What happens in an economy when banks close down?

Ben Norman and Peter Zimmerman have this fascinating post on financial history.

Greece banks closed last year and the post draws parallel from Irish example in 1970s. Now unlike Greece banks Ireland banks closed due to strikes. What happened was interesting:

What happens when a country’s banking system shuts down?  Just how damaging is it to the economy?  During the 20th century, the Republic of Ireland’s banking system suffered industrial disputes, some of which caused the main banks to close for several months.  When Greek banks closed temporarily last year, some commentators (e.g. Independent (2015), FT (2015)) recalled how, previously, the Irish public ingeniously circumvented the banking system and kept economic activity going.  Using material in the Bank of England’s Archive relating to the 1970 dispute, we shed light on how halcyon those days really were.

The industrial dispute closed most of the Irish banking system in May 1970 (Figure 1).  It was not the first time the Irish banks had closed: there had been strikes in 1950-51 and 1966.  Nor was it the last: there was a further significant strike in 1976.  But the 1970 “lock‑out” of bank staff was notable for being the longest.  Formally, it lasted around six months.

As per the Irish Banks’ Standing Committee notice, even before complete closure of the banks, their staff had been working short hours, and a backlog in cheque clearing had built up throughout April.  Furthermore, although the banks reopened their doors in mid‑November, it was early 1971 before banking business was back to normal.  In short, banking in Ireland was disrupted for nearly a full year.

Despite this, the Irish economy did not implode (see Chart). 

So what happened? People kept issuing cheques knowing banks will eventually honour them:

With all the main Irish banks closed, interbank payments ground to a halt.  Cash already circulating continued to be used for payments.  Without the main banks open to channel it to where it was needed, though, shortages emerged.  And there was no practical means for the Central Bank of Ireland to get more notes into the economy.

Denied access to a functioning banking system, Irish people continued writing each other cheques.  Cheques were generally accepted as payment because the cheque’s recipient (payee) expected it would clear and settle within days of presenting it at a bank.  Until a cheque settles, the payee faces counterparty risk, should the signatory to the cheque (payer) not honour it.  During the Irish dispute, people accepted cheques in lieu of payment as IOUs.  By doing so, they were shouldering the risk until the banks reopened.  It was unclear, for a long time, when the dispute would end.

How did payees manage this risk for such a prolonged period?  Notoriously, local publicans were well-placed to judge the creditworthiness of payers.  (They had an informed view of whether the liquid resources of would-be payers were stout or ailing!)  For example, John Dempsey, a publican in Balbriggan, near Dublin, was “…holding cheques for thousands of pounds, but I’m not worried.  The last bank strike went on for 12 weeks and I didn’t have a single ‘bouncer’. … I deal only with my regulars … I refuse strangers.  I suppose I’ve been able to keep a few local factories going.”

Retailers played a similar role, also accepting cheques to recycle cash back into the economy.  Already during May, “…at Dunnes, one of Ireland’s biggest chain stores…up three flights of steps to the Accounts Dept. ventures a steady stream of people hoping to cash cheques.  They range from a school teacher timidly producing his monthly salary cheque for £45 to the cashier of a manufacturing firm presenting a cheque for hundreds of pounds to change into cash for wage packets.  ‘They are mostly strangers to us, and we just have to play it by ear in deciding whether to accept a cheque’, said an official.”

The cheques became the paper money. After all how does it matter?

Though, this did not apply to all. Some sections suffered as well. So it was not without costs. In the end, it is important that banking systems continue:

Obviously the circumstances of Ireland (1970) were different to Greece (2015): in Ireland there was no doubt over banks’ solvency, whereas the Greek banks closed to prevent a large-scale depositor run.  It is difficult to imagine cheques – in any case nowadays a payment method in decline – being widely accepted in a country on the brink of a financial crisis.  Our Irish case study suggests that the economic effects of the dispute were not benign, even though there were no doubts about the solvency of the banks.  Such major disruptions to the banking system cannot easily be overcome at low cost.  If true in 1970, this is likely to be even truer in today’s more complex, interconnected financial systems.

Nice bit from history.

One wonders why there are no such stories from Indian banking.

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