Overview of Financial Stability Issues

1. Seminar on Financial Stability and Development Overview of Financial Stability Issues

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

7. 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

13. The data favour strict policy Honohan-Klingebiel, 2003

14. Large potential impact of policy on cost

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

16. 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)

17. Market discipline: the players

18. 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

19. 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

20. Fiscal, Monetary and Incentive Issues (outline) • Ensuring the bank has enough capital, liquidity and incentives • Government claims on the restructured banks • Implications for debt management • Implications for monetary policy

21. 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… • Monetary 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: • Inject assets to ensure capitalization and prospective earnings consistent with safe-and-sound banking • Restructure liability structure to protect taxpayer subject to adequate incentives • Rebalance government debt (maturity etc.) • 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