Bank Runs: Moral Hazard in Kabul

September 8th, 2010

If you’ve been following the melodrama surrounding the Bank of Kabul unfold, you’ll already know that the situation has (somewhat) stabilized.  If you haven’t, here’s what you missed.  Last week panic struck when President Karzai approved the dismissal of the Bank’s CEO, Sherkhan Farnood, amid numerous allegations of large scale corruption.  According to high-level reports, top executives of the bank had been lending millions of dollars to the political elite for purchases of high-end real estate in Dubai.  In the face of United Arab Emirates’ alarming real estate bubble, these investments are looking frighteningly sour.

If this had occurred in the U.S. or another financially mature economy, depositors may regard such a scandal with disdain and perhaps a little unease.  But U.S. citizens would not worry about losing their deposits, thanks in large part to the Federal Deposit Insurance Corporation, which insures deposits on all accounts in U.S. member banks, up to $250,000 (raised from $100,000 in the face of the financial crisis).  Unfortunately banking in Afghanistan is not like banking in the U.S.  Afghanistan’s banking system is young and fairly shallow.  In fact, the country runs on a largely cash economy where only about 5 percent of citizens even hold bank accounts.

As a result of the CEO’s corruption, the public’s alarm, and the fledgling banking system, there was a run on the Bank of Kabul.  In the first two days of the panic, thousands of customers withdrew a total of $200 million.

Bank runs occur when depositors lose confidence in a bank.  In the U.S., they are remembered from the Great

"Run on Banks:" people milling about outside of a bank, February 1933. | Source: Franklin D. Roosevelt Library via WikiCommons

Depression with images of long lines of angry and fearful depositors.  Though they cause tremendous and disproportionate economic damage, these panics are not always incompressible from the point of view of depositors.

In one of the most stable versions of banking in the world, the U.S. Federal Reserve requires American banks to carry only about 10% of their liabilities (deposits) in cash, called the reserve requirement. Though it might seem low, this is actually a much higher portion than banks would chose to carry without the restriction.  The U.S. also has other regulations and safeguards that insure its banks can cover large-scale withdrawals.  But in an economy without banking safeguards, experience and trust, depositors would rightly feel anxious that the bank holds only 10% of their deposits in cash.  Particularly when faced with the news that corrupt, unscrupulous executives made bank’s loans that may be sour.

In Afghanistan the potential of the bank reaching the end of its cash-on-hand is very real.  From this week-long crisis, the bank has lost nearly $300 million of its $500 million in cash. One skittish depositor waiting in line last week told one reporter, “For now, I want to withdraw my money. If the bank is able to create confidence, for sure I will put my money back in Kabul Bank. I don’t want to close my account.”

So that explains the panic.  But looking back to the root causes of this problem, we might ask: what went wrong?

In my opinion, this is the perfect example of something economists call moral hazard. It goes back that saying “too big to fail” that has reverberated throughout the international discussion for almost two years.  Moral hazard occurs when a person (or company) believes he is insulated from risk and so acts in a way that is different than if he had to assume that risk.  So in the case of “too big to fail,” many bankers will make risky loans, believing the lenders of last resort, such as the Federal Reserve or the International Monetary Fund, will not allow them to fail.

These bankers understand that a meltdown of Afghanistan’s financial sector would put the country at risk economically and would pose not only a threat to efforts to build a viable state, but also national security worldwide.  Governments in the U.S. and Europe have together injected trillions of dollars into a failing financial sector and have spent hundreds of billions on an effort to build a viable state in Afghanistan.  What is a few billion more to save the country from a financial meltdown.

So the bankers made some unsavory loans to themselves.  Moral hazard coupled with rampant corruption is not pretty.

In my opinion, it is therefore a good thing that the U.S. has ruled out the possibility of a Washington-funded bailout.  On the other hand, addressing the other side—endemic corruption that plagues every level of Afghanistan’s government—will not be as easy.

Written by Ann Hollingshead

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