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The G20 Agenda and Financial Reforms: Lessons from the South

The G20 Agenda and Financial Reforms: Lessons from the South. Andrew Powell Inter American Development Bank LAC/G20 Meeting IDB, Washington DC April 21 st 2010. Motivation. The G20 has set an ambitious agenda especially regarding financial sector reform in response to the crisis

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The G20 Agenda and Financial Reforms: Lessons from the South

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  1. The G20 Agenda and Financial Reforms: Lessons from the South Andrew Powell Inter American Development Bank LAC/G20 Meeting IDB, Washington DC April 21st 2010

  2. Motivation The G20 has set an ambitious agenda especially regarding financial sector reform in response to the crisis This crisis had several hallmarks of an “emerging country financial crisis” But unlike previous crises, LAC escaped the worst and is recovering – albeit with greater challenges in the Caribbean and Central America Did Latin America learn some of the lessons from its tumultuous financial history? What are the lessons regarding Financial Reform from the South?

  3. Why Was this Crisis like anEmerging Market Crisis? Characteristics • Credit Boom and Weak Supervision • The Importance of Liquidity • Cross-Border Aspects • Banking, Politics and Crisis Resolution Recent EM Crises • Latin American debt and financial crises of the 1980’s • Tequila crisis of 1995 • Asian crisis of 1997 • Russian crisis of 1998 and subsequent contagion • Argentine & Uruguayan crisis of 2002

  4. Elements of the Ambitious G20 Agenda • Return the world to high, sustainable, and balanced growth, commitment to fiscal responsibility and sustainability • Strengthening the IMF, more of an ILOR • Bank Capital: Quantity, Quality, Leverage, Cyclicality (end 2010) • Basel II (end 2011) • Systemic institutions, intensive supervision, additional capital, liquidity, and other prudential requirements (Oct 2010) • Derivatives: standardized OTC contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (end-2012). • Cross-border and complex institution resolution (end-2010) • Rating Agencies, oversight of the ratings business • Compensation packages (Mar 2010) • A single set of global accounting standards (Jun 2011) • Countermeasures against tax havens from (Mar. 2010)

  5. Outline of the Talk • 1. Sustainable Growth, Anti-Cyclical Measures • 2. Liquidity • 3. International Financial Architecture • 4. Basel II and the Quantity and Quality of Capital • 5. On Cross Border Issues • 6. Resolution, Costs of Crises and Politics • 7. Information and Standardization • 8. On Market Discipline • 9. Conclusions and Agenda & attempting to draw out lessons from the South

  6. 1. Sustainable Growth • There is still little Consensus on what (really) caused the crisis • Arguably there is more consensus on the micro. incentive problems and regulatory failures, • And less on the macro: for example was the Great Moderation in fact the Great Delusion?

  7. Great Moderation or Great Delusion? Major OECD Economies. Source: Borio (2009)

  8. An AsideA Comment by Borio (2009)… • “…not even the often more critical academic community provided any support for change. Indeed, as regards macroeconomic policy, that community turned out to be part of the problem, not of the solution. The prevailing paradigm assumed that price stabilization was synonymous with macroeconomic stabilization.” (!!) • One might question whether the “prevailing paradigm” included academic work on emerging economy crises

  9. Debates • The standard deviation of growth and other variables was low, but was this sustainable? • High growth with low inflation: what was the role of the “savings glut” and of “global imbalances”? • Knight: (2007) the low risk premium was not due to unusually low risk but unusually high risk-taking • Was monetary policy was too loose, would tighter money have halted the credit boom, would it have created deflation? • The South had to some extent learnt the lesson that monetary policy is not enough, for example there is need for other anti-cyclical instruments

  10. LAC has implemented some anti-cyclical measures... • Following Spain, Uruguay and Colombia both implemented anti-cyclical provisioning. • But it turns out its not quite that simple. • Latin American Banks have significant excess capital….

  11. LAC: Capital Requirements are Higher and Banks Have Excess Capital

  12. Calibrating Anti-Cyclical Rules:Its not that simple • With a rule that lowers requirements in the bad times, banks have less incentive to maintain a buffer in the good times • Anti-cyclical rules therefore have less effect than may be imagined, or very strong anti-cyclical rules are required - Aliaga-Diaz, Olivero and Powell (2009). • Still, such measures may reduce volatility and these are averages, some banks have less buffer than others • Question for the North: why were the buffers of (some) banks so low (the Great Delusion)?

  13. 2. Liquidity: need for complementary anti-cyclical liquidity rules • Emerging market crises have amply displayed the importance of liquidity - and what happens when it dries up • Examples were the Tequila crisis (Mexico and Argentina 1994/1995), the Asian crisis of 1997 and especially after the Russian default in June 1998, across many EM’s • Quantum leaps in spreads on secondary markets, transmissions of illiquidity across seemingly unrelated markets and even basic markets for Government assets closing for primary issues • Spurred much academic work: Calvo, Caballero etc., more recently Moore, “Contagious Illiquidity”

  14. And the Official Community had previously recognized the importance of liquidityEG: REPORT OF THE WORKING GROUP ONSTRENGTHENING FINANCIAL SYSTEMS (G22 Oct. 1998) • “Recent crises in emerging markets have highlighted the importance of liquidity management in foreign as well as domestic currency. Depending on the structure of the assets and the liabilities of a country, liquidity risks may be concentrated in different sectors.” • “Authorities should recognise that contagion effects arising from developments in third countries can trigger massive portfolio adjustments, thereby threatening the ability of borrowers in a country to rollover short-term funding.” • “The Working Group recommends that the IMF, in the context of Article IV surveillance and associated technical assistance activities, give due attention to the macroeconomic dimensions of liquidity and related risks” • Did not imagine this would apply to the US, the UK and the most developed financial markets

  15. What has the South done? • Significant build-up of international reserves • Liquidity requirements (remunerated), reserve requirements (more a tax), can raise when liquidity high • Aside on capital controls: Chilean style capital controls on all inflows have a tax and a liquidity component • Aside on securitization: LAC has tended to have strong rules on funds, what assets can funds buy, affecting the demand side • Focus in the South has been macro-prudential, and the role of “systemic liquidity” • Arguably the focus in the North to date is more micro considering liquid assets vs. projected outgoings/needs of institutions

  16. 3. International Financial Architecture • The International Community did respond this time around and in particular strengthened the IMF which acted more as an ILOLR • Reflects calls from many after Tequila (1995), the Asian crisis (1997) and the Russian crisis (1998), especially from Calvo.

  17. Extraordinary International Financial Assistance for Emerging Markets • Increase in Multilaterals’ lending capacity • Recapitalization of the IMF (US$ 500 bn) • New Special Drawing Rights (SDR) allocation (US$ 250 bn) • IFI Flexibility • IMF Flexible Credit Line (FCL – Colombia, Mexico) and High-Access Precautionary Arrangements (HAPAs) • Increases in Lending from Development Banks and now Recapitalization (IADB (for LAC), World Bank etc.) • Fed Swap Lines (made available for Brazil, Mexico in LAC)

  18. Spreads Reaction: The Role of Access to ILOLR Facilities (EMBI +, in bps) 3000 2700 2400 2100 1800 1500 1200 900 600 300 02-Sep-08 14-Sep-08 26-Sep-08 08-Oct-08 20-Oct-08 01-Nov-08 13-Nov-08 25-Nov-08 Lehman Crisis 20-Jul-98 01-Aug-98 13-Aug-98 25-Aug-98 06-Sep-98 18-Sep-98 30-Sep-98 12-Oct-98 Russian/LTCM Crisis “The Crisis and Its Aftermath” (IDB, 2010, Izquierdo and Talvi (coords.)) No Access to Multilateral Financial Support • No Article IV Consultation for the last two years EMs without Access during the Lehman Crisis1 No ILOLR Control Group 2: EMs during the Russian/LTCM Crisis3 Same Fundamentals • In arrears with the IMF No ILOLR • In default with bond holders With ILOLR Control Group 1: EMs with Access during the Lehman Crisis2 1 Includes Argentina, Ecuador and Venezuela 2 Countries with access to ILOLR during the Lehman Crisis with the same credit rating as countries without access during the Lehman Crisis. Includes Belize, Dominican Republic, Georgia, Ghana, Indonesia, Jamaica, Lebanon, Pakistan, Philippines, Serbia, Sri Lanka, Turkey, Ukraine and Uruguay. 3 Countries that during the Russian/LTCM Crisis had the same credit ratings as countries without access during the Lehman Crisis. Includes Brazil, Bulgaria, Lebanon, Ecua dor, Russia, Turkey and Venezuela.

  19. But the International Financial Architecture remains incomplete • What happens to countries that do not qualify for ILOLR access? • Arozemena and Powell (2003) in a liquidity protection vs. moral hazard model, show negative shocks imply greater incentives to deviate from a “good equilibrium” of Safe Policies and Committed IMF protection to the inferior mixed strategy equilibrium of the one-shot game… • Currently, IMF “withdrawal” implies a policy vacuum, only some very loose “principles” on how to restructure your debt

  20. Jamaica: an interesting case of a country with high willingness-to-pay, trying to do it right • Low growth and high debt (138% of GDP), the global crisis pushed the country into deep recession, interest rates and the fiscal deficit soared • Authorities resisted a forced restructuring, but given voluntary nature of the eventual Swap only domestic debt included and with no principal haircut • The Swap was about as successful as it could have been in terms of participation and savings (3.5% of GDP) • Yet the new IMF program calls for primary surpluses of 6.5% increasing to 9% over the medium term • Questions: has Jamaica escaped the debt-growth trap? Would it have been different with some type of SDRM?

  21. 4. Capital: Long Live Basel II! • “All major G20 financial centers commit” to implement by 2011 – Pittsburgh declaration • LAC has been somewhat Basel II skeptical, & countries have sought different Pillar 1 options: • Brazil: Simplified Standardized and IRB for qualifying banks (no Credit Ratings) • Chile: Standardized Approach (i.e.: Ratings) • Colombia: Initially IRB, now more SA • Uruguay (and others): Softly-Softly, gradually adopting measures consistent with Basel II • Source: IDB project on Basel II Implementation • Is Basel II a Good Fit for Emerging Economies? Basel II Pillar 1 Approaches Simplified Standardized Approach (SSA) – Basel 1+ Standardized Approach (SA) – Use of Credit Ratings and a table to map to requirements Internal Rating Based Approach (IRB) - Banks’ rating methodologies and estimated PD’s and a standard curve

  22. Fitting into the Basel II Framework • LAC Quantity and Quality of Capital had improved: by revealed preference, the recommended minimum of 8% is too low and rules on quality of capital also tend to be tighter • Majnoni and Powell (2005)1 made the following arguments: • A lack of rated claims reduce the value of Standardized Approach (as would poor Rating Agency standards) • On the Internal Rating Based Approach: • Is it wise to give such autonomy to banks, to classify credits? • Several LAC countries have central “ratings” for provisioning • Proposal: a Centralized Rating Based Approach, banks rate on a std. scale • Calibration: 8% too low, correlation assumptions, 99.9% tolerance • Recommendation: CRB and treat Basel II Pillar 1 as a set of building blocks to be adapted as required, not as a black box 1Majnoni, G. and A. Powell (2005). “Reforming Bank Capital Requirements” Economia, Spring 2005. See also Powell (2002) and Powell (2004).

  23. Other Aspects of Basel II andthe (new) Leverage Ratio • To the extent the new leverage ratio binds, all the complex stuff in Pillar 1 becomes redundant • But there is much else in Basel II (eg: Scope, Op. Risk, Securitization, Credit Risk Mitigation) • And Pillar 3 if taken literally will reveal much information for IRB Banks… • A Pillar 3 Cross Border Issue: need to ensure that Subsidiaries and significant Branches of International Banks in the South publish Pillar 3 requirements…(Majnoni and Powell (2005)

  24. 5. Cross Border Issues • Several EM crises (and previous failures in the North) have had their cross-border dimensions… • Argentina: the 1995 Tequila crisis showed foreign banks may cut credit lines even to their branches, heralding the “Loser of Last Resort” theory. • Argentina: the 2002 crisis, arguably foreign banks capitulated with “pessification” to avoid potential liabilities in international courts. • Uruguay: in the 2002 crisis authorities left foreign banks on their own, which mostly worked, except Argentina stopped its banks assisting their branches (and a rather special contagion for one of Uruguay’s private banks).

  25. Thoughts on the Current Debate • As deposit insurance remains national, Consolidated Supervision may be Necessary but it is not Sufficient (certainly for Subsids. and possibly even for Branches). Subsids are akin to call options and banks may have incentives to reduce capital therein reducing the exercise price & increasing the value of the call – Majnoni and Powell (2007) • “Regulatory cooperation” is not enough (Colleges are where Americans do their first degrees!). • Basel II’s Pillar II should state explicitly that if a Subsidiary or a Branch is significant for the Host they should be jointly supervised and the Host should be the primary agent to gather information • The legal position regarding international banks’ responsibilities to their depositors remains unclear and bankruptcy codes (“single” vs. “multiple entity” resolution) remain a source of uncertainty. • The Recent BCBS Report on Cross Border Bank Resolution recognizes the incentives for “ring fencing” but the implications for supervision are not fully spelled out. • Only a “convergence of resolution methods” may not be enough

  26. LAC Also Needs to Pay Attention to Complexity and South-South X-Border • Lehmann Bros. had 2985 legal entities operating in 50 countries. • LAC is host to many legal entities in such structures; where its unclear how a Subsidiary fits into a structure, action is required • Legal structures do not correlate with corporate structures and supervisory treatment remains an open question e.g.: how do LAC regulators feel if a bank’s entire back-office operations for LAC are located in country X? • Moreover LAC needs to pay attention to increased South-South cross border banking, in South America but especially in the Caribbean and Central America • Recent example: CL Financial in T&T:

  27. Complex structure across many countries Source: CCMF Report on CL Financial

  28. Cross Border Issues Abound in the Caribbean Financial System (Commercial Banks Only) Haiti, Guyana and Suriname in the Periphery T&T in the Center By ownership & by market Network visualization by Pajek software: for a short description see Batagelj V., Mrvar A.: Pajek - Analysis and Visualization of Large Networks. in Jünger, M., Mutzel, P., (Eds.) Graph Drawing Software. Springer, Berlin 2003. p. 77-103

  29. 6. On Resolution, the Costs of Banking Crises and Politics Chile 1981 Output Cost Fiscal Cost Source: Leaven and Valencia (Systemic Banking Crises database, following Caprio et al),

  30. The Costs of Banking Crises: Lessons from the South • According to Leaven and Valencia (Systemic Banking Crises database, following Caprio et al), Chile holds the record for the most costly banking crisis in History • Costs of banking crises have varied widely depending on: • The initial conditions • The extent of “gambling for resurrection” • The timing and the type of Government response (broadly whether “accommodating vs. a “bite the bullet” approach) • Many trade-offs, in particular between discretion, speed of action and accountability.

  31. Bite the Bullet versus Accommodation • Source: Caprio et al. “Finance for Growth” (2008) This suggests the final costs of this crisis will be large

  32. Innovations in ResolutionTechniques from the South • The thrust has been to break the bail out versus liquidation “all or nothing” decision and find an efficient “third way” • Argentina developed a particular technique in the late 1990’s to split a bank’s balance sheet into a good bank to be sold, in theory with minimum public financial support (De la Torre, 2000) • There are many trade-offs involved • Maintain financial stability, minimize systemic risk • Protect consumers, limit moral hazard, minimize public sector support • Similar techniques have been adopted in other countries e.g.: Guatemala prior to the failure of BanCafé which was resolved successfully • N.b.: Dujovne and Guidotti (2001) suggested “living wills”.

  33. Banking, Politics and the Fiscal • EM crises illustrate financial systems are “special” : • Whether there were ex ante lender of last resort policies or not, there tended to be lenders of last resort, ex post • Deposit insurance existed ex post whether it existed ex ante and if it existed ex ante, it tended to be widened ex post • As private banks’ risk-appetite diminished and lending rules became stricter, public banks expanded and public intervention in credit markets increased • Private (and public) banks “buy favors” at a time when public support is required and politically available • All of the above have implications for the fiscal • Secondary effects work both ways: debt crises (in part the result of the fiscal consequences of a financial crisis) can drag financial systems down (again)

  34. 7. Information and Standardization • Many LAC countries (following Italy and Spain) have developed extensive databases covering most loans • Developed initially to analyze major borrowers’ risks to the financial system and to control related lending, they have found multiple uses including reducing the pure rents and costs of private credit bureaus to research on credit risk as well as supervision • The unique client index is a particular supervisory favorite of mine • The Icelandic crisis illustrates the continued relevance of related lending – see FT April 13th “Iceland Accused of Negligence Over Bank Crisis” and Basel II is weaker on this relative to most LAC norms • All countries attempting to implement Basel II would find such databases invaluable to test calibration, compare banks’ rating methodologies and ensure the major risks to the financial system are understood across borrowers and instruments • Information and liquidity are intimately tied; the costs in terms of increased basis risk of standard contracts and documentation may be outweighed by liquidity and safety concerns. • The G20 call for standard derivatives to be centrally registered may need to be extended to credit instruments and non-standard instruments attract higher capital and/or liquidity requirements

  35. 8. Market Discipline • Numerous studies have shown market discipline functions in LAC e.g.: Galindo, Powell and xxx • Some countries in the South went further and experimented with a Sub-Debt. type rule with mixed success – see Calomiris and Powell 19xx. • Relevant to new proposals in the North for prompter corrective action suing CDS spreads – see Hart and Zingales 2010.

  36. 9. Conclusions and Agenda • LAC has been through several financial crises and the fact it survived the current crisis suggests some lessons have been learnt • On ILOLR, Bank Capital, Liquidity, Bank Resolution and Information: there are as many lessons for the North from the South as vice versa • Still, the G20 work program suggests an agenda for the South going forward…

  37. Selected Elements for anAgenda for the South • Sustainable growth: what does balanced global growth mean for LAC? What global growth pattern should LAC press for in G20? How might this be achieved? • Anti-cyclical capital and liquidity, which rules and how to calibrate? • LAC should try to change the debate, from “capital controls” to “prudential liquidity management” • Basel II: which elements to implement, how to use the building blocks and how should they be calibrated? • Systemic risk: how should LAC implement a systemic risk charge? • Cross Border & Complexity: when should structures be required to change? Pillar 2: joint supervision, rights and responsibilities of the Host, Pillar 3: information and transparency of Subsids. Instruments of Market Discipline? • South-South cross-border: analysis: special rules required? • Resolution techniques, ring-fencing, cross-border supervision? • Information and standardization in LAC, happy with current policies?

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