Patricia, Crypto and Dark Magic V

“Imagine you enter GTB and you’re told your funds have been converted into commercial papers... they can’t assure you’ll get your money back in full... won’t you tear the branch manager’s shirt???"

Part 5: Financial Regulations are Meant to Protect You.

Here is a great rule of thumb: “If a financial service is not licensed, you should steer clear of it”.

One theory of government, or at least a very loose idea of it, is that citizens choose a government to carry out some crucial tasks for the good of the public. These tasks are tasks that the citizens would otherwise struggle to carry out individually. If we agree with this theory, at least for the purpose of our discussion, then regulating the financial space is one such crucial task that the government performs on behalf of the citizens. Let me illustrate this with a very simplified progression:

1. Citizens choose their government and provide money to the government through taxes. This money is to be used by the government for different purposes but generally for the benefit of citizens.

2. There is no way that citizens can DEFINE what a bad financial institution should be since they are not experts.

3. The government can take from this general money citizens contributed to source experts who make the rules that DEFINE what a bad financial institution is.

4. The experts define what minimum standards a financial institution must have, and define what is safe or unsafe for a financial institution to do, etc. All of these become the law.

5. The government now gives licences to people who meet these standards, and this licence is a badge that the institution is safe.

6. The government also continues to monitor financial operations even after it has granted the licences. It does this to ensure that it continues to be safe for citizens to have their money kept in these institutions.

7. Where the institution fails, the government has to repay citizens for the losses. The idea is that the government is giving badges that mean a financial institution is safe, so it is kind of responsible when it turns out that a badge-holder is not safe.

8. Since citizens paid their taxes and dealt only with financial institutions that the government said were safe, the government should repay affected citizens from the general fund if a licensed financial institution fails. 

This is overly simplified, but it will have to be enough for the purpose of this discussion. You just need to get the general idea: we contribute towards the government and when things fail, we can expect the government to give back to us.

Here is a great rule of thumb: “if a financial service is not licensed, you should steer clear of it”.

Someone made a very important point on X, formerly Twitter, asking if a licensed bank could do what Patricia has done and get away with it. Here is the tweet:

“Imagine you enter GTB and you’re told your funds have been converted into commercial papers but they exactly can’t assure you you’ll get your money back in full unless they turn a profit, won’t you tear the branch manager’s shirt???”

So let’s look at what happens when a licensed institution is unable to pay users their money. Again, a lot of this is generally simplified.

When a licensed bank is unable to pay its customers their money, it is generally because the money has been tied up in a loan or some other business that is yet to return profit. The money is usually not missing, it is just tied up somewhere, and you can point to where it is tied up. This is called a Liquidity Problem. The bank is not in debt, it just cannot bring out enough cash for the number of people who want their money back. Business is not bad, there is just no cash at hand.

This is different from a Solvency Problem, where the bank is just flat-out in problems because its debts are more than its assets. Let us adapt a very useful illustration from Matt Levine:

Liquidity Problem looks like this:

1. You are a bank.

2. You have N100 as the total sum customers deposited with you. This is a liability because it is money you owe to customers.

3. You have only N20 cash in your vault.

4. You have N100 in loans that you have given out, the loans are not faulty. This is an asset because you will earn N100.

5. Your customers all want their N100 back.

6. You have only N20 to give out.

7. If customers wait, when the N100 loans come in, you can pay depositors and still have N20 left to do business.

This is a liquidity issue. You are not in debt, you just cannot return the money right now. You have a total of N120 in assets (N20 cash in the vault plus N100 good loans to be repaid) and just N100 in liabilities (deposits to return to your customers).

Solvency Problem looks like this:

1. You are a bank.

2. You have N100 as the total sum customers deposited with you. This is a liability because it is money you owe to customers.

3. You have only N20 cash in your vault.

4. You have N100 in loans that you have given out.

5. N60 of the loans went to your CEO’s brother, who bought a Mustang to boost his reputation and crashed it. He is never paying back and you cannot sell the Mustang to get the money back.

6. You rewrite your loans to N40. Your assets are N40.

7. You have only N20 to give out.

8. No matter how long customers wait, you will never have enough money to pay them.

This is a solvency issue. You are in debt, and you cannot return the money right now or ever. You have a total of N60 in assets (N20 cash in the vault plus N40 good loans to be repaid) but a whooping N100 in liabilities (deposits to return to your customers).

To help with the rest of this article, when you see “Liquidity Problem”, say “The money is coming back later”. When you see “Solvency Problem", say “The money is not coming back."

I wonder what kind of problem it is when an unlicensed exchange loses users’ money to a hack. If you think the money is coming back, you can tell yourself it is a liquidity problem, I guess. However, if you think it is not coming back, it is definitely a solvency problem. Perhaps it is Schrödinger's Problem and we will never know until we know.

If you have a liquidity problem, your bank should not fail, it should just find cash to pay customers right now. So, the banks simply approach the Central Bank for a loan saying: “Look, we need cash to give our customers, but we don’t have it because it is tied up in safe businesses, and we cannot get it now”. The Central Bank checks your records and sees that everything is in order, and you have complied with all process laws, so it loans you the cash. The bank run stops. So if you are a regulated bank, a Liquidity Problem is unlikely to make you crumble. Again, this is extremely simplified.

This central bank loan arrangement is quite common and banks borrow a lot of money from the CBN just to be able to give you your money back when you ask for it. Of course, you are not aware of this because you really do not have to be aware. This borrowing is usually done under a scheme known as the CBN Discount Window (opens as PDF) Standing Lending Facility. The interest rates on the CBN loan are generally favourable and low so that banks can still make a profit. Again, there are other ways through which banks source cash when they have a Liquidity Problem, but our focus is on how regulators help banks, hence the Standing Lending Facility.

I am pointing out this difference because unlicensed businesses like crypto exchanges can fail when they have a liquidity problem. Sometimes, the business is good, but money is tied up, which is not a bad thing. Unfortunately, they have no one to loan them cash, so they fail. They also, unfortunately, cannot run to the Central Bank.

We spoke about options available to Patricia, yesterday, and we guessed that Patricia would either have to sell itself or take a loan from private persons to raise funds if it intends to pay customers. This is even if it can find anyone who thinks it is profitable to hand it money. The problem is that both options mean they lose equity or have to pay higher interest rates than normal. The investor/lender is a businessman, not the government. It means the owners of the exchange would have to give up ownership of the business just to get money to give customers or enter into another debt to pay back customers. If the owners of the exchange are unwilling to lose ownership and unwilling to take on new debt, the business fails.

What if a licensed bank is having a Solvency Problem i.e. the bank is in greater debt than its assets can cover, or if the bank has somehow lost customers’ money due to bad practices, or any reason at all, such that the money is not coming back? Well, there is still some saving. In this case, the CBN and the Asset Management Corporation of Nigeria (AMCON) would take over the bank and keep the bank operational, injecting money into it so users do not lose their money. The logic is that the government told users that the bank was safe when it issued it a licence, so the government would keep it running while looking for someone to buy it. This bailout happens a lot, actually. It has been reported that from 2009 - 2018, the CBN and AMCON have spent N3.83 trillion bailing out sick banks. Thank God for financial regulations, and taxes!

The Central Bank and AMCON specifically acquired Skye Bank when it suspected that it would have a Solvency Problem soon. Skye Bank had used the Standing Lending Facility (solution to a Liquidity Problem) so much that the CBN realized there was a Solvency Problem. So the CBN revoked Skye Bank’s licence but kept it running as Polaris Bank until new investors bought it from the government. Interestingly, the government announced that it was retaining all the former staff of Skye Bank because they had no wrongdoing, apparently business was just bad. Fun fact; the Skye Bank debacle, five years ago, was the very first time I ever wrote a piece to educate the public about law and finance.

What if the bank did shady stuff and committed fraud? There are actually instances where the bank staff are responsible for the failure of the bank due to fraud. The government still intervenes and keeps the bank running! What it does, is that it sues the bank staff responsible for such fraud and secures a prison sentence. The example of Bank PHB comes to mind. In 2011, the CBN revoked the licence of Bank PHB and some others. It was not until another ten years, in 2021, that courts would sentence both the Managing Director, Francis Atuche and the Chief Financial Officer, Ugo Anyanwu for stealing over N25 billion naira. Interestingly, Francis Atuche is also a co-defendant in a different lawsuit for an alleged fraud of N125 billion naira as well.

Sometimes there is no Liquidity Problem or Solvency Problem, but the Central Bank still revokes the licences of banks, because they are not obeying the banking regulations. I call this a “Perceived Future Problem”. The regulator realizes that you are moving like a bank destined for doom, so it just kicks you off the financial system. When this happens, it also ensures to repay customers money into alternative bank accounts. In May 2023, the CBN revoked the license of over 170 Microfinance Banks. Subsequently, the National Deposit Insurance Corporation (NDIC) asked customers of those banks to provide alternative accounts for it to reimburse their monies.

Here is a great rule of thumb: “if a financial service is not licensed, you should steer clear of it”. Financial regulations are meant to protect you.

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Thank you for reading.