Public Debt Restructuringand Banking

James RoafSovereign Asset and Liability Management Division

Monetary and Capital Markets Department, IMF

World Bank/IMF/Federal Reserve SystemSeminar for Senior Bank Supervisors from Emerging Markets

Washington DC, October 18, 2007

Outline

• Public debt restructuring – recent experience

• Involvement of banking sectorExamples: Russia, Argentina and Uruguay

Direct exposure to government paper is only part of bank’s problems.

• Policy challenges and role of supervisionVulnerability to sovereign debt crisis and restructuring

Crisis mitigation and management

Role of supervision in reducing vulnerability

Role of the Fund

Part IExperience of recent sovereign

debt restructurings

Sovereign debt restructuringsof the past decade

• Since 1998, about 15 sovereign debt crises and restructurings involving private creditors, including:

Russia (1998-2000)Ukraine (1998-2000)Pakistan (1999)Ecuador (1999-2000)Argentina (2001-05)Uruguay (2002-03)Various others, including Caribbean recently.

• Good source, used extensively here: “Debt Defaults and Lessons from a Decade of Crises”, Sturzenegger and Zettelmeyer, 2007.

Restructurings are still rare events (fortunately)

• Indeed have become rarer with improved EM fundamentals and debt management practices, high global liquidity and longer-term flows to EM countries.

• EMs have come out well in recent subprime turmoil.Bond spreads widened temporarilySome countries delayed debt auctions and international issuanceBut situation normalized quickly

• But still potential for debt problems in some EM countries.Risk that countries take present easy financing environment for grantedRisk of global slowdown affecting EMs, especially through commodity prices.

Features of restructurings

• Focused on bonds, unlike bank debt crises of 1980s. First time since 1930s.

• Creditor losses more dispersed under bond restructuring, but concerns about creditor coordination and holdouts.

• Informal consultations leading to exchange offers, unlike previous formal negotiations with creditor committees.

• Some restructurings involve arrears, some “pre-default”• Participation rates have mostly been high, and restructurings

generally quicker than 1980s bank debt restructurings (except Argentina).

Suggests creditor coordination problems smaller than expected.

Domestic and external debt• Restructurings involved both domestic and external

debt, but usually treated differently.Russia restructured domestic debt but not new external bonds.Pakistan restructured external debt but not domestic debt.Argentina gave much better terms on debt held by residents than by nonresidents.Ecuador restructured external bonds and short-term foreign-currency domestic debt, but not other domestic debt.Uruguay treated domestic and external debt on more similar terms.

• Relevant to banks, who are likely to be holding predominantly domestic debt.

Scale of restructurings

• NPV “haircuts” in public debt restructurings have varied widely:

Russia nonresidents 61 percent, residents 48 percentPakistan 31 percent (external only)Ecuador external 29 percent, domestic 38 percentArgentina external 75 percent, domestic 41 percentUruguay external 13-15 percent, domestic 24-38 percentDominican Republic 1.5 percent (external only)

• Debt/GDP ratios have also varied widely across crisis cases, and often been lower than non-crisis countries

Recent developments in public debt markets

• Dramatic broadening of EM investor base.• Many sovereigns have been successful in moving from foreign-

currency/external debt to local-currency/domestic debt“Original sin” is reduced.Reduces risk to sovereign, possibly at cost of higher interest rates and shorter maturities.May make it harder to protect domestic institutions from restructuring, because scope for differential treatment is reduced.

• External bonds now typically include collective action clauses (CACs) to aid in smooth restructuring.

63 percent of EM sovereign external bonds now contain CACs.

• Official sector debt receding in significance, and within the total non-Paris Club lenders becoming more important.

Part IIInvolvement of banking sector in

public debt crises

Banking sector involvement in recent restructurings

• Sovereign debt restructurings have mostly been “double” or “triple” crises – debt, currency and banking.

Fiscal solvency is key in maintaining confidence in the currency

• Causality goes both ways, for example:Argentina had reasonably well-supervised banking system, but crisis led to bank run, and government actions further undermined banking sectorEcuador debt crisis was precipitated by banking crisisRussia crisis originated in fiscal sector but balance sheet exposures of banks magnified problems

• Given explicit or implicit guarantees, and political pressures, banking system liabilities can become contingent liabilities of the public sector.

• Banks can be hit by public debt crises in other countries.Latvian banks after Russia crisis, Uruguay banks after Argentine crisis.

Debt and banking crisis example 1: Russia (1998)

• Background to crisisGovernment T-bills (GKO) pyramid reflected large fiscal imbalances.Weak bank supervision, rapid multiplicity of banks (1,700 by 1997).Banks bought government paper heavily, becoming major financers of government while also becoming heavily dependent on income from government debt, crowding out other lending. Banks held bulk of government debt.Banks also provided forex hedge to nonresidents investing in GKOs (under fixed exchange rate), thus building up huge open forex exposure.

Debt and banking crisis example 1: Russia (1998, cont.)

• Impact of crisis on banks and policy responsesGKO default and ruble devaluation of August 17, 1998 wiped out financial sector capital. Moratorium imposed on banks’ payments to nonresidents.Deposit runs began, interbank transactions ceased, and payments system froze. CBR injected massive liquidity, lowered reserve requirements, made “rehabilitation loans” to systemically important banks, “nationalized” commercial bank deposits in large state-owned bank.Measures restarted payments system and ended deposit runs, but fueled inflation and depreciation.Cautious and piecemeal approach to bank restructuring, relied mostly on regulatory forbearance and selective interventions rather than generalized recapitalization. System did gradually recapitalize.

Debt and banking crisis example 2: Argentina (2001-02)

• Background to crisis

Perennial fiscal problem, slow growth, adverse terms of trade and overvalued exchange rate. Debt levels did not seem excessive but rising fast and increasing rollover risk, heavy forex exposure.

Banking system generally well supervised and capitalized, forex exposures under control.

Government pushed its debt onto banks through 2001, but exposure remained moderate at about 25 percent of assets.

Debt and banking crisis example 2: Argentina (2001-02, cont.)

• Impact of crisis on banks and policy responsesBanks were involved in November 2001 “Phase 1” exchange of bonds held by residents for longer term loans with lower interest rates.Expectations of devaluation and default led to deposit run and a deposit freeze; Default on external debt and devaluation took place in December 2001.Government instituted asymmetric pesification of dollar deposits at 1.4:1 and bank loans at 1:1, while market rate was already at around 2:1. This rendered the banking system insolvent. Banks suffered further losses as depositors sued in court for payment of deposits in original dollar value. Leakages from deposit freeze led liquidity injections, and tightening of deposit and exchange restrictions. Regulatory forbearance exercised.Government eventually compensated banks for losses due to asymmetric pesification with new government bonds. Freeze on sight deposits lifted at end-2002.Restructuring of nonresident debt holdings finally completed in 2005. Relatively favorable treatment given to domestic banks compared to foreign bondholders was not a major bone of contention.

Debt and banking crisis example 3: Uruguay (2002-03)

• Background to crisisEconomy suffered fallout from Argentine crisis, and pressure on exchange rate to join in devaluation.Public debt at a little over 50 percent of GDP but almost all in US dollars, and little held by domestic banks.High financial dollarization: over 90 percent of deposits in dollars. 40 percent of deposits held by nonresidents, mainly Argentines, as Uruguay played role of safe haven in region.

Debt and banking crisis example 3: Uruguay (2002-03, cont.)

• Impact of crisis on banks and policy responsesWithdrawal of deposits by Argentines in need of liquidity increased rapidly in early 2002, precipitating bank deposit runs.Provision of liquidity by the central bank rapidly depleted reservesCurrency floated in June 2002, with 50 percent depreciation leading to large rise in public debt ratio, undermining ability of government to rescue distressed banks.Bank holiday declared in July. Strategy on exit from holiday avoided Argentina-style freeze on sight deposits, in order to ensure continued operation of payments system. Instead IMF-financed stability fund fully backed dollar deposits at core setof domestic banks.Foreign banks left to operate normally, on assumption that parents would continue to support their subsidiaries for reasons of reputational risk, given limits on financial risk due to small size of Uruguay market. (Assumption proved correct).Public debt was restructured in market-friendly exchange in May 2003. Banks were little affected by the restructuring itself, under which face values were maintained and maturities extended.

Impact of public debt restructuringon banks: lessons

• Impact has differed very widely:Russia - banks very severely affected; Belize - hardly any impact

• Depends on range of factors including:Initial soundness of banking systemDegree of bank exposure to public debt and to exchange rate Correlation between public debt and other bank assetsSize of haircut in restructuringTreatment of domestic and external debt in restructuringDegree to which banks are protected from restructuring, or compensatedDeposit insurance system, and credibility of government deposit guaranteesAccounting rules for restructured instruments and regulatory forbearancePresence of foreign banks and presence of nonresident depositors.

Part IIIPolicy Challenges

Public debt restructuring andbanking crisis management

• As with any crisis threatening banks, objective to maintain soundness of system:

Avoid self-fulfilling bank crisis, runs on deposits etc.Avoid economic dislocation

Preserve payment systemMaintain adequate levels of financial intermediation

• Complication in debt crisis is that public sector becomes part of the problem rather than part of the solution

Public sector debt on bank balance sheets is weakening their solvency and liquidityProblems in public sector likely to put pressure on exchange rate, adding to balance sheet problems of banks with forex exposureLikely to be correlation between losses on public debt holdings and other assets in banks’ portfoliosMay be difficult to recapitalize weak banks using public resources or provide credible deposit guarantees

Bank exposure to sovereign debt• Government paper has various important roles on bank balance

sheetsHighly liquid, use as collateral, instrument of monetary policy, etc

• But these roles require only modest holdings. Vulnerabilities arise if government debt become large as share of total bank assets, or if banking system is used as a “captive” investor by the government.

• Degree of exposure varies widely across countries, as shown in BIS survey data.

Has generally been rising in Latin America and parts of EuropeSterilization of capital inflows may have been a factor in increases.Recapitalization of banks in Indonesia, Korea and Turkey with government securities.

Bank exposure to government debtBank holdings of government and CB securities

percent of banks' total assets

0

10

20

30

40

50

Mexico

Chile

Peru

Colombia

Venezu

elaArge

ntina

Malaysi

a

Hong K

ong S

ARTha

iland

Korea

China

Singa

pore

Philip

pines

Indon

esia

India

South

Afri

caHun

gary

Czech R

epub

licIsr

aelPo

land

Saud

i Arab

iaTurk

ey

1999-20012004-2006

Source: BIS/CGFS

Bank presence in debt marketsBanks' share of domestic bond markets

percent of total bonds outstanding

0

10

20

30

40

50

60

70

80

PeruMex

icoBraz

ilColo

mbia

Malaysi

aThai

land

Philipp

ines

Korea

Singap

ore India

China

South

Africa

Israel

Poland

Saudi

Arabia

Hunga

ryTurk

ey

Czech

Repub

lic

20002005

Source: BIS/CGFS

Implications of increased bank holdings of government debt

• Interest rate exposures may have risenStress tests point to potential losses from shifts in interest rates

Large exposures could constrain central bank’s ability to raise interest rates

• Reliance on profits from government securities when interest rates are falling could lead to complacency and failure to manage risks of lending to private sector

• Points to increased need for risk management capacity in the banking system

Avoiding regulatory bias towards holding government debt

• From a pure risk management perspective, sovereign debt of own country involves some risks:

Correlation with loans and other bank assets is likely to be highHoldings of public debt carry risk of political/moral pressure to rollover

debt under duress.

• Basel II says government debt should carry capital risk weighting according to country credit ratings – but that home country domestic currency debt may be exempted.

Zero risk-capital weighting of domestic debt is practiced by many countries, but not all (e.g. Argentina, Georgia , Venezuela).Zero-weighting may not be appropriate from risk perspective. If anything, own-country domestic public debt would appear more risky than many other assets.May also have adverse growth consequences: literature discusses bias away from lending to real sector, especially during recessions.

Countries may try to protect banks from direct impact of restructuring

• May avoid restructuring altogether good: adjust macro policies to restore debt sustainabilitybad: “gamble for redemption”/procrastinate

• May exclude some classes of debt in restructuring, or give more favorable termsRestructure only external debtExclude bonds held predominately by banksPerform same operation on all debt (e.g. reduce interest rates) but in way that favors banksIntercreditor equity is an issue in achieving high participation, but creditors may tolerate more favorable treatment for banks, given their importance in economy.Harder to achieve if banks are predominant holders of government debt.

• May apply equal treatment to all creditors but partially compensate banks with new bonds

“Tidier” solution: generally preferable approach, but depends on circumstancesMay make restructuring easier to sell to creditorsAllows tailoring of new instruments to bank needs and government payment capacity.

Stylized impact of public debt operations on banking crisis management tools

May be necessaryShould be avoidableHaircut on depositors

May be only viable policy option in conditions of

widespread bank insolvency

Use only as last resortTemporary takeover of banks by government

Unlikely to be availableCould be considered in limited casesRecapitalization with public funds

Use for viable banks with safeguards

Use for viable banks with safeguardsRegulatory forbearance

Resolution

May be necessaryUse only as last resort

Administrative controls (deposit freeze, extension of deposit maturities, securitization of

deposits)

Unlikely to be availableMay be availableGeneralized deposit guarantee

May be restricted or unavailable

Available, primary tool for containmentLender of last resort

Containment

Severe debt crisis scenario

Limited debt restructuring scenarioInstrument

Crisis phase

Role of the IMF – surveillance and TA

• Fund surveillance activities help identify risks to sovereign balance sheets, and risks and vulnerabilities of domestic banking system, including exposure to sovereign debt.

Debt sustainability frameworkBalance sheet approachContingent claims approach

• Fund technical assistance helps debt managers and supervisors todevelop policies and strategies to reduce vulnerabilities to crisis.

• Fund engages in discussion with market participants in country and in foreign investor community to identify risks, and to understand new instruments and innovations and possible channels of contagion.

Role of the IMF – debt restructurings

• Fund helps develop an appropriate policy framework for a country that decides to restructure its sovereign debt.

can discuss restructuring options with country and its advisers, and encourages government to pursue collaborative engagement with creditors.can act as “honest broker” in providing information on macroeconomic policy and payment envelope to creditors.

• Fund (and World Bank) provides advice to countries on resolution of banking crises, including when public debt restructuring is involved.

Fund has considerable experience in this area, unlike country authorities (hopefully)

• Traditional role of Fund financing to resolve balance of payments problems may be closely linked to efforts to address banking sector vulnerabilities.

Fund financing eases economic adjustment needed to rebuild reserves, reassures depositors and creditors, enhances credibility of deposit guarantees.Approval of Fund-supported macro program provides credibility and confidence.

Some conclusions and lessons

• High bank exposure to public debt carries risks.Move away from zero risk-weighting of domestic government debt?Increased need for risk management capacity in banking system

• Direct effects of restructuring on bank balance sheets can be reduced by design of restructuring or issuance of special compensatory bonds.

• But experience has been that direct cost of debt restructuring is only part of the problems banks face in a public debt crises –other issues can be more significant.

Capacity of government to resolve banking crisis is diminished in debt crisis.Provides further reasons for strong supervision and regulatory frameworks in EM countries with potential public debt problems.

Some conclusions and lessons (cont.)

• Weak supervision obviously adds to problems. But even good efforts of supervisory policy can be undermined by poor policy decisions by government

Government may lean on banks as “financiers of last resort” as debt problems loom.Difficult decisions made in heat of crisis can do huge damage to banking system.Strong rules-based, legally supported regulatory framework may help avoid interference.

• Important for bank supervisors and government debt managers to coordinate, both in stable times and in times of crisis.

The End