Banking Crises, Regulatory Reform and Resolution Charles Calomiris May 11, 2010.
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Banking Crises, Banking Crises, Regulatory Reform and Regulatory Reform and Resolution Resolution Charles Calomiris Charles Calomiris May 11, 2010 May 11, 2010
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Transcript of Banking Crises, Regulatory Reform and Resolution Charles Calomiris May 11, 2010.
Banking Crises, Regulatory Banking Crises, Regulatory Reform and ResolutionReform and Resolution
Charles CalomirisCharles Calomiris
May 11, 2010May 11, 2010
Macroeconomics and Macroeconomics and BankingBanking
View that banks are sources of shocks and View that banks are sources of shocks and propagators of shocks in the propagators of shocks in the macroeconomy was “rediscovered” in macroeconomy was “rediscovered” in 1980s, and has received more attention in 1980s, and has received more attention in the past decade, especially after the Asian the past decade, especially after the Asian and Mexican crises.and Mexican crises.
This view has substantial historical This view has substantial historical precedent, and supporting historical precedent, and supporting historical evidence, and is only “new” in the sense evidence, and is only “new” in the sense that it was ignored by most that it was ignored by most macroeconomists in 1950s, 1960s and macroeconomists in 1950s, 1960s and 1970s.1970s.
Why the Rediscovery?Why the Rediscovery?
Banking instability became more of Banking instability became more of an issue in macroeconomics.an issue in macroeconomics.
Key trendsKey trends Frequency of banking crisesFrequency of banking crises Coinciding of banking crises/capital Coinciding of banking crises/capital
crunches with macroeconomic declinescrunches with macroeconomic declines Mixing of banking crises with exchange Mixing of banking crises with exchange
rate or sovereign crises.rate or sovereign crises.
EM Banks Especially UnstableEM Banks Especially Unstable Fiscal costs of banking crises in EMs Fiscal costs of banking crises in EMs
amounted to about $1 trillion in the amounted to about $1 trillion in the 1980s and 1990s, which was equal to 1980s and 1990s, which was equal to all foreign assistance transfers from all foreign assistance transfers from developed countries from 1950-2001.developed countries from 1950-2001.
Many of these collapses also involve Many of these collapses also involve twin crises (collapses of both exchange twin crises (collapses of both exchange rate and banking systems), with dire rate and banking systems), with dire macroeconomic consequences.macroeconomic consequences.
Why is this happening? What can be Why is this happening? What can be done?done?
Central Questions about Bank Risk and Central Questions about Bank Risk and Prudential RegulationPrudential Regulation
Why are crises so common and so severe Why are crises so common and so severe now?now?
Are banking crises and their causes the Are banking crises and their causes the same or different from those of the past?same or different from those of the past?
Are crises inherent in the function and Are crises inherent in the function and structure of banks?structure of banks?
Which supervision and regulation rules Which supervision and regulation rules work?work?
Should government pursue counter-cyclical Should government pursue counter-cyclical forbearance policies, or procyclical forbearance policies, or procyclical prudential regulation?prudential regulation?
Bank Function and StructureBank Function and Structure Banks control risk via intensive screening, Banks control risk via intensive screening,
contracting, and monitoring, involving contracting, and monitoring, involving private information production.private information production.
Bank function and structureBank function and structure Delegated monitoring on asset side, liquidity Delegated monitoring on asset side, liquidity
creation on liability sidecreation on liability side Maturity and liquidity transformationMaturity and liquidity transformation First-come-first-served ruleFirst-come-first-served rule
Essential structure and function of banks Essential structure and function of banks has created a special role for debt market has created a special role for debt market discipline of banks, in contrast to other discipline of banks, in contrast to other firms.firms.
Does this make banks risky? Does that Does this make banks risky? Does that explain EM banking crises?explain EM banking crises?
Alternative view: Insider lending, moral Alternative view: Insider lending, moral hazard, politics of bailouts (Populism meets hazard, politics of bailouts (Populism meets cronyism)cronyism)
Crises have different shapesCrises have different shapes Currency depreciation only, reflecting an overvaluation Currency depreciation only, reflecting an overvaluation
of the currency, but without effects on banking systemof the currency, but without effects on banking system Brazil 1999: overvalued currency, lack of fiscal discipline, but Brazil 1999: overvalued currency, lack of fiscal discipline, but
banks relatively healthy, no resurrection risk bettingbanks relatively healthy, no resurrection risk betting Banking collapse onlyBanking collapse only
Australia 1893: costs of losses in banks absorbed by Australia 1893: costs of losses in banks absorbed by stockholders and depositors, not taxpayersstockholders and depositors, not taxpayers
Twin crises, in which banking collapses and exchange Twin crises, in which banking collapses and exchange rate collapses happen together. The new phenomenon rate collapses happen together. The new phenomenon of twin crises (only a handful were observed in pre-1980 of twin crises (only a handful were observed in pre-1980 era). But twin crises can also be distinguished according era). But twin crises can also be distinguished according to the dominant direction of causationto the dominant direction of causation fiscal crisis => banking instability as in Argentina 2001, where fiscal crisis => banking instability as in Argentina 2001, where
government lacked the safety valve of inflationary monetary government lacked the safety valve of inflationary monetary policy, and thus stole bank capital as last resort means of policy, and thus stole bank capital as last resort means of financing; financing;
or banking instability => fiscal crisis, as in Mexico 1994 and or banking instability => fiscal crisis, as in Mexico 1994 and East Asia 1997, although in these cases there was also an East Asia 1997, although in these cases there was also an overvaluation problem of real exchange rate, in Mexico because overvaluation problem of real exchange rate, in Mexico because of boom in demand, and in Asia because of cumulative decline of boom in demand, and in Asia because of cumulative decline in productivityin productivity
Financial system feedback during Financial system feedback during crisescrises
Overextended banks
and firms
Rapid rise in interest ratesCapital outflow
Currency devaluation
Risk factors show themselves during Risk factors show themselves during crisescrises
LawLaw: inability to have orderly workout in financial : inability to have orderly workout in financial distress leads to backlog of unresolved debts; distress leads to backlog of unresolved debts; reversal of privatization contracts, redenomination of reversal of privatization contracts, redenomination of contracts, limits on capital flows, nationalization of contracts, limits on capital flows, nationalization of assets.assets.
InformationInformation: markets react dramatically to crises : markets react dramatically to crises (shut down of orderly information processing, high (shut down of orderly information processing, high adverse selection costs)adverse selection costs)
Fiscal policyFiscal policy: lack of political will to reduce : lack of political will to reduce expenditures, improve tax collection, avoid inflation expenditures, improve tax collection, avoid inflation tax.tax.
BankingBanking: desire to protect bankers, who are often : desire to protect bankers, who are often borrowers and political allies, too, leads to lack of borrowers and political allies, too, leads to lack of credible discipline ex ante, and big bailouts ex post. credible discipline ex ante, and big bailouts ex post. Quasi privatization can be worse than public banks Quasi privatization can be worse than public banks from the standpoint of the severity of crises.from the standpoint of the severity of crises.
KEY POINTKEY POINT: All these risks can be observed in : All these risks can be observed in advance of the crisis!advance of the crisis!
Recent crises forecasted in particular countriesRecent crises forecasted in particular countries Mexico: The dog that did not bark in December 1994.Mexico: The dog that did not bark in December 1994.
Fiscal spending and bank lending, election yearFiscal spending and bank lending, election year Overvaluation (Dornbusch)Overvaluation (Dornbusch) Bank privatizations, lack of recapitalizationsBank privatizations, lack of recapitalizations Recession began in 1993Recession began in 1993 Sterilization, reserve outflows, tesobonos liquidity riskSterilization, reserve outflows, tesobonos liquidity risk
East Asia: Diminishing returns / cronyismEast Asia: Diminishing returns / cronyism Weak bank balance sheets, high corporate leverage were knownWeak bank balance sheets, high corporate leverage were known Low or negative return on invested capital due to crony bankingLow or negative return on invested capital due to crony banking Overvaluation related to declining productivityOvervaluation related to declining productivity Recessions reflecting declining productivity, overvaluationRecessions reflecting declining productivity, overvaluation
Brazil: Insufficient fiscal reformBrazil: Insufficient fiscal reform OvervaluationOvervaluation Old story of unsustainable peg given rising inflationOld story of unsustainable peg given rising inflation
Argentina: Insufficient fiscal reformArgentina: Insufficient fiscal reform CoparticipationCoparticipation Labor, tax policies, recession (overvaluation-induced deflation)Labor, tax policies, recession (overvaluation-induced deflation) Destruction of banking sectorDestruction of banking sector
Causation in MexicoCausation in Mexico Spending, weak privatized banks (Haber article), Spending, weak privatized banks (Haber article),
off-balance sheet exposures raise debt and off-balance sheet exposures raise debt and expected monetization.expected monetization.
As reserves are drained, central bank sterilizers, As reserves are drained, central bank sterilizers, thereby increasing current money supply.thereby increasing current money supply.
Rise in money and expected money drive up Rise in money and expected money drive up prices, leading to overvaluation and increasing prices, leading to overvaluation and increasing pressure on exchange rate.pressure on exchange rate.
ZedilloZedillo’’s non-reform leads market to realize s non-reform leads market to realize inevitability of collapse, and run begins.inevitability of collapse, and run begins.
FX exposure is combination of direct bets and FX exposure is combination of direct bets and defaults linked to dollar debt.defaults linked to dollar debt.
Banks double bets on FX by having lots of both Banks double bets on FX by having lots of both (in violation of regs, done with swaps via Wall (in violation of regs, done with swaps via Wall Street).Street).
Uncanny (forecasted) replay of Chile 1982-83 Uncanny (forecasted) replay of Chile 1982-83 crisis.crisis.
Rising Debt, SterilizationRising Debt, Sterilization
Sterilization had been the ruleSterilization had been the rule
Inflation and base growth Inflation and base growth linkedlinked
Inflation increasingly threatened exchange Inflation increasingly threatened exchange raterate
Mexican DevaluationMexican Devaluation
0
1
2
3
4
5
6
7
8
9
Jun-
94
Aug
-94
Oct
-94
Dec
-94
Feb-
95
Apr
-95
Jun-
95
Aug
-95
Oct
-95
Dec
-95
Feb-
96
Apr
-96
Jun-
96
Aug
-96
Oct
-96
Dec
-96
Mex
ican
Pes
os /
U.S
. Dol
lar
Asian CrisesAsian Crises March and April 1997, the Economist March and April 1997, the Economist
and FT have special reports on and FT have special reports on declining fortunes of Asian banks, and declining fortunes of Asian banks, and possible crises there.possible crises there.
Alwyn Young writes about declining Alwyn Young writes about declining productivity as threat to sustainability productivity as threat to sustainability of so-called Asian miracle in 1994-95.of so-called Asian miracle in 1994-95.
Short-term borrowing in dollars Short-term borrowing in dollars increases as risk rises (largely increases as risk rises (largely interbank, interbank, ““protectedprotected””?, and with ?, and with different weights according to Basel).different weights according to Basel).
IMF assistance bails out those debts.IMF assistance bails out those debts.
Bank Losses in Asian CrisesBank Losses in Asian Crises
Thailand Indonesia KoreaThailand Indonesia Korea
1997NPL/TL1997NPL/TL 19% 19% 17% 17% 16% 16%
1997NPL/GDP1997NPL/GDP 30% 30% 10% 10% 22% 22%
Cleanup Cost /Cleanup Cost / 42% 55% 20% 42% 55% 20%
1999 GDP1999 GDP
Diminishing Returns => Increasingly Diminishing Returns => Increasingly Inefficient Capital Investment in East Asia in Inefficient Capital Investment in East Asia in
1980s, 1990s1980s, 1990sReturn on Capital Return on Capital Employed Minus Employed Minus Interest Rate, 1992Interest Rate, 1992
IndonesiaIndonesia -12%-12%KoreaKorea - 3%- 3%MalaysiaMalaysia 3%3%PhilippinesPhilippines -13%-13%ThailandThailand - 9%- 9%
Source: Pomerleano (1998)Source: Pomerleano (1998)
Micro Level Stylized FactsMicro Level Stylized Facts
As the 1990s progressed . . .
•Asian corporations experienced a decline in performance.
•Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars).
•Asian corporate managers increased the leverage of their firms.
How Can You Bet the Country?How Can You Bet the Country? Government bailouts are anticipated, intermediated Government bailouts are anticipated, intermediated
by governmentby government’’s relationship with the IMF, which s relationship with the IMF, which injects dollars to government, which pays them to injects dollars to government, which pays them to crony firms with outstanding short-term debts.crony firms with outstanding short-term debts.
Taxpayers pick up the pieces.Taxpayers pick up the pieces. High leverage of ex ante insolvent banks and firms High leverage of ex ante insolvent banks and firms
indicates that both borrowers and US, Japanese, indicates that both borrowers and US, Japanese, and European bank lenders anticipated this.and European bank lenders anticipated this.
Note: Capital flows, per se, are not the problem, but Note: Capital flows, per se, are not the problem, but rather the allocation of risk by government rather the allocation of risk by government associated with those flows. There is an argument associated with those flows. There is an argument for waiting to liberalize capital flows until incentives for waiting to liberalize capital flows until incentives and financial regulation have been fixed.and financial regulation have been fixed.
This is a particularly important issue for China, This is a particularly important issue for China, given that it could repeat the Asian crisis pattern, given that it could repeat the Asian crisis pattern, given diminishing returns and lack of market given diminishing returns and lack of market discipline in banking system.discipline in banking system.
Trends in Corporate Trends in Corporate Leverage RatiosLeverage RatiosCountry ComparisonsCountry Comparisons
0
50
100
150
200
250Median Leverage Across Countries
19921996
Rating Ratio
AAA 13.4
AA 21.9
A 32.7
BBB 43.4
BB 53.9
B 65.9
BrazilBrazil’’s Controlled Devaluation (Healthy s Controlled Devaluation (Healthy banks)banks)
ArgentinaArgentina’’s Crisis Anticipateds Crisis Anticipated
Interest Rates on 30-Day Time Deposits in Pesos and Dollars
0
10
20
30
40
50
60
Jan
-00
Feb
-00
Mar-
00
Ap
r-0
0
May
-00
Jun
-00
Jul-
00
Au
g-0
0
Sep
-00
Oct-
00
No
v-0
0
Dec-0
0
Jan
-01
Feb
-01
Mar-
01
Ap
r-0
1
May
-01
Jun
-01
Jul-
01
Au
g-0
1
Sep
-01
Oct-
01
No
v-0
1
Dec-0
1
Jan
-02
Inte
rest
Ra
te (
%)
Pesos
Dollars
Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).
ArgentinaArgentina’’s Crisis Anticipateds Crisis Anticipated
Difference Between Interest Rates on 30-Day Time Deposits in Argentina in Pesos and Dollars vs. EMBI+ Argentina Strip Spread
-5
0
5
10
15
20
25
30
Jan
-00
Mar
-00
May
-00
Jul-
00
Sep
-00
No
v-0
0
Jan
-01
Mar
-01
May
-01
Jul-
01
Sep
-01
No
v-0
1
Jan
-02
Dif
fere
nce
in
In
tere
st R
ate
s (%
)
0
1000
2000
3000
4000
5000
6000
EM
BI+
Arg
enti
na
Str
ip S
pre
ad
Weekly Interest Rate Difference
Daily EMBI+ Argentina Strip Spread
Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).
Deposit OutflowsDeposit Outflows
Monthly Dollar Deposits in Argentina, 2001
43
44
45
46
47
48
49
50
51
52
53
54
Jan
-01
Feb
-01
Mar
-01
Ap
r-0
1
May
-01
Jun
-01
Jul-
01
Au
g-0
1
Sep
-01
Oct
-01
No
v-0
1
Dec
-01
Bil
lio
n U
.S.
Do
lla
rs
Source: Argentina Ministry of Economy & Production, Macroeconomic Statistics (available at http://www.mecon.gov.ar/peconomica/basehome/infoeco_ing.html).
International Reserve Outflows, 2001International Reserve Outflows, 2001
0
5
10
15
20
25
30
35
40
Jan
-01
Feb
-01
Mar
-01
Ap
r-0
1
May
-01
Jun
-01
Jul-
01
Au
g-0
1
Sep
-01
Oct
-01
No
v-0
1
Dec
-01
Bil
lio
n P
eso
s
Note: Because of a change in the BCRA’s definition of international reserves, data after October 31, 2001 includes public bonds involved in reverse repo-operations. Data before October 31 does not include these bonds.Source: Banco Central de la República Argentina, International Reserves and BCRA’s Financial Liabilities (available at http://www.bcra.gov.ar/).
Annual Capital Inflows by TypeAnnual Capital Inflows by Type
-20
-10
0
10
20
30
40
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
Bil
lio
n U
.S. D
oll
ars
Total
FDI
Equity
Debt
Other
Note: Equity inflow was not available until 1992. I use the following variables from the IMF’s International Financial Statistics as components of capital inflows:1) FDI: line 78bed (Direct Investment in the Reporting Economy, n.i.e.)2) Equity: line 78bmd (Equity Securities Liabilities)3) Debt: line 78bnd (Debt Securities Liabilities).4) Other: line 78bid (Other Investment Liabilities, n.i.e.)Source: International Monetary Fund, International Financial Statistics, June 2004.
Argentine DevaluationArgentine Devaluation
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
Jun-0
0
Au
g-0
0
Oct-
00
Dec-0
0
Feb
-01
Ap
r-0
1
Jun-0
1
Au
g-0
1
Oct-
01
Dec-0
1
Feb
-02
Ap
r-0
2
Jun-0
2
Au
g-0
2
Oct-
02
Dec-0
2
Arg
en
tin
e P
eso
s /
U.S
. D
oll
ar
Role of fixed exchange ratesRole of fixed exchange rates
All of the problems discussed would still All of the problems discussed would still be problems under flexible exchange be problems under flexible exchange ratesrates
But fixed exchange rates make things But fixed exchange rates make things worse by create sudden adjustments, and worse by create sudden adjustments, and thus big accumulations of risk.thus big accumulations of risk.
This not only causes sudden problems, it This not only causes sudden problems, it also worsens resurrection risk taking by also worsens resurrection risk taking by giving banks and firms something to bet giving banks and firms something to bet on.on.
Panics vs. InsolvenciesPanics vs. Insolvencies Concern that too much, unwarranted, Concern that too much, unwarranted,
sudden market discipline can create sudden market discipline can create undesirable social costs from contraction undesirable social costs from contraction of bank deposits during “panics” is the of bank deposits during “panics” is the primary justification for bank safety nets in primary justification for bank safety nets in theory and in history (deposit insurance, theory and in history (deposit insurance, and lender of last resort).and lender of last resort).
Such systemic panics (as distinct from Such systemic panics (as distinct from periods of high bank failure) resulted from periods of high bank failure) resulted from a combination of observable shocks and a combination of observable shocks and unobservable incidence of shocks, in unobservable incidence of shocks, in combination with the structure of banks combination with the structure of banks (liquidity transformation, fcfs rule).(liquidity transformation, fcfs rule).
U.S. Experience with PanicsU.S. Experience with Panics
1857, 1873, 1884, 1890, 1893, 1896, 19071857, 1873, 1884, 1890, 1893, 1896, 1907 Observable shock was a dual threshold of Observable shock was a dual threshold of
9% stock market decline over a quarter, 9% stock market decline over a quarter, and 50% increase in seasonally adjusted and 50% increase in seasonally adjusted liabilities of failed business (NEWS liabilities of failed business (NEWS RELEVANT FOR BANKS)RELEVANT FOR BANKS)
Some shocks originated in NYC and were Some shocks originated in NYC and were related to securities markets, use of funds related to securities markets, use of funds by NYC banks: In 1857, loans to bond by NYC banks: In 1857, loans to bond dealers, connections to RRs, was the dealers, connections to RRs, was the problem. Some shocks may relate more to problem. Some shocks may relate more to peripheral areas (perhaps 1893).peripheral areas (perhaps 1893).
Dealing with PanicsDealing with Panics Costly bank panics were almost Costly bank panics were almost
exclusively a U.S. phenomenon by the exclusively a U.S. phenomenon by the mid-19mid-19thth century. Market discipline, century. Market discipline, along with inter-bank cooperation and along with inter-bank cooperation and lending, central banks, and clearing lending, central banks, and clearing house actions to share risks dealt with house actions to share risks dealt with threat of panics effectively, except in threat of panics effectively, except in U.S. where branching limits, U.S. where branching limits, pyramiding of reserves created pyramiding of reserves created concentrations of risk, and made concentrations of risk, and made coordination difficult.coordination difficult.
Desire to keep unit banking, and risk Desire to keep unit banking, and risk of panics explains why U.S. originates of panics explains why U.S. originates deposit insurance.deposit insurance.
Dealing with Panics (Cont’d)Dealing with Panics (Cont’d) Banks assisted each other, sometimes Banks assisted each other, sometimes
through formal clearing house actions.through formal clearing house actions. Market discipline kept risky banks in Market discipline kept risky banks in
check, and made other banks see check, and made other banks see advantage to identifying and punishing advantage to identifying and punishing risky banks quickly.risky banks quickly.
Suspension was used as a last resort, Suspension was used as a last resort, and market discipline created and market discipline created incentives to restore convertibility incentives to restore convertibility quickly.quickly.
Resumption of convertibility would Resumption of convertibility would occur when secondary market discounts occur when secondary market discounts on bank paper approached zero.on bank paper approached zero.
Historical Banking System Historical Banking System CollapsesCollapses
Panics in U.S. did not produce banking Panics in U.S. did not produce banking collapses, because the combination of collapses, because the combination of market discipline, clearing house market discipline, clearing house support, and temporary suspension of support, and temporary suspension of convertibility (until asymmetric convertibility (until asymmetric information was resolved) insulated information was resolved) insulated banks from costs.banks from costs.
1893, worst of U.S. panics, coincided 1893, worst of U.S. panics, coincided with large exogenous agricultural with large exogenous agricultural problems, but bank failures produced problems, but bank failures produced negative net worth of failed banks of negative net worth of failed banks of only 0.1% of GDP.only 0.1% of GDP.
Historical Collapses (Cont’d)Historical Collapses (Cont’d) Worldwide, from 1873 to 1913, there Worldwide, from 1873 to 1913, there
were no more than seven episodes of were no more than seven episodes of severe bank failure worldwide (defined severe bank failure worldwide (defined as collapses that produced banking as collapses that produced banking losses where negative net worth of losses where negative net worth of failed banks in a country exceeded 1% failed banks in a country exceeded 1% of GDP)of GDP)
Argentina 1890 (~10%), Australia 1893 Argentina 1890 (~10%), Australia 1893 (~10%), Norway 1900 (~3%), Italy (~10%), Norway 1900 (~3%), Italy 1893 (~1%), Brazil various (hard to 1893 (~1%), Brazil various (hard to measure, but all much less than 10%). measure, but all much less than 10%). Only 2-3 of these are “twin crises.”Only 2-3 of these are “twin crises.”
Historical Comparison between Historical Comparison between Today and Pre-WWI Era Today and Pre-WWI Era
Appropriate?Appropriate? 18701870s-1913 is a time when capital flows s-1913 is a time when capital flows to emerging markets were high relative to emerging markets were high relative to GDP, limited liability banking was to GDP, limited liability banking was growing rapidly around the world, growing rapidly around the world, countries relied on fixed exchange rates, countries relied on fixed exchange rates, and macroeconomic climate was very and macroeconomic climate was very volatile.volatile.
This suggests that according to some This suggests that according to some explanations of crises (exchange rate explanations of crises (exchange rate fixed, free chartering of banks, multiple fixed, free chartering of banks, multiple equilibria due to foreign capital flows) we equilibria due to foreign capital flows) we should see more then than now. But we should see more then than now. But we do not.hdo not.h
Historical Collapses (Cont’d)Historical Collapses (Cont’d) Land booms and busts underlay these collapses, Land booms and busts underlay these collapses,
and often bank risk was subsidized by government and often bank risk was subsidized by government in one way or another. Argentina, Italy subsidized in one way or another. Argentina, Italy subsidized risky bank lending on land; Norway and Australia risky bank lending on land; Norway and Australia promoted land booms in other ways.promoted land booms in other ways.
Banking collapses for some U.S. states also directly Banking collapses for some U.S. states also directly traced to safety net policies. Agriculture boom and traced to safety net policies. Agriculture boom and busts and banking collapses were much more busts and banking collapses were much more severe in states with deposit insurance (WWI price severe in states with deposit insurance (WWI price bets).bets).
Twin crises in Italy and Argentina in 1890s Twin crises in Italy and Argentina in 1890s reflected feedback from banking crises to fiscal reflected feedback from banking crises to fiscal collapse of government (foreshadowing today’s collapse of government (foreshadowing today’s crises).crises).
State-Level Deposit Insurance in 1920sState-Level Deposit Insurance in 1920s
3 3 InsuredInsured 15 Controls 15 Controls
Asset SizeAsset Size $320 $320 $622$622Equity / AssetsEquity / Assets 0.11 0.11 0.130.13Growth during BoomGrowth during Boom 185% 185% 128%128%Loans / AssetsLoans / Assets 0.76 0.76 0.700.70Negative NW of fails Negative NW of fails
/ Survivors NW/ Survivors NW 3.5 3.5 0.50.5
Source: Calomiris JEH 1990.Source: Calomiris JEH 1990.
How the Safety Net Causes Bank CollapsesHow the Safety Net Causes Bank Collapses Safety net removes market discipline that Safety net removes market discipline that
used to operate, both as a check on used to operate, both as a check on conscious risk taking, and on quality of conscious risk taking, and on quality of bank management making risk taking bank management making risk taking decisions. Both effects are important.decisions. Both effects are important.
These two channels do not operate with These two channels do not operate with constant adverse effects, but rather, their constant adverse effects, but rather, their effects vary over the cycle. effects vary over the cycle.
Conscious risk taking increases in wake of Conscious risk taking increases in wake of losses (resurrection bets on unlikely losses (resurrection bets on unlikely outcomes with high risk premia, especially outcomes with high risk premia, especially in currency markets, which deepens in currency markets, which deepens extent of twin crises through feedback extent of twin crises through feedback effects).effects).
Management quality problem can be most Management quality problem can be most hazardous during booms, and becomes hazardous during booms, and becomes visible during busts (WWI grain price bets).visible during busts (WWI grain price bets).
Why Few Why Few Twin CrisesTwin Crises Historically?Historically?
Other than those exceptions, fiscal Other than those exceptions, fiscal discipline coincided with and reinforced discipline coincided with and reinforced benefits of market discipline over banks.benefits of market discipline over banks.
Governments adhering to gold standard Governments adhering to gold standard had access to international capital had access to international capital markets, and could act to protect banks markets, and could act to protect banks with classical lender of last resort liquidity with classical lender of last resort liquidity assistance.assistance.
Mexico 1907 and Russia 1899-1900 are Mexico 1907 and Russia 1899-1900 are prime examples of successful assistanceprime examples of successful assistance
Assistance was limited by credible Assistance was limited by credible commitment to stay on gold standard, commitment to stay on gold standard, which in turn ensured access to funds as which in turn ensured access to funds as needed. (Contrast to IMF)needed. (Contrast to IMF)
What About the Great What About the Great Depression?Depression?
New research (Calomiris and Mason, 1997, New research (Calomiris and Mason, 1997, 2003) shows that panics were not nationwide 2003) shows that panics were not nationwide phenomenon until very late (early 1933)phenomenon until very late (early 1933)
For the most part, fundamental shocks For the most part, fundamental shocks (deflationary monetary policy, gold standard, (deflationary monetary policy, gold standard, agric. distress, other bad economic policies) agric. distress, other bad economic policies) caused insolvencies by many banks, not caused insolvencies by many banks, not panics.panics.
And, despite the severe shocks and many And, despite the severe shocks and many failures, losses of failed banks 1930-1933 only failures, losses of failed banks 1930-1933 only about 3-4% of GDP.about 3-4% of GDP.
Banking Collapses TodayBanking Collapses Today In contrast, about 150 episodes since 1978 of In contrast, about 150 episodes since 1978 of
banking system collapses with costs of more than banking system collapses with costs of more than 1% of GDP, more than 20 with costs in excess of 1% of GDP, more than 20 with costs in excess of 10% of GDP, and many of those have costs in 10% of GDP, and many of those have costs in excess of 20% of GDP.excess of 20% of GDP.
This is unprecedented. Collapses often coincide This is unprecedented. Collapses often coincide with currency collapse due to fiscal implications with currency collapse due to fiscal implications of banking collapse for government. This reflects of banking collapse for government. This reflects changes in political economy of banking systems changes in political economy of banking systems (similar to Eichengreen 1996 argument on (similar to Eichengreen 1996 argument on inflation process).inflation process).
Like Italy and Argentina pre-WWI, these Like Italy and Argentina pre-WWI, these severe collapses have been directly traced severe collapses have been directly traced to incentives fromto incentives from government policies government policies protecting banks from market disciplineprotecting banks from market discipline..
How Did / Do Disciplined Systems How Did / Do Disciplined Systems Behave?Behave?
Old-Fashioned Disciplined BankingOld-Fashioned Disciplined Banking Equity/Assets and Asset risk managed to target Equity/Assets and Asset risk managed to target
low default risk on debt of bank. During good low default risk on debt of bank. During good times, equity capital is cheap (no lemons times, equity capital is cheap (no lemons problems) and lending opportunities are good, problems) and lending opportunities are good, so both risk and equity capital rise.so both risk and equity capital rise.
When shock hits, banks face prospect of loss of When shock hits, banks face prospect of loss of deposits due to combination of risk aversion deposits due to combination of risk aversion and need for liquidity of depositors, and and need for liquidity of depositors, and asymmetric information problem about losses asymmetric information problem about losses within bank.within bank.
As banks lose deposits they act to restore As banks lose deposits they act to restore confidence by contracting loans, cutting confidence by contracting loans, cutting dividends, and expanding cash asset holdings.dividends, and expanding cash asset holdings.
NYC Bank Capital and Risk 1920-NYC Bank Capital and Risk 1920-19361936
NYC Banks’ Loans/Cash, Equity, NYC Banks’ Loans/Cash, Equity, DividendsDividends
Loans/CashLoans/Cash Equity/Assets Equity/Assets DividendsDividends
19221922 2.12.1 0.180.18
19291929 3.33.3 0.330.33 $392m$392m
19331933 1.01.0 0.150.15
19401940 0.30.3 0.100.10 $162m$162m
Source: Calomiris-Wilson JB 2004.Source: Calomiris-Wilson JB 2004.
Discipline Reflected on Liability Discipline Reflected on Liability SideSide
If discipline exists, it appears in three If discipline exists, it appears in three forms:forms: Interest cost of debt goes up with riskInterest cost of debt goes up with risk Rationing effect: deposits declineRationing effect: deposits decline Shift to high-cost, “monitored” marginal fundsShift to high-cost, “monitored” marginal funds
These effects are consistently visible These effects are consistently visible historically, as well as currently, in all historically, as well as currently, in all types of countries.types of countries.
Bank liability data, and liability interest Bank liability data, and liability interest rate data are the most reliable, rate data are the most reliable, consistently reported data on balance consistently reported data on balance sheets, which helps make them especially sheets, which helps make them especially useful as indicators.useful as indicators.
Example: Chicago 1932Example: Chicago 1932 1932 1932 Failures 1932 Failures 1932
SurvivorsSurvivorsNumberNumber 46 46 62 62
1931 R1931 RDD 2% 2% 1% 1%
1931 Borr/Debts1931 Borr/Debts 12% 12% 2% 2%
1931 Dep growth1931 Dep growth -45% -45% -33% -33%
Source: Calomiris-Mason 1997 AER.Source: Calomiris-Mason 1997 AER.
Example: Argentina 1995Example: Argentina 1995
1995 1995 Failures 1995 Failures 1995 SurvivorsSurvivors
RRDD paid in 1993 paid in 1993 13% 13% 9.5% 9.5%
Example: Mexico 1996Example: Mexico 1996
Even though there was 100% deposit Even though there was 100% deposit insurance, the losses were so large, insurance, the losses were so large, and the political debate so uncertain, and the political debate so uncertain, that insured deposits were not that insured deposits were not necessarily protected.necessarily protected.
Banamex (marginally solvent) paid Banamex (marginally solvent) paid 17% on its funds, on average, but 17% on its funds, on average, but Bank Serfin (deeply insolvent) paid Bank Serfin (deeply insolvent) paid 29%29%
Market Discipline Even with Market Discipline Even with InsuranceInsurance
All banks Banamex SerfinAll banks Banamex Serfin
1996 Dep. Int.1996 Dep. Int. 25.2% 25.2% 17.4% 28.9% 17.4% 28.9%
1994 branches 5,051 710 5611994 branches 5,051 710 561
1996 branches 6,264 912 5781996 branches 6,264 912 578
Contrast Old (Stable) System with Contrast Old (Stable) System with Protected (Unstable) SystemProtected (Unstable) System
Old, disciplined system reduced bank Old, disciplined system reduced bank risk in response to shocks.risk in response to shocks.
New system sees banks increasing New system sees banks increasing risks in response to shock (doubling risks in response to shock (doubling their bets), especially taking on their bets), especially taking on exchange risk.exchange risk. Chile 1982-1983Chile 1982-1983 U.S. Savings and Loans in 1980sU.S. Savings and Loans in 1980s Mexico 1993-1994Mexico 1993-1994 Japan 1990-1997Japan 1990-1997 Korea, Thailand, etc. 1995-1997Korea, Thailand, etc. 1995-1997
Risk-Based Capital RegulationRisk-Based Capital Regulation Basel and similar systems supposedly Basel and similar systems supposedly
target risk-based capital, which is target risk-based capital, which is similar to targeting default risk of debt, similar to targeting default risk of debt, although measurement of risk and although measurement of risk and capital are imperfect (to say the least) capital are imperfect (to say the least) and ratios are arbitrary.and ratios are arbitrary.
If this is successful, it results in If this is successful, it results in regulatory discipline with effects similar regulatory discipline with effects similar to market discipline: When a bank loses to market discipline: When a bank loses capital, it contracts risk, cuts dividends, capital, it contracts risk, cuts dividends, in order to comply with standard and in in order to comply with standard and in doing so reduces default risk.doing so reduces default risk.
Procyclical Effects?Procyclical Effects? If effective, this sort of capital regulation If effective, this sort of capital regulation
necessarily exacerbates the business necessarily exacerbates the business cycle, since losses of capital (during onset cycle, since losses of capital (during onset of recession) produce contraction of bank of recession) produce contraction of bank loan supply, which aggravates the loan supply, which aggravates the recession.recession.
Calomiris and Mason (AER 2003) estimate Calomiris and Mason (AER 2003) estimate that market discipline during U.S. Great that market discipline during U.S. Great Depression was responsible for income Depression was responsible for income declines roughly one-third as large in declines roughly one-third as large in percentage terms as the percentage percentage terms as the percentage declines in loan supply. These are very declines in loan supply. These are very large effects.large effects.
Procyclical Effects (Cont’d)Procyclical Effects (Cont’d) Two points warrant emphasis:Two points warrant emphasis: First, any prudent risk-managing bank will First, any prudent risk-managing bank will
have to contract risk in response to loss, have to contract risk in response to loss, so procyclicality is an inevitable feature so procyclicality is an inevitable feature of a well-managed banking system.of a well-managed banking system.
Second, “forebearance” (the decision by Second, “forebearance” (the decision by regulators to relax requirements because regulators to relax requirements because of a concern about loan supply) tends to of a concern about loan supply) tends to produce a produce a larger procyclical effectlarger procyclical effect, , because resurrection risk taking leads to because resurrection risk taking leads to systemic collapse, and often systemic collapse, and often unproductive risk taking prior to collapse. unproductive risk taking prior to collapse.
Policy in the Real WorldPolicy in the Real World Even though policy makers are aware that forbearance Even though policy makers are aware that forbearance
is counterproductive, they still do it.is counterproductive, they still do it. Politics tends to produce strong incentives for protection Politics tends to produce strong incentives for protection
of banks and forbearance, more in some countries than of banks and forbearance, more in some countries than in others (Demirguc-Kunt, Kane and Laeven 2007).in others (Demirguc-Kunt, Kane and Laeven 2007).
Book capital requirements invite discretionary Book capital requirements invite discretionary forbearance, as do reliance on supervisory judgments forbearance, as do reliance on supervisory judgments when measuring risk and capital.when measuring risk and capital.
Also, policymakers may lack timely information, or Also, policymakers may lack timely information, or incentive to put forth effort to collect it, so some incentive to put forth effort to collect it, so some forbearance may be inadvertent.forbearance may be inadvertent.
S&R fails. Barth-Caprio-Levine find that S&R fails. Barth-Caprio-Levine find that regulatory and regulatory and supervisory practices, other than practices that supervisory practices, other than practices that introduce market discipline, make no difference introduce market discipline, make no difference for banking sector growth or stability. Market for banking sector growth or stability. Market discipline promotes both greater stability and discipline promotes both greater stability and higher growth.higher growth.
Institutional EnvironmentDemocratic, Political Structure/System
Technology, Information Infrastructure
Judi
cial
, Leg
al,
Reg
ulat
ory
Env
iron
men
tM
arket Structure
Media
The Market:Depositors,creditors,
rating agencies
Politicians
Regulators andsupervisors
Borrowers, counterparties
Corruption
corruption Banks
The Public
corruption
A Framework for Bank Regulation,
Barth Caprio and Levine
Barth et al BookBarth et al Book Study of regulatory practices across 150 Study of regulatory practices across 150
countries, asking whether regulations countries, asking whether regulations improve bank stability and growth; and also improve bank stability and growth; and also exploring how regulations reflect and alter exploring how regulations reflect and alter political economy and corruption.political economy and corruption.
Variation in regulatory practice is enormous Variation in regulatory practice is enormous (capital regulation, deposit insurance (capital regulation, deposit insurance coverage, government ownership of banks, coverage, government ownership of banks, foreign entry permitted, bank powers foreign entry permitted, bank powers allowed).allowed).
Evidence favors the “private interest” (or Evidence favors the “private interest” (or “grabbing hand”) view over the “public “grabbing hand”) view over the “public interest” (or “helping hand”) view of bank interest” (or “helping hand”) view of bank regulation and supervision in EMs.regulation and supervision in EMs.
Barth et al FindingsBarth et al Findings““ Across the different statistical approaches, we Across the different statistical approaches, we find that empowering direct official supervision find that empowering direct official supervision of banks and strengthening capital standards do of banks and strengthening capital standards do not boost bank development, improve bank not boost bank development, improve bank efficiency, reduce corruption in lending, or lower efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence banking system fragility. Indeed, the evidence suggests that fortifying official supervisory suggests that fortifying official supervisory oversight and disciplinary powers actually oversight and disciplinary powers actually impedes the efficient operation of banks, impedes the efficient operation of banks, increases corruption in lending, and therefore increases corruption in lending, and therefore hurts the effectiveness of capital allocation hurts the effectiveness of capital allocation without any corresponding improvement in bank without any corresponding improvement in bank stability.stability.In contrast to these findings…bank supervisory In contrast to these findings…bank supervisory and regulatory policies that facilitate private and regulatory policies that facilitate private sector monitoring of banks improve bank sector monitoring of banks improve bank operations.”operations.”
Barth et al Details: Univariate Barth et al Details: Univariate RegressionsRegressions
Dependent Var: Bank Credit to Private Dependent Var: Bank Credit to Private Sector/GDPSector/GDP
(Controls not reported)(Controls not reported)
Entry Req. IndexEntry Req. Index Negative InsignificantNegative InsignificantLimits on For. EntryLimits on For. Entry Negative SignificantNegative SignificantEntry Appl. DeniedEntry Appl. Denied Negative SignificantNegative SignificantActivities RestrictionsActivities Restrictions Negative SignificantNegative SignificantCapital RegulationsCapital Regulations Positive MarginalPositive MarginalPrompt Corrective PowerPrompt Corrective Power Negative InsignificantNegative InsignificantOfficial Supervisory PowerOfficial Supervisory Power Negative SignificantNegative SignificantSupervisory IndependenceSupervisory Independence Negative Negative
InsignificantInsignificantGovernment-Owned BankingGovernment-Owned Banking Negative Negative
SignificantSignificantPrivate Monitoring IndexPrivate Monitoring Index Positive SignificantPositive Significant
Barth et al: Multivariate Barth et al: Multivariate RegressionRegression
Dependent Var: Bank Credit to Private Sector/GDPDependent Var: Bank Credit to Private Sector/GDP
(Controls not reported)(Controls not reported)
Entry Req. IndexEntry Req. Index Positive InsignificantPositive Insignificant
Activities RestrictionsActivities Restrictions Negative SignificantNegative Significant
Capital RegulationsCapital Regulations Positive InsignificantPositive Insignificant
Official Supervisory PowerOfficial Supervisory PowerPositive InsignificantPositive Insignificant
Government-Owned BankingGovernment-Owned Banking Negative InsignificantNegative Insignificant
Private Monitoring IndexPrivate Monitoring Index Positive SignificantPositive Significant
Barth et al: Multivariate Barth et al: Multivariate RegressionRegression
Dependent Var: Bank Crisis Probability (logit)Dependent Var: Bank Crisis Probability (logit)(Controls not reported)(Controls not reported)
Entry Req. IndexEntry Req. Index Positive InsignificantPositive InsignificantActivities RestrictionsActivities Restrictions Positive SignificantPositive SignificantCapital RegulationsCapital Regulations Negative InsignificantNegative InsignificantOfficial Supervisory PowerOfficial Supervisory Power Negative InsignificantNegative InsignificantGovernment-Owned BankingGovernment-Owned Banking Positive MarginalPositive MarginalMoral Hazard IndexMoral Hazard Index Positive SignificantPositive SignificantPolitical OpennessPolitical Openness Positive InsignificantPositive InsignificantMH x POMH x PO Negative SignificantNegative Significant
Moral Hazard = Dep Insurance GenerosityMoral Hazard = Dep Insurance Generosity
Barth et al: Multivariate Barth et al: Multivariate RegressionRegression
Dependent Var: Corruption of Banking Dependent Var: Corruption of Banking OfficialsOfficials
(Controls not reported)(Controls not reported)
Official Supervisory PowerOfficial Supervisory Power Positive Positive SignificantSignificant
Government-Owned BankingGovernment-Owned Banking Positive Positive SignificantSignificant
Private MonitoringPrivate Monitoring Negative Negative SignificantSignificant
Other Evidence on Foreign Bank EntryOther Evidence on Foreign Bank Entry Greater supply of credit (Goldberg, Dages, Greater supply of credit (Goldberg, Dages,
Kinney 2000), although based more on “hard” Kinney 2000), although based more on “hard” information than “soft” information (Mian information than “soft” information (Mian 2003)2003)
Less local presence => greater volatility of Less local presence => greater volatility of credit (Herrero and Peria 2005)credit (Herrero and Peria 2005)
Giannetti and Ongena (2005) find that foreign Giannetti and Ongena (2005) find that foreign presence reduces connected lending problems, presence reduces connected lending problems, improves access of funds to efficient non-improves access of funds to efficient non-connected borrowers, and improves efficiency connected borrowers, and improves efficiency of capital allocation, although effect seems of capital allocation, although effect seems confined to medium and large firmsconfined to medium and large firms
Similarly, Bonin and Imai (2005) show that sale Similarly, Bonin and Imai (2005) show that sale of Korean banks to foreign lenders had large of Korean banks to foreign lenders had large negative effects on stock returns of related negative effects on stock returns of related borrowers.borrowers.
% Banking System Foreign-Controlled (IMF % Banking System Foreign-Controlled (IMF 2000)2000)
19941994 19991999Czech Rep.Czech Rep. 5.8 5.8 49.349.3HungaryHungary 19.819.8 56.656.6PolandPoland 2.1 2.1
52.852.8ArgentinaArgentina 17.917.9 48.648.6BrazilBrazil 8.4 8.4 16.816.8ChileChile 16.316.3 53.653.6ColombiaColombia 6.2 6.2 17.817.8MexicoMexico 1.0 1.0 18.818.8PeruPeru 6.7 6.7 33.433.4VenezuelaVenezuela 0.3 0.3 41.941.9KoreaKorea 0.8 0.8 4.3 4.3MalaysiaMalaysia 6.8 6.8 11.511.5ThailandThailand 0.5 0.5 5.6 5.6
How can bank regulatory policy How can bank regulatory policy help?help?
Repeal the safety netRepeal the safety net. Perhaps a good idea . Perhaps a good idea (a vast body of empirical evidence indicates (a vast body of empirical evidence indicates deposit insurance makes systems more prone deposit insurance makes systems more prone to failure, not less), but this is hard to do, and to failure, not less), but this is hard to do, and there is often implicit insurance even when there is often implicit insurance even when explicit insurance is repealed.explicit insurance is repealed.
Narrow bankingNarrow banking. This is repeal in disguise.. This is repeal in disguise. Internal ModelsInternal Models. Regulators’ incentives are . Regulators’ incentives are
still to forbear, and thus credibility is lacking. still to forbear, and thus credibility is lacking. Regulation and supervision become extremely Regulation and supervision become extremely complicated. For developing countries, the complicated. For developing countries, the cost of implementing complex regulatory cost of implementing complex regulatory apparatus is very high, because banking apparatus is very high, because banking systems are small (100 countries with systems are small (100 countries with banking system deposits under $10 billion).banking system deposits under $10 billion).
Combining Safety Nets, S&R, and Combining Safety Nets, S&R, and Elements of Market DisciplineElements of Market Discipline
Once the government is involved in protecting Once the government is involved in protecting banks, markets have little incentive to take banks, markets have little incentive to take risks, and thus little incentive to monitor, or to risks, and thus little incentive to monitor, or to act upon information.act upon information.
S&R can incorporate market discipline if it finds S&R can incorporate market discipline if it finds a way to (1) require banks to offer some a way to (1) require banks to offer some component of risky debt to finance themselves, component of risky debt to finance themselves, (2) ensure that the pricing of that instrument is (2) ensure that the pricing of that instrument is observable to them and the market, and (3) observable to them and the market, and (3) establish rules that force S&R to act upon the establish rules that force S&R to act upon the information produced by the market.information produced by the market.
What Is NOT Market DisciplineWhat Is NOT Market Discipline Disclosure rules, by themselves, are of little Disclosure rules, by themselves, are of little
use, since market may have little reason to use, since market may have little reason to care about disclosure.care about disclosure.
The presence of uninsured debt is not The presence of uninsured debt is not necessarily indicative of market discipline necessarily indicative of market discipline because the debt may effectively have the because the debt may effectively have the option to leave when things go wrong, or option to leave when things go wrong, or because government may use mergers or because government may use mergers or other protection to bail it out, justified by other protection to bail it out, justified by “least cost resolution policy”“least cost resolution policy”
Insiders’ holdings of debt (which can be hard Insiders’ holdings of debt (which can be hard to track), or outsiders’ holdings protected via to track), or outsiders’ holdings protected via derivatives written by the bank, won’t derivatives written by the bank, won’t provide discipline.provide discipline.
Getting Market Discipline to Work: The Getting Market Discipline to Work: The Integrated Approach of Argentina c. Integrated Approach of Argentina c.
19991999 An integrated approach to S&R, in which An integrated approach to S&R, in which
credible market discipline is required, and credible market discipline is required, and produced by a combination of reforms, is the produced by a combination of reforms, is the best approach.best approach.
One of the best examples of this approach One of the best examples of this approach was Argentina in the late 1990s. The collapse was Argentina in the late 1990s. The collapse of the system in 2001-2002 was not due to of the system in 2001-2002 was not due to regulatory failure, but rather its success. regulatory failure, but rather its success. Cavallo seized bank equity in 2001 to Cavallo seized bank equity in 2001 to alleviate the government’s fiscal problems alleviate the government’s fiscal problems because domestic banks were only place to because domestic banks were only place to find the money.find the money.
Argentina 1992-2000Argentina 1992-2000 Free foreign entry (competitive pressure, skills)Free foreign entry (competitive pressure, skills) Encouragement of privatization of loss-making Encouragement of privatization of loss-making
provincial banks (pay provinces to privatize and provincial banks (pay provinces to privatize and renounce bank chartering). 18 privatized 1992-renounce bank chartering). 18 privatized 1992-99.99.
No explicit deposit insurance (modified in 1995)No explicit deposit insurance (modified in 1995) Book equity capital requirement depends on Book equity capital requirement depends on
loan interest rateloan interest rate VAR to set capital requirement for market risk VAR to set capital requirement for market risk
based on market volatilitybased on market volatility Liquidity requirement can be satisfied with Liquidity requirement can be satisfied with
standbys (rewards banks that command market standbys (rewards banks that command market confidence)confidence)
Aggressive NPL policyAggressive NPL policy
Argentina (Cont’d)Argentina (Cont’d) BASIC System: Integration of rules for BASIC System: Integration of rules for
information information creation, disclosure, and usecreation, disclosure, and use.. Central de riesgo information pool (crafted to Central de riesgo information pool (crafted to
minimize free riding, while allowing banks to minimize free riding, while allowing banks to avoid bad credits, and avoid double pledging avoid bad credits, and avoid double pledging of collateral).of collateral).
Auditing supervised, bonded.Auditing supervised, bonded. Subordinated debt requirement forces banks Subordinated debt requirement forces banks
to issue 2% of deposits in the form of to issue 2% of deposits in the form of uninsured subordinated debt held at arms uninsured subordinated debt held at arms length. (Concentration of uninsured claim may length. (Concentration of uninsured claim may be desirable, as more informed, and harder to be desirable, as more informed, and harder to renege if amount is small…no systemic renege if amount is small…no systemic excuse.)excuse.)
Banks rated by approved rating agencies Banks rated by approved rating agencies (good intentions, bad outcome). (good intentions, bad outcome). Ratings reform proposals today.Ratings reform proposals today.
Argentina (Cont’d)Argentina (Cont’d) Subordinated debt is not occurring in a Subordinated debt is not occurring in a
vacuum, but rather alongside other capital vacuum, but rather alongside other capital and liquidity rules, and other rules, that give and liquidity rules, and other rules, that give market opinions power in the regulatory market opinions power in the regulatory process.process.
Problems with implementation of sub debt Problems with implementation of sub debt rule. rule. Lack of compliance penalized in theory, but not Lack of compliance penalized in theory, but not
clear whether penalized in practice.clear whether penalized in practice. No clear regulatory actions (e.g., closure) required No clear regulatory actions (e.g., closure) required
based on high yields or inadequate issuance. No based on high yields or inadequate issuance. No public information on yields, amount, compliance.public information on yields, amount, compliance.
Not exempted from least-cost resolution.Not exempted from least-cost resolution. Arms length holding not enforced effectively.Arms length holding not enforced effectively.
Argentina (Cont’d)Argentina (Cont’d) Still, there is evidence that sub debt helpedStill, there is evidence that sub debt helped Low compliance was indicative of bank Low compliance was indicative of bank
weakness, and central bank realized this, so it weakness, and central bank realized this, so it gave them a signal, but not one that the public gave them a signal, but not one that the public had access to (so no discipline on regulatory had access to (so no discipline on regulatory forbearance). Source: Calomiris-Powell 2001.forbearance). Source: Calomiris-Powell 2001.
1996-99 1996-99 1996-99 1996-99
High compliance Low High compliance Low compliancecompliance
RRDD 7% 7% 8% 8%
NPLNPL 14% 14% 25% 25%
Equity ratioEquity ratio 0.157 0.157 0.183 0.183
Argentina (Cont’d)Argentina (Cont’d) More generally, Argentina showed More generally, Argentina showed
healthy signs of operating with prudent healthy signs of operating with prudent (old-fashioned) risk management.(old-fashioned) risk management.
One indication of the effectiveness of the One indication of the effectiveness of the system is the fact that deposit growth system is the fact that deposit growth rates reflect deposit risk, and that rates reflect deposit risk, and that deposit risk is related to book measures deposit risk is related to book measures of asset risk and equity capital.of asset risk and equity capital.
Another indication of effectiveness is Another indication of effectiveness is that banks that experienced increases that banks that experienced increases in their interest cost of debt acted in their interest cost of debt acted quickly to reduce risk, and thus bring quickly to reduce risk, and thus bring interest cost back down.interest cost back down.
Argentina (Cont’d)Argentina (Cont’d)Dependent Variable: Quarterly Deposit Dependent Variable: Quarterly Deposit
GrowthGrowth
RegressorRegressor CoefficientCoefficient Stand.ErrorStand.Error
Eq Ratio (-1)Eq Ratio (-1) 0.277 0.277 0.074 0.074
Loan Int. RateLoan Int. Rate -0.254 -0.254 0.121 0.121
Loans/CashLoans/Cash -0.0032 -0.0032 0.0007 0.0007
Sample period: 1993:3-1999:1Sample period: 1993:3-1999:1
Number of Observations: 1,138Number of Observations: 1,138
Adjusted R-Squared: 0.31Adjusted R-Squared: 0.31
Argentina (Cont’d)Argentina (Cont’d)Deposit Interest Rate AutoregressionDeposit Interest Rate Autoregression
Dependent Variable: Quarterly Deposit Dependent Variable: Quarterly Deposit Interest CostInterest Cost
RegressorRegressor CoefficientCoefficient Stand.ErrorStand.Error
RRDD (-1) (-1) -1.29 -1.29 0.04 0.04
Adjusted R-Squared: 0.58Adjusted R-Squared: 0.58Number of Observations: 688Number of Observations: 688
Broad ConclusionsBroad Conclusions Safety net is major source of risk, market Safety net is major source of risk, market
discipline is the ONLY credible mitigator discipline is the ONLY credible mitigator of risk.of risk.
Market discipline is best introduced with Market discipline is best introduced with an integrated approach that results in an integrated approach that results in the the creation, disclosure and usecreation, disclosure and use of of credible information in the marketplace.credible information in the marketplace.
Government regulatory transparency is Government regulatory transparency is as important as government mandates as important as government mandates for promoting market discipline.for promoting market discipline.
Market discipline is a complement, not a Market discipline is a complement, not a substitute for S&R (e.g., insider substitute for S&R (e.g., insider holdings).holdings).
Specific RecommendationsSpecific Recommendations Good ideas for bringing markets into S&R process:Good ideas for bringing markets into S&R process:
Free entry, privatization of SOBs, limited safety netFree entry, privatization of SOBs, limited safety net Use of loan interest rate to set capital requirementUse of loan interest rate to set capital requirement Reform of credit ratings: numbers with penalties.Reform of credit ratings: numbers with penalties. Standbys abroad should substitute for cash reservesStandbys abroad should substitute for cash reserves BASIC Argentine system (except use of credit ratings)BASIC Argentine system (except use of credit ratings) Improve on Argentine sub debt to avoid back door Improve on Argentine sub debt to avoid back door
bailouts, insider holdings, derivatives; to enforce bailouts, insider holdings, derivatives; to enforce public disclosure; and to establish prompt corrective public disclosure; and to establish prompt corrective action rules to limit forbearance in response to failure action rules to limit forbearance in response to failure to gain market confidence (defined by market yields, to gain market confidence (defined by market yields, flows on debt)flows on debt)
Sub debt’s form can be flexible (e.g., two year Sub debt’s form can be flexible (e.g., two year maturity CDs held by banks abroad) depending on maturity CDs held by banks abroad) depending on environment, and contingent capital certificates are environment, and contingent capital certificates are an improvement on sub debt (discussed further an improvement on sub debt (discussed further below).below).
Cutting Edge IdeasCutting Edge IdeasCoCosCoCos
Require on top of higher common/assets Require on top of higher common/assets minimum requirement of 12%, a CoCo minimum requirement of 12%, a CoCo requirement of 10% of quasi market value of requirement of 10% of quasi market value of firm (face value debt +MVE)firm (face value debt +MVE)
Trigger must be credible, predictable, timely, Trigger must be credible, predictable, timely, and based on comprehensive view of bank.and based on comprehensive view of bank.
Goldman proposes book value, but it is not Goldman proposes book value, but it is not credible or timely.credible or timely.
Cumulative market value decline trigger would Cumulative market value decline trigger would work (say, 40% from peak).work (say, 40% from peak).
Dilution risk would force voluntary preemptive Dilution risk would force voluntary preemptive issues of common stock ahead of triggers.issues of common stock ahead of triggers.
Result would be that banks almost never go Result would be that banks almost never go under.under.
Design Prompt Corrective Action (PCA) trigger Design Prompt Corrective Action (PCA) trigger based on similar cumulative value decline basis.based on similar cumulative value decline basis.
Macro Prudential RulesMacro Prudential Rules
Macro prudential regulation that raises Macro prudential regulation that raises capital requirements during normal capital requirements during normal times in order to lower them during times in order to lower them during recessions.recessions.
Additional macro prudential regulatory Additional macro prudential regulatory triggers that increase regulatory triggers that increase regulatory requirements for capital, liquidity, or requirements for capital, liquidity, or provisioning as a function of credit provisioning as a function of credit growth, asset price growth, and growth, asset price growth, and possibly other macroeconomic risk possibly other macroeconomic risk measures. (Borio Drehman paper.)measures. (Borio Drehman paper.)
Case Study: Colombia 2006-2008Case Study: Colombia 2006-2008 Financial system loans annual growth rose from 10% in Financial system loans annual growth rose from 10% in
December 2005 to 27% by December 2006. December 2005 to 27% by December 2006. Core CPI rose gradually relative to credit (from 3.5% in April Core CPI rose gradually relative to credit (from 3.5% in April
2006 to 4.8% in April 2007). 2006 to 4.8% in April 2007). Real GDP growth in 2007 was 8%.Real GDP growth in 2007 was 8%. Current account deficit rose from 1.8% GDP in second half of Current account deficit rose from 1.8% GDP in second half of
2006 to 3.6% GDP in first half of 2007.2006 to 3.6% GDP in first half of 2007. Monetary authority reacted directly to credit growth in real Monetary authority reacted directly to credit growth in real
time: Interest rates were increased 400 bps from April 2006 to time: Interest rates were increased 400 bps from April 2006 to July 2008. July 2008.
But central bank saw too small a market response to this, so it But central bank saw too small a market response to this, so it increased reserve requirements for banks and increased reserve requirements for banks and convinced superintendency to raise provisioning for credit, convinced superintendency to raise provisioning for credit, imposed measures to raise costs of borrowing short-term imposed measures to raise costs of borrowing short-term
from abroad (deposit requirement reactivated), and from abroad (deposit requirement reactivated), and limited not only currency mismatches of banks and other FX limited not only currency mismatches of banks and other FX
exposure in the system, but also gross currency positions exposure in the system, but also gross currency positions (to avoid counterparty risks).(to avoid counterparty risks).
Credit growth is now “only” 13%; risk-weighted capital ratio for Credit growth is now “only” 13%; risk-weighted capital ratio for banks is 13.9%, and first half 2008 is 4.9% above first half of banks is 13.9%, and first half 2008 is 4.9% above first half of 2007, expected to fall to about 3.5% for 2008 as a whole. 2007, expected to fall to about 3.5% for 2008 as a whole.
Fix Too Big To FailFix Too Big To Fail CoCos for large banks probably will take care of much CoCos for large banks probably will take care of much
of the problem. of the problem. Regulatory surcharge (which takes the form of higher Regulatory surcharge (which takes the form of higher
required capital, higher required liquidity, or more required capital, higher required liquidity, or more aggressive provisioning) on large, complex banks.aggressive provisioning) on large, complex banks.
Detailed regularly updated plans for intervention and Detailed regularly updated plans for intervention and resolution of large, complex institutions resolution of large, complex institutions prepared by prepared by themthem, which specify how control the bank’s , which specify how control the bank’s operations when transferred to a prepackaged bridge operations when transferred to a prepackaged bridge bank if the bank became severely undercapitalized. bank if the bank became severely undercapitalized.
Hybrid reliance on bankruptcy with special Hybrid reliance on bankruptcy with special resolution authority triggered by credible resolution authority triggered by credible determination of real systemic risk. determination of real systemic risk. Key problem: Key problem: how to keep unwarranted resolutions from how to keep unwarranted resolutions from happening?happening?
Aftermath of crisesAftermath of crises Does crisis tend to lay groundwork for Does crisis tend to lay groundwork for
more or less liberalization? more or less liberalization? It can go either way, depending on domestic It can go either way, depending on domestic
political environment (Mexico, East Asia and political environment (Mexico, East Asia and Brazil vs. Argentina)Brazil vs. Argentina)
How to deal with massive insolvencies?How to deal with massive insolvencies? There are many possible mechanismsThere are many possible mechanisms
Liquidation via market (but adverse selection Liquidation via market (but adverse selection problems, legal system and information limits)problems, legal system and information limits)
AMCs a solution? No, since they also must liquidate, AMCs a solution? No, since they also must liquidate, and same problems plague them; also corruption and same problems plague them; also corruption plagues them, much more than in U.S. or plagues them, much more than in U.S. or Scandinavia.Scandinavia.
Creative solutions that work with market incentives Creative solutions that work with market incentives (Punto Final program in Mexico)(Punto Final program in Mexico)
Assistance to recapitalize banks (RFC vs. Japan)Assistance to recapitalize banks (RFC vs. Japan) Foreign entry of banks to speed reestablishment of Foreign entry of banks to speed reestablishment of
credit.credit. Debt moratorium (cultura de no pago in Mexico)Debt moratorium (cultura de no pago in Mexico) Debt redenomination (Argentina; U.S. precedents)Debt redenomination (Argentina; U.S. precedents)
US Bank Assistance in 1930s vs. JapanUS Bank Assistance in 1930s vs. Japan ’’s in s in 1990s (w/ Mason)1990s (w/ Mason)
US Banking problemsUS Banking problems Real shocks, not runs (until 1933) (Calomiris-Real shocks, not runs (until 1933) (Calomiris-
Mason 2003a)Mason 2003a) Market discipline Market discipline Capital crunch (Calomiris- Capital crunch (Calomiris-
Wilson 2004)Wilson 2004) Depositor preferences (active vs. passive)Depositor preferences (active vs. passive) Loan supply contractsLoan supply contracts Dividends cutDividends cut
Large adverse macroeconomic consequences of Large adverse macroeconomic consequences of credit contraction (Calomiris-Mason 2003b)credit contraction (Calomiris-Mason 2003b)
Asset market illiquidity problems, too, from Asset market illiquidity problems, too, from liquidation of bank assets, which slowed liquidation of bank assets, which slowed resolutionresolution
US in 1930s (ContUS in 1930s (Cont’’d)d) Policy ResponsePolicy Response
RFC lending (inadequate)RFC lending (inadequate) RFC preferred stock begins in 1933RFC preferred stock begins in 1933
Selective: Targeting marginal banks, field Selective: Targeting marginal banks, field office autonomy seems to have limited office autonomy seems to have limited abuseabuse
Limits behavior: Dividends, capital, voting Limits behavior: Dividends, capital, voting on management issues; Regression on management issues; Regression evidence suggests that RFC conditionality evidence suggests that RFC conditionality matteredmattered
Seems to be effective, reduces failure riskSeems to be effective, reduces failure risk
Comparison Comparison RFC Recipients Non-RFC Recipients Non-
RecipientsRecipients
Fail Prob Fail Prob ’’3131 0.1470.147 0.0960.096
Fail Prob Fail Prob ’’3434 0.0110.011 0.0040.004
Div Pay Div Pay ’’3434 0.0010.001 0.0080.008
Japan in the 1990sJapan in the 1990s
Little deposit market disciplineLittle deposit market discipline Convoy system spreads assistanceConvoy system spreads assistance Dividend payments to common stock Dividend payments to common stock
remain large (liquidity for Keiretsu firms)remain large (liquidity for Keiretsu firms) Banks do not have to accumulate Banks do not have to accumulate
additional capital to get assistanceadditional capital to get assistance Assistance seems to have had no effect Assistance seems to have had no effect
on failure risk or lending, and NPLs have on failure risk or lending, and NPLs have grown over timegrown over time
What might have worked What might have worked better?better?
Conditional AssistanceConditional Assistance Dividend limitsDividend limits Capital plan with matching requirement Capital plan with matching requirement
(note that this is self-selecting)(note that this is self-selecting) Introduce Market Discipline in RegulationIntroduce Market Discipline in Regulation
Minimum sub debt or other uninsured debtsMinimum sub debt or other uninsured debts Interest rate-sensitive capital requirementsInterest rate-sensitive capital requirements High reserve requirements, but allow High reserve requirements, but allow
offshore SLOCs in lieu of reserve offshore SLOCs in lieu of reserve requirementsrequirements
Debt redenomination: US in 1860s, US in Debt redenomination: US in 1860s, US in 1930s1930s
In both cases, this was a convenient way In both cases, this was a convenient way of using the change in numeraire of debt of using the change in numeraire of debt to restore net worth of banks and to restore net worth of banks and borrowers.borrowers.
Civil War: legal tender acts saved banks Civil War: legal tender acts saved banks after shock of December 1861 by making after shock of December 1861 by making bank liabilities decline with bank assets bank liabilities decline with bank assets (govt. bonds).(govt. bonds).
Great Depression: elimination of gold Great Depression: elimination of gold clauses actually increased values of bonds, clauses actually increased values of bonds, implying that effect on default premium implying that effect on default premium outweighed effect on face value.outweighed effect on face value.
Key advantages: speed, no reliance on Key advantages: speed, no reliance on institutional quality.institutional quality.
ArgentinaArgentina’’s Redenomination s Redenomination 20022002
Does same logic apply to Argentina 2002?Does same logic apply to Argentina 2002? Fiscal crisis leads to arm twisting of banks Fiscal crisis leads to arm twisting of banks
to buy bonds, then eventual collapse of to buy bonds, then eventual collapse of banks and exchange rate.banks and exchange rate.
““PesificationPesification”” of debt could provide relief of debt could provide relief to borrowers, especially high dollar debt to borrowers, especially high dollar debt firms in non-tradables sector.firms in non-tradables sector.
Asymmetric aspect of pesification hurt Asymmetric aspect of pesification hurt banks and had clear political element, but banks and had clear political element, but we can conceptually separate it from we can conceptually separate it from pesification.pesification.
Argentina (ContArgentina (Cont’’d)d) ArgentinaArgentina’’s peculiar vulnerability to s peculiar vulnerability to
devaluation devaluation Investment evidenceInvestment evidence Stock market reactionsStock market reactions Conclusion: There seems to have been Conclusion: There seems to have been
a significant positive effect on market a significant positive effect on market and on non-tradable producers with and on non-tradable producers with high dollar debt exposures.high dollar debt exposures.
Net benefit?Net benefit?
Figure 1C: Reinhart-Rogoff-Savastano Composite Dollarization Index Level vs.Exports-to-GDP Ratio for Reinhart-Rogoff-Savastano’s Fifty Highest Dollarized Countries
Uganda
Turkmenistan
Pakistan
Hungary
Georgia
Estonia
El Salvador
Costa Rica
Belarus
Armenia
Thailand
Philippines
Moldova
Jamaica
Côte d'Ivoire
Bahrain
Vietnam
Russia
Mongolia
Kyrgyz RepublicYemen
Tanzania
Sierra Leone
MalawiGuinea
Croatia
Congo DR
Indonesia
Turkey
Tajikistan
Jordan
Honduras
Ghana
Zambia
São Tomé & Príncipe
Mozambique
Lebanon
Guinea-Bissau
Paraguay
Cambodia
Peru
Angola
Bulgaria
Argentina
UruguayBolivia
Ecuador
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
8 10 12 14 16 18 20 22 24 26Reinhart-Rogoff-Savastano Composite Index Level: 1996-2001
2001
Exp
orts
/GD
P
Non-Tradable FirmsNon-Tradable Firms Tradable FirmsTradable Firms
MexicoMexico MeanMean FirmsFirms Std. DevStd. Dev MeanMean FirmsFirms Std. DevStd. Dev
High-High-Dollar Dollar Debt Debt FirmsFirms
0.07110.0711 77 0.06690.0669 0.14600.1460 2323 0.14600.1460
Low-Low-Dollar Dollar Debt Debt FirmsFirms
0.16250.1625 2828 0.21410.2141 0.12240.1224 2525 0.08930.0893
DifDif -0.0914-0.0914 0.02360.0236
T-StatT-Stat -1.9155-1.9155 0.66950.6695
Pr(Dif ≥ 0)Pr(Dif ≥ 0) 0.03240.0324 0.74630.7463
Non-Tradable FirmsNon-Tradable Firms Tradable FirmsTradable Firms
ArgentinaArgentina MeanMean FirmsFirms Std. DevStd. Dev MeanMean FirmsFirms Std. DevStd. Dev
High-High-Dollar Dollar Debt Debt FirmsFirms
0.07240.0724 66 0.09590.0959 0.18170.1817 77 0.15790.1579
Low-Low-Dollar Dollar Debt Debt FirmsFirms
0.06440.0644 55 0.03970.0397 0.21550.2155 77 0.15370.1537
DifDif 0.00800.0080 -0.0339-0.0339
T-StatT-Stat 0.18620.1862 -0.4069-0.4069
Pr(Dif ≥0)Pr(Dif ≥0) 0.57120.5712 0.34560.3456
DDADDAtt-1-1 -0.1449-0.1449 -1.79-1.79
(0.0809)(0.0809) 0.0760.076
DDADDAtt-1-1 x ARG x ARG 0.21920.2192 1.631.63
(0.1346)(0.1346) 0.1060.106
TR x DDATR x DDAtt-1-1 0.12420.1242 1.211.21
(0.1029)(0.1029) 0.2300.230
TR x DDATR x DDAtt-1-1 x ARG x ARG -0.2684-0.2684 -1.64-1.64
(0.1638)(0.1638) 0.1040.104
EVENT STUDYEVENT STUDY Dependent VariableDependent Variable
Cumulative Raw Cumulative Raw ReturnsReturns
Cumulative Abnormal Cumulative Abnormal ReturnsReturns
Independent VariablesIndependent Variables CoefficientCoefficient(Std. Error)(Std. Error)
T-StatT-StatP>|t|P>|t|
CoefficientCoefficient(Std. Error)(Std. Error)
T-StatT-StatP>|t|P>|t|
TRTR 0.15610.1561 3.823.82 0.12490.1249 2.372.37
(0.0409)(0.0409) 0.0010.001 (0.0528)(0.0528) 0.0260.026
DDADDAtt-1-1 0.24470.2447 2.332.33 0.34730.3473 2.562.56
(0.1051)(0.1051) 0.0280.028 (0.1356)(0.1356) 0.0170.017
ConstantConstant -0.0255-0.0255 -0.49-0.49 -0.0959-0.0959 -1.42-1.42
(0.0524)(0.0524) 0.6310.631 (0.0676)(0.0676) 0.1680.168
Regression StatisticsRegression Statistics
ObservationsObservations 2929 2929
RR22 0.40700.4070 0.29120.2912
Adjusted RAdjusted R22 0.36130.3613 0.23670.2367
Root MSERoot MSE 0.10090.1009 0.13010.1301
