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Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes

Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes. Augusto de la Torre The World Bank 3 rd Annual International Seminar on Critical Issues in Financial Stability: Preventing and Confronting Bank Insolvency Washington, DC - June 4-6, 2003.

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Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes

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  1. Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes Augusto de la Torre The World Bank 3rd Annual International Seminar on Critical Issues in Financial Stability: Preventing and Confronting Bank Insolvency Washington, DC - June 4-6, 2003

  2. Seismic zones under financial globalization Wretched Trinity: Weak currency Nominal inflexibility Weak institutions Multiple equilibria Exploding public debt dynamics Current account / fiscal deficits  Contagion Risk (Runs) Overvalued currency IV II Currency mismatches Maturity mismatches Excessive risk taking, looting I Weak institutions III Excessive leverage  Blessed Trinity: International currency Nominal flexibility Sound institutions Incentive Distortions

  3. Seismic zones under financial globalization Multiple equilibria Exploding debt dynamics Current account / fiscal deficits  Contagion Risk (Runs) Run on the currency Depositor run on system IV II Currency mismatches Maturity mismatches Run by foreign portfolio investors Low currency & maturity mismatches Excessive risk taking, looting I III Excessive leverage  Depositor flight to quality Incentive Distortions

  4. Management and Resolution IssuesDiffer Substantially Depending on Crisis Type • Containment • International reserves, interest rates • LOLR, deposit guarantees, expensive debt rollover • Breach of contracts -- deposit securitization, debt defaults, forcible stock pesification • Loss allocation and restructuring • Inflation (if not dollarized) versus admin. allocation • Bank and corporate resolutions, with risk of socialization of bad assets (bailouts) • Government bond based restructuring?

  5. Management and Resolution Issues (cont.) Differ Substantially Depending on Crisis Type • Regeneration (flows and incentives) • Hyperinflation – permanent impairment of national currency as store of value • Bailouts – permanent erosion of market discipline • Forcible containment (widespread contract breaches) – permanent weakening of institutional arrangements and credibility Regeneration and learning from crises – a function of the quality of political institutions

  6. Type IV crises – regeneration issues • Growth regeneration depends on… • Confidence and capital re-flows • Degree of openness in trade structure • Speed/effectiveness of loss allocation and restructuring • …but its sustainability requires regeneration of financial intermediation… • Establishment of currency as “store of value” • Questions on new industrial organization of sector (narrow banks, offshores, etc.) • Segmentation of access • …and institutional regeneration • Contractual and regulatory environment • Democratic governance

  7. Type IV crises – int’l architecture issues • Imperfections of int’l financial markets • Contagion (Calvo’s EMF) • Defaults (int’l bankruptcy, exit consents, UDROPs, floor to debt to facilitate agreement on haircuts) • Potential role of IFIs in peso debt markets development • Externalities of fluctuations in international currencies • Fixing them would benefit EMs the most… • …but incentives for industrial countries are weak • Multilateral & regional institutions have a major responsibility

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