1

Overview of Financial Stability

Issues

Seminar on Financial Stability and Development

2

No. of systemic crises in progress worldwide1980-2002

02468

101214161820

1980 1985 1990 1995 2000

3

Fiscal cost of banking crises

0

5

10

15

20

25

30

35

40

45

50

Sweden

91

Mal

aysia

91

Colom

bia

82

Sri La

nka

89

Parag

uay

95

Spain

77

Norway

87

Seneg

al 8

8

Hunga

ry 9

1

Finlan

d 91

Czech

89

Bulga

ria 9

6

Ecuad

or 9

6

Brazil

94

Philip

pines

83

Slove

nia 9

2

Mal

aysia

97

Mex

ico 9

4

Japa

n 92

Venez

uela

94

Cote

d'Ivo

ire 8

8

Korea

97

Urugu

ay 8

1

Thaila

nd 9

7

Chile

81

Indo

nesia

97

% o

f GD

P

4

Varied sources of crises

• Unstable macro conditions– positive feedback loop– but banking often not causal– unhedged positions a special feature

• Unraveling of government impositions– China, Vietnam, Zambia, etc.

• Management failures– “diverted deposits” fraud

5

Four distinctive features of recent resolutions

• Skewed distribution of losses– not all banks fail: the fittest survive

• State-owned as well as private bank losses– Even in macro-related collapses,

• Turkey=50%, Indonesia=46%

• Information emerges slowly– One-shot resolution is rare: it’s not over ’til it’s over

• Currency depreciation has often been central– Sometimes a trigger, sometimes a resolution tool

6

Anti-crisis policy matters

• To contain current and future costs

• But what is good anti-crisis policy? Contested. Research casts doubt on received wisdom.

• Containment & resolution phases: accommodation versus intervention

• Prevention stages: reliance on official supervision vs. market discipline

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Containment phase

Goals:• Protect functioning of payments mechanism• Limit contagion • Preserve macroeconomic stability• Stop erosion of bank capital

8

Resolution and restructuring phase

Goals:• Allocation of losses• Recovery of claims• Restoration of good management…

... and sound financial structure (design of financial instruments relevant)

9

Who gets bailed-out (and why)?

• Small depositors?• Other domestic depositors?• Interbank creditors?• Other domestic creditors?• Foreign creditors?• Shareholders?• Borrowers?

10

How banking crises hit the budget

• Lender of last resort (liquidity loans go bad) (Venezuela/Peru)

• Un(der) funded deposit insurance (USA)

• Capital injection in failing bank (China)

• Subsidized/underwritten purchase and assumptions• Borrower support mechanisms (Mexico)

• Blanket depositor guarantee (Turkey)

• Other (e.g. Argentina compensatory mechanism, 1989)

11

Fiscal costs vs. output slumps

Fiscal costs are not the whole story– fiscal costs partly just a transfer

...but impose deadweight costs on the economy– also reflect underlying portfolio losses– may not capture all costs

...including macro slump

But total economic costs are correlated with fiscal costs -- perhaps more so than measured GDP dips

12

Fiscal cost of and output dip after banking crisis

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60 70

Output dip: cumulative % of GDP

Fis

cal c

ost (

% o

f GD

P)

13

The data favour strict policy

Type of accommodating measure (and percent of cases where it was used)

Additional cost of adopting each accommodating measure (% of GDP)

Liquidity support (58%) 6.3 Forbearance (24%) 6.7 Blanket guarantee (55%) 2.9 Multiple recapitalizations (24%) 6.3 Debt relief (21%) 3.1 Memo: actual sample (base case cost)

6.7

Honohan-Klingebiel, 2003

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Large potential impact of policy on cost

0 10 20 30 40 50 60 70

All accommodating

Actual

All strict

Per cent of GNP

15

Policy on prevention

• Market discipline (3rd pillar of Basel II) may be a better bet than you think, especially given increased complexity and speed of change

(& even in unsophisticated environments)

• But needs to be fostered (including information disclosure)

…not chilled by– Explicit deposit guarantees– State ownership

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Dimensions of private monitoring

• Bank accounting rules• Auditing and disclosure requirements• Rating of banks• Deposit insurance (limitations on)• Subordinated debt requirement

Barth et al (2003)

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Market discipline: the players

Many or few? What might

they do? Sensitive to upside risk?

Large depositors Potentially many Withdraw No

Debtholders Potentially many Move prices No

Equity holders Potentially many Move prices Yes

Info specialists Few Publish info Not much

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Post-containment resolution issues: Points of contention

• Capital and ownership– shareholders & subordinated claimholders should pay– but then what?

• Fiscal, monetary and incentive effects of recapitalization– getting the balance right

• Mixed performance AMCs

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Capital and ownership: options

• Relying on existing shareholders– But risk of self-dealing and looting– Leaves State in poor bargaining position– Preserves existing power structures (cf Rajan-

Zingales)

• Seeking domestic merger partner– 2 weak banks = 1 strong one?

• Finding other local owners (where?)• Nationalization (only temporary solution)• Foreign buyers

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• Ensuring the bank has enough capital, liquidity and incentives

• Government claims on the restructured banks

• Implications for debt management

• Implications for monetary policy

Fiscal, Monetary and Incentive Issues (outline)

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Getting the priorities right

When banks are being recapitalized:

Don’t subordinate incentive design…

to monetary

or fiscal

straitjackets

…because of false ideas about constraints

22

And this is because…

onetary policy:

Can use other instruments to offset unwanted liquidity effects of bank restructuring,

Fiscal policy:

Attempts to ease the fiscal pressure through instrument are often an ineffective attempt to conceal true losses by deferring recognition.

23

Proposed priority of actions:

1. Inject assets to ensure capitalization and prospective earnings consistent with safe-and-sound banking

2. Restructure liability structure to protect taxpayer subject to adequate incentives

3. Rebalance government debt (maturity etc.)

4. Sterilize any undesired monetary side-effects

24

AMCs: Prerequisites for success

• Skilled resources, • Professional management (management information

systems, transparency in operations and processes)• Political independence• Appropriate funding• Adequate bankruptcy and foreclosure laws

– Some AMCs have superpowers

“Doomed to failure if governments transfer what had been politically motivated loans” - Klingebiel