without the need to pay the penal rates for the funding. Of course the bill needs to be footed by someone and that’s where the public, tax rates and higher credit interest rates come in. As the old saying goes “what you don’t know, can’t hurt you”. In this case it can.
A lack of transparency increases the likelihood for the banks to conceal the true extent of operational assistance received from the central bank and as a result there is provision for large concealed re-distributions, with terms that do not appropriately compensate the public for the risks.
In other words…
Let’s consider the declaration found at the top of The South African Reserve Bank’s homepage: “The primary purpose of the Bank is to achieve and maintain price stability in the interest of balanced and sustainable economic growth in South Africa. Together with other institutions, it also plays a pivotal role in ensuring financial stability”. In conjunction with a statement such as; “The Constitution of the Republic mandates the National Treasury to ensure transparency, accountability and sound financial controls in the management of public finances”, found on the National Treasury’s homepage, it becomes obvious how a Lifeboat may possibly affect public finances. Given such a dynamic relationship between the two bodies, it’s important to distinguish between the justification for a central bank assisting a distressed bank and the practices of the intervention; between the legitimacy of the ends and the means undertaken.
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