Harare — "I'm not aware of any banking crisis in history, almost without exception, that was not accompanied by falling inflation" (George Magnus, senior economic adviser to UBS, quoted by Reuters on 17/01/08).

This observation by Magnus is quite correct because a banking crisis acts as a very powerful contractionary monetary policy due to the significant reduction in asset prices. In a banking crisis, credit is rationed as banks stop lending so as to conserve the little liquidity they may be in possession in order to honour their liabilities whose payment dates are normally brought forward due to panic withdrawals by depositors and investors. Furthermore, stocks fall thereby forcing banks to liquidate their equities positions, in a bid to create liquidity, at a loss. The same applies to other asset classes such as foreign currency and property.

If credit is being strictly rationed and asset prices falling as is currently the case with equities in Zimbabwe, investment, consumption and just about anything else that can be put off will be put off. These effects are the same as the intended effects of an effective monetary policy regime. The inflation implications are the same -- a decline in inflation.

Zimbabwe has a classical example of the effect of a banking crisis on inflation. Tight liquidity conditions that saw money market shortages worsening to over Z$90 billion during the last quarter of 2003 significantly affected the viability of banks. For instance, the money market that had, hitherto, been experiencing surplus liquidity conditions tightened significantly to an average of over Z$90 billion during the period October to December 2003. As a result, interest rates hardened with the 90-day NCD rate rising from 65% in June 2003 to 160% in October and 600% in December. Banks stopped lending and asset prices like shares fell due to the resultant decline in investment and consumption levels. The result was a decline in annual inflation from a then all-time high of 622.8% in January 2004 to a thirty-two month low of 123.7% in March 2005.

The same can be said about the US economy today. The banking crises currently taking place there caused by a significant deterioration in asset quality due to exposures to poor quality mortgage securities (Ninja mortgages) has caused significant credit rationing a fall in asset prices. As a result, there is a "...strong probability is that we will get at least disinflation in 2008," (Magnus, 2008).

This effect of banking crises on inflation provides a reason why the monetary authorities in Zimbabwe may not intervene to ease the current liquidity crunch that has negatively affected the profitability of banks.

A more important reason for non-intervention is that although there is need for authorities to take some remedial action in a banking crisis, they should also consider how their intervention affects the banks' future behaviour. One goal of crisis resolution is to reduce the disruption to the payments system and damage to the confidence in the financial system as a whole. Authorities could be concerned with the knock-on effects on the supply of credit to the productive sectors of economy.

But actions to deal with these aspects clearly lead to future moral hazard. If any protection provided to banks in a crisis is greater than they expected, this could increase their risk-taking in the future. In a widespread crisis the authorities are therefore likely to face a trade-off between maintaining financial stability today (through offering protection to failing banks) and jeopardising future financial stability through increasing moral hazard later on, if today's actions make future assistance more likely. Judging from recent statements by the Reserve Bank of Zimbabwe (RBZ) Governor, the monetary authority is of the view that banks should be treated with kid gloves as "...some banking institutions have been noted to be engaging in some imprudent and unethical practices which are creating artificial shortages" (RBZ Press Statement on The Cash Situation, 21 July 2008, p 4). As a result, the banks have become illiquid due to "...tying depositors' funds in illiquid speculative investments in the stock exchange, Real Estate, motor vehicles, foreign currency and other forms of non-core investments" (Ibid). The authorities have been incensed by this alleged misconduct by banks to an extent that any bank that does not have security in the form of Treasury bills will pay through the nose if it goes to borrow from the Central Bank as it will meet an awful rate of 1500% per day. Those with security are not spared either as 975% per day is also not a joke.

Surely given this background, the Central Bank should not be accused of taking advice from people like Bagehot who says, "...any aid to a present bank is the surest mode of preventing the establishment of a future good bank" (). Without disputing the concerns of the RBZ it should also noted that unlike during the 2003/04 whereby the crises were bank-specific, this time around it is an industry-wide phenomenon. Does this imply that all banks have been engaging in imprudent and engaging in unethical practices? Certainly not! The industry wide liquidity challenges are mainly due to the following factors: (a) Increase in the Statutory Reserve Ratios to a maximum of 50% on 6 December 2007, (b) Slowdown in the fiscal and quasi-fiscal expenditures especially subsidised credit facilities from the Central Bank; and (c) Increase in the daily maximum cash withdrawal limit from Z$50 million and Z$100 million for individuals and companies, respectively to Z$500 million on 18 January 2008. For those institutions with exposures in high-yielding, non-interest earning assets such as equities the reason is to preserve their capital by diluting the negative effects of exposures in non-negotiable certificates of deposits and Treasury bills which yield 340% and 0% per annum, respectively. Given the current hyperinflationary environment, these assets are yielding negative returns in real terms. Yet when the banks seek accommodation from the Central Bank they are, as already noted, hit under the feet with rates of the between 975-1500% per day.

Having said all this, if a banking crisis becomes protracted, it is imperative for the authorities to intervene despite the moral hazard implications. Although the fiscal costs of restructuring may seem extremely large at first, they fade with time compared to the negative long-term effects of systemic banking crises. This is because the resources committed to resolving a crisis are diverted from other productive uses while economic reforms are delayed and stabilisation programs are abandoned. The economy suffers from higher interest rates, lower growth and higher unemployment for a protracted period.