Chapter 17. Policy Responses to Systemic Banking Crises
- Christopher Crowe, Simon Johnson, Jonathan Ostry, and Jeronimo Zettelmeyer
- Published Date:
- August 2010
Luc Laeven and Fabian Valencia1
Financial crises can be damaging and contagious, prompting calls for swift policy responses. The financial crises of the past have led affected economies into deep recessions and sharp current account reversals. Some crises turned out to be contagious, rapidly spreading to countries with no apparent vulnerabilities. Among the many causes of financial crises are a combination of unsustainable macroeconomic policies (including large current account deficits and unsustainable public debt), excessive credit booms, large capital inflows, and balance sheet fragilities, combined with policy paralysis arising from a variety of political and economic constraints. In many financial crises, currency and maturity mismatches were a salient feature, whereas in others off-balance sheet operations of the banking sector were prominent (for a review of the literature on macro origins of banking crisis, see Lindgren, Garcia, and Saal, 1996; Dooley and Frankel, 2003; and Collyns and Kincaid, 2003).
At the writing of this chapter, the current global financial crisis is evolving with breakneck speed. The debate about why it happened and how it will unfold is still very much ongoing. Although it may be too early to write about the lessons learned, authorities do not have the luxury to wait and have already embarked on large-scale interventions in the financial sector and beyond.
Choosing the best way of resolving a financial crisis and accelerating economic recovery is far from unproblematic. There has been little agreement on what constitutes best practice or even good practice. Policy responses will need to depend on the nature of the crisis.
Many divergent approaches have been proposed and tried to resolve systemic crises more efficiently. These differences in approach reflect in part different policy objectives. Some have focused on reducing the fiscal costs of financial crises, others on limiting the economic costs in terms of lost output and on accelerating restructuring, whereas again others have focused on achieving longterm, structural reforms. Trade-offs are likely to arise between these objectives (for an overview of existing literature on how crisis resolution policies have been used and the trade-offs involved, see Claessens, Klingebiel, and Laeven, 2003; Hoelscher and Quintyn, 2003; and Honohan and Laeven, 2005). Governments may, for example, consciously incur large fiscal outlays in resolving a banking crisis through certain policies, with the objective of accelerating recovery. Alternatively, structural reforms may only be politically feasible in the context of a severe crisis with large output losses and high fiscal costs.
This chapter introduces and describes a new dataset on banking crises, with detailed information about the type of policy responses employed to resolve crises in different countries. The emphasis is on policy responses to restore the banking system to health. The database covers all systemically important banking crises for the period 1970 to 2007, and has detailed information on crisis management strategies for 42 systemic banking crises from 37 countries.
Governments have employed a broad range of policies to deal with financial crises. Central to identifying sound policy approaches to financial crises is the recognition that policy responses that reallocate wealth toward banks and debtors and away from taxpayers face a key trade-off. Such reallocations of wealth can help to restart productive investment, but they have large costs. These costs include taxpayers’ wealth that is spent on financial assistance and indirect costs from misallocations of capital and distortions to incentives that may result from encouraging banks and firms to abuse government protections. Those distortions may worsen capital allocation and risk management after the resolution of the crisis.
Institutional weaknesses typically aggravate the crisis and complicate crisis resolution. Bankruptcy and restructuring frameworks are often deficient. Disclosure and accounting rules for financial institutions and corporations may be weak. Equity and creditor rights may be poorly defined or weakly enforced. In addition, the judiciary system is often inefficient.
Many financial crises, especially those in countries with fixed exchange rates, turn out to be twin crises with currency depreciation exacerbating banking sector problems through foreign currency exposures of borrowers or banks themselves. In such cases, another complicating factor is the conflict of objectives: between the desire to maintain currency pegs on the one hand and the need to provide liquidity support to the banking system on the other.
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance (for empirical evidence on this, see Demirg’t and Detragiache, 2002; Honohan and Klingebiel, 2003; and Claessens, Klingebiel, and Laeven, 2003; and Claessens, Klingebiel, and Laeven, 2003).
Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities, and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery (see the analyses in Honohan and Klingebiel, 2003; Claessens, Klingebiel, and Laeven, 2005; and Laeven and Valencia, 2008). The caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.
The remainder of the chapter is organized as follows. Section 17.2 presents new data on the timing of banking crises, currency crises, and sovereign debt crises. Section 17.3 presents variable definitions of the data collected on crisis management techniques for a subset of systemic banking crises. Section 17.4 presents descriptive statistics of data on containment and resolution policies, fiscal costs, and output losses. Section 17.5 discusses the ongoing global liquidity crisis that originated with the U.S. subprime crisis. Section 17.6 concludes.
17.2. CRISIS DATES
17.2.1. Banking Crises
We start with a definition of a systemic banking crisis. Under our definition, in a systemic banking crisis, a country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. As a result, nonperforming loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by sharp falls in asset prices (such as equity and real estate prices) following runups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. In some cases, the crisis is triggered by depositor runs on banks, though in most cases it is a general realization that systemically important financial institutions are in distress.
Using this broad definition of a systemic banking crisis that combines quantitative data with some subjective assessment of the situation, we identify the starting year of systemic banking crises around the world since the year 1970. Unlike prior work (Caprio and Klingebiel, 1996; and Caprio and others, 2005), we exclude banking system distress events that affected isolated banks but were not systemic in nature. As a cross-check on the timing of each crisis, we examine whether the crisis year coincides with deposit runs, the introduction of a deposit freeze or blanket guarantee, or extensive liquidity support or bank interventions, using data from the IMF’s International Financial Statistics (IFS) database. 2 This way, we are able to confirm about two-thirds of the crisis dates. Alternatively, we require that it becomes apparent that the banking system has a large proportion of nonperforming loans and that most of its capital has been exhausted. 3 This additional requirement applies to the remainder of crisis dates.
In sum, we identify 124 systemic banking crises over the period 1970 to 2007. This list is an updated, corrected, and expanded version of the Caprio and Klingebiel (1996) and Caprio and others (2005) banking crisis databases. Table 17.1 lists the starting year of each banking crisis, as well as some background information on each crisis, including peak nonperforming loans (percent of total loans), gross fiscal costs (percent of GDP), output loss (percent of GDP), and minimum real GDP growth rate (in percent). Peak nonperforming loans is the highest level of nonperforming loans as percentage of total loans during the first five years of the crisis. Gross fiscal costs are computed over the first five years following the start of the crisis using data from Hoelscher and Quintyn (2003), Honohan and Laeven (2005), IMF Staff reports, and publications from national authorities and institutions. Output losses are computed by extrapolating trend real GDP, based on the trend in real GDP growth up to the year preceding the crisis, and taking the sum of the differences between actual real GDP and trend real GDP expressed as a percentage of trend real GDP for the first four years of the crisis (including the crisis year). 4 Minimum real GDP growth rate is the lowest real GDP growth rate during the first three years of the crisis.
|Systemic||Share of||Gross Fiscal||Output||Minimum|
|Banking Crisis||NPLs at Peak||Cost||Loss||Real GDP|
|Country||(starting date)||(%)||(% of GDP)||(% of GDP)||Growth Rate|
|Bosnia and Herzegovina||1992||–6.4|
|Central African Rep.||1976||0.0||2.5|
|Central African Rep.||1995||40||1.1||–8.1|
|Congo, Dem. Rep. of||1983||0.0||0.5|
|Congo, Dem. Rep. of||1991||81.0||–13.5|
|Congo, Dem. Rep. of||1994||75||0.0||–5.4|
|Congo, Rep. of||1992||63.2||–5.5|
|São Tomé and Príncipe||1992||90||0.0||0.7|
17.2.2. Currency and Sovereign Debt Crises
Building on the approach in Frankel and Rose (1996), we define a “currency crisis” as a nominal depreciation of the currency of at least 30 percent that is also at least a 10 percent increase in the rate of depreciation compared to the year before. In terms of measurement of the exchange rate depreciation, we use the percent change of the end-of-period official nominal bilateral dollar exchange rate from the World Economic Outlook (WEO) database of the IMF. For countries that meet the criteria for several continuous years, we use the first year of each five-year window to identify the crisis. This definition yields 208 currency crises during the period 1970 to 2007. It should be noted that this list also includes large devaluations by countries that adopt fixed exchange rate regimes.
We identify and date episodes of sovereign debt default and restructuring by relying on information from Beim and Calomiris (2001), World Bank (2002), Sturzenegger and Zettelmeyer (2006), and IMF staff reports. The information compiled includes year of sovereign defaults to private lending and year of debt rescheduling. Using this approach, we identify 63 episodes of sovereign debt defaults and restructurings since 1970. Table 17.2 provides the complete list of starting years of systemic banking crises, currency crises, and sovereign debt crises.
|Country||(starting date)||(year)||(default date)||(year)|
|Argentina||1980, 1989, 1995,||1975, 1981, 1987,||1982, 2001||1993, 2005|
|Bolivia||1986, 1994||1973, 1981||1980||1992|
|Bosnia and Herzegovina||1992|
|Brazil||1990, 1994||1976, 1982, 1987,||1983||1994|
|Central African Rep.||1976, 1995||1994|
|Chile||1976, 1981||1972, 1982||1983||1990|
|Congo, Dem. Rep. of||1983, 1991, 1994||1976, 1983, 1989,||1976||1989|
|Congo, Rep. of||1992||1994||1986||1992|
|Costa Rica||1987, 1994||1981, 1991||1981||1990|
|Côte d’Ivoire||1988||1994||1984, 2001||1997, n.a.|
|Dominican Republic||2003||1985, 1990, 2003||1982, 2003||1994, 2005|
|Ecuador||1982, 1998||1982, 1999||1982, 1999||1995, 2000|
|Equatorial Guinea||1983||1980, 1994|
|Gambia, The||1985, 2003||1986||1988|
|Ghana||1982||1978, 1983, 1993,|
|Guinea||1985, 1993||1982, 2005||1985||1992|
|Hong Kong SAR|
|Iceland||1975, 1981, 1989|
|Iran, I.R. of||1985, 1993, 2000||1992||1994|
|Israel||1977||1975, 1980, 1985|
|Jamaica||1996||1978, 1983, 1991||1978||1990|
|Lao People’s Dem. Rep.||1972, 1978, 1986,|
|Madagascar||1988||1984, 1994, 2004||1981||1992|
|Mexico||1981, 1994||1977, 1982, 1995||1982||1990|
|Myanmar||1975, 1990, 1996,|
|Nicaragua||1990, 2000||1979, 1985, 1990||1980||1995|
|Nigeria||1991||1983, 1989, 1997||1983||1992|
|Papua New Guinea||1995|
|Paraguay||1995||1984, 1989, 2002||1982||1992|
|Peru||1983||1976, 1981, 1988||1978||1996|
|Philippines||1983, 1997||1983, 1998||1983||1992|
|São Tomé and Principe||1992||1987, 1992, 1997|
|Serbia, Republic of||2000|
|Sierra Leone||1990||1983, 1989, 1998||1977||1995|
|Sudan||1981, 1988, 1994||1979||1985|
|Suriname||1990, 1995, 2001|
|Syrian Arab Republic||1988|
|Trinidad and Tobago||1986||1989||1989|
|Turkey||1982, 2000||1978, 1984, 1991,||1978||1982|
|United States||1988, 2007|
|Uruguay||1981, 2002||1972, 1983, 1990,||1983, 2002||1991, 2003|
|Venezuela||1994||1984, 1989, 1994,||1982||1990|
|Vietnam||1997||1972, 1981, 1987||1985||1997|
|Zambia||1995||1983, 1989, 1996||1983||1994|
|Zimbabwe||1995||1983, 1991, 1998, 2003|
17.2.3. Frequency of Crises and Occurrence of Twin Crises
Table 17.3 reports the frequency of different types of crises (banking, currency, and sovereign debt), as well as the occurrence of twin (banking and currency) crises or triple (banking, currency, and debt) crises. We define a twin crisis in year t as a banking crisis in year t combined with a currency crisis during the period [t–1, t+1]; we define a triple crisis in year t as a banking crisis in year t combined with a currency crisis during the period [t–1, t+1] and a sovereign debt crisis during the period [t–1, t+1].
|Banking Crisis||Currency Crisis||Sovereign Debt||Twin Crisis||Triple Crisis|
We find that banking crises were most frequent during the early 1990s, with a maximum of 13 systemic banking crises starting in the year 1995. Currency crises were also common during the first half of the 1990s, but the early 1980s also represented a high mark for currency crises, with a peak in 1981 of 45 episodes. Sovereign debt crises were also relatively common during the early 1980s, with a peak of 10 debt crises in 1983. In total, we count 124 banking crises, 208 currency crises, and 63 sovereign debt crises over the period 1970 to 2007. Note that several countries experienced multiple crises. Of these 124 banking crises, 42 are considered twin crises and 10 can be classified as triple crises, using our definition.
17.3. CRISIS CONTAINMENT AND RESOLUTION
In reviewing crisis policy responses, it is useful to differentiate between the containment and resolution phases of systemic restructuring (see Honohan and Laeven, 2005; and Hoelscher and Quintyn, 2003, for further details). During the containment phase, the financial crisis is still unfolding. Governments tend to implement policies aimed at restoring public confidence to minimize the repercussions on the real sector of the loss of confidence by depositors and other investors in the financial system. The resolution phase involves the actual financial, and to a lesser extent operational, restructuring of financial institutions and corporations. Whereas policy responses to crises naturally divide into immediate reactions during the containment phase of the crisis, and long-term responses towards resolution of the crisis, immediate responses often remain part of the long-run policy response. Poorly chosen containment policies undermine the potential for successful long-term resolution. It is thus useful to recognize the context in which policy responses to financial crises occur.
For a subset of 42 systemic banking crises episodes (in 37 countries) that are well documented, we have collected detailed data on crisis containment and resolution policies using a variety of sources, including IMF staff reports, World Bank documents, and working papers from central bank staff and academics. This section explains in detail the type of data collected and defines variables in the process, organized by the following categories: initial conditions, containment policies, resolution policies, macroeconomic policies, and outcome variables.
17.3.1. Overview and Initial Conditions
We start with information on initial conditions of the crisis, including whether or not banking distress coincided with exchange rate pressures and sovereign debt repayment problems, initial macroeconomic conditions, the state of the banking system, and institutional development of the country.
Crisis date is the starting date of the banking crisis, including year and month, when available. The timing of the banking crisis follows the approach described in Section 17.2.
Currency crisis indicates whether or not a currency crisis occurred during the period [t–1, t+1], where t denotes the starting year of the banking crisis. The timing of a currency crisis follows the approach described in Section 17.2, except that we do not impose the restriction that we only keep the first year of each five-year window for observations that meet the criteria for several continuous years. For example, if the currency experiences a nominal depreciation of at least 30 percent that is also at least a 10 percent increase in the rate of depreciation in both years t–2 and t–1, with t the starting year of the banking crisis, we treat year t–1 as the year of the currency crisis for the purposes of creating this variable. We also list the year of the currency crisis, denoted as year of currency crisis.
Sovereign debt crisis indicates whether or not a sovereign debt crisis occurred during the period [ t–1, t+1], where t denotes the starting year of the banking crisis. The timing of a sovereign debt crisis follows the approach described in Section 17.2. We also list the year of the sovereign debt crisis, denoted asyear of sovereign debt crisis.
In terms of initial macroeconomic conditions, we have collected information on the following variables. Each of these variables are computed at time t–1, wheretdenotes the starting year of the banking crisis, using data from the IMF’s IFS and WEO databases. Fiscal balance/GDP is the ratio of the general government balance to GDP. 5Public debt/GDPis the ratio of the general government gross debt to GDP. Inflation is the percentage increase in the consumer price index. Net foreign assets (Central Bank) is the net foreign assets of the central bank in millions of U.S. dollars. Net foreign assets / M2 is the ratio of net foreign assets (central bank) to M2. Deposits / GDP is the ratio of total deposits at deposit-taking institutions to GDP. GDP growth is real growth in GDP. Finally, current account / GDP is the ratio of current account to GDP.
We have collected the following information on the state of the banking system. Peak NPL is the peak ratio of nonperforming loans to total loans (in percent) during the years [ t, t+5], where t is the starting year of the crisis. This is an estimate using data from Honohan and Laeven (2005) and IMF staff reports. In all cases, we use the country’s definition of nonperforming loans. Government-owned is the share of banking system assets that is government owned (in percent) in year t–1. Data are from La Porta, Lopez-De-Silanes, and Shleifer (2002) and refer to the year 1980 or 1995, whichever is closer to the starting date of the crisis, t . When more recent data is available from IMF staff reports, such data are used instead. Significant bank runs indicates whether or not the country’s banking system experiences a depositors’ run, defined as a one-month percentage drop in total outstanding deposits in excess of 5 percent during the period [ t, t–1]. This variable is constructed using data from IFS. Credit boom indicates whether or not the country has experienced a credit boom leading up to the crisis, defined as three-year precrisis average growth in private credit to GDP in excess of 10 percent per annum, computed over the period [ t–3, t–1]. This variable is constructed using data from IFS.
As proxy for institutional development, we collect data on the degree of protection of credit rights in the country. Creditor rights is an index of protection of creditors’ rights from Djankov, McLiesh, and Shleifer (2007). The index ranges from 0 to 4, and higher scores denote better protection of creditor rights. We use the score in the year t, where t denotes the starting year of the banking crisis.
17.3.2. Crisis Containment Policies
Initially, the government’s policy options are limited to those policies that do not rely on the formation of new institutions or complex new mechanisms. Immediate policy responses include (1) suspension of convertibility of deposits, which prevents bank depositors from seeking repayment from banks; (2) regulatory capital forbearance, 6 which allows banks to avoid the cost of regulatory compliance (for example, by allowing banks to overstate their equity capital in order to avoid the costs of contractions in loan supply); (3) emergency liquidity support to banks; or (4) a government guarantee of depositors. Each of these immediate policy actions are motivated by adverse changes in the condition of banks.
Banks suffering severe losses tend not only to see rising costs but also to experience liability rationing, either because they must contract deposits to satisfy their regulatory equity capital requirement, or because depositors at risk of loss prefer to place funds in more stable intermediaries. Banks, in turn, will transmit those difficulties to their borrowers in the form of a contraction of credit supply (Valencia, 2008). Credit will become more costly and financial distress of borrowers and banks more likely.
The appropriate policy response will depend on whether the trigger for the crisis is a loss of depositor confidence (triggering a deposit run), regulatory recognition of bank insolvency, or the knock-on effects of financial asset market disturbances outside the banking system, including exchange rate and wider macroeconomic pressures.
Deposit withdrawals can be addressed by emergency liquidity loans, usually from the central bank when market sources are insufficient, by an extension of government guarantees of depositors and other bank creditors, or by a temporary suspension of depositor rights in what is often called a “bank holiday.” Each of these techniques is designed to buy time, and in the case of the first two, that depositor confidence can soon be restored. The success of each technique will crucially depend on the credibility and creditworthiness of the government.
Preventing looting of an insolvent or near-insolvent bank requires a different set of containment tools, which may include administrative intervention including the temporary assumption of management powers by a regulatory official, or closure, which may for example include the subsidized compulsory sale of a bank’s good assets to a sound bank, together with the assumption by that bank of all or most of the failed entity’s banking liabilities; or more simply an assisted merger. Here the prior availability of the necessary legal powers is critical, given the incentive for bank insiders to hang on, as well as the customary cognitive gaps causing insiders to deny the failure of their bank.
Most complex of all are the cases where disruption of banking is only one part of a wider problem of financial and macroeconomic turbulence. In this case, the bankers may be innocent victims of external circumstances, and it is now that special care is needed to ensure that regulations do not become part of the problem.
Adopting the correct approach to an emerging financial crisis calls for a clear understanding of what the underlying cause of the crisis is, as well as a quick judgment as to the likely effectiveness of the alternative tools that are available. The actions taken at this time will have a possibly irreversible impact on the ultimate allocation of losses in the system. In addition, the longer-term implications (e.g., creation of future moral hazard) also need to be taken into account.
All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Because bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.
We collect information on the following crisis containment policies. First, we collect information on whether the authorities impose deposit freezes, bank holidays, or blanket guarantees to halt or prevent bank runs. Deposit freeze indicates whether or not the authorities imposed a freeze on deposits. If a freeze on deposits is implemented, we collect information on the duration of the deposit freeze (in months), and the type of deposits affected. Bank holiday indicates whether or not the authorities initiated a bank holiday. In case a bank holiday is introduced, we collect information on the duration of the bank holiday (in days). Blanket guarantee indicates whether or not the authorities introduced a blanket guarantee on deposits (and possibly other liabilities). In case a blanket guarantee is introduced, we collect information on the date of introduction and the date of removal of the blanket guarantee and compute the duration that the guarantee is in place (in months). We also collect information on whether or not a previous explicit deposit insurance arrangement was in place at the time of the introduction of the blanket guarantee.
Next, we collect information on the timing and scope of emergency liquidity support to financial institutions. Liquidity support indicates whether or not emergency liquidity support, measured as claims from monetary authorities on deposit money banks (IFS line 12E) to total deposits, is at least 5 percent and at least doubled with respect to the previous year during the period [ t, t+3], where t is the starting year of the banking crisis. We also collect information on whether or not liquidity support was different across banks, and whether or not emergency lending was remunerated. If liquidity support was remunerated, we collect information on whether or not interest was at market rates. We also collect information on the peak of liquidity support (in percent of deposits), computed as the maximum value (in percent) of the ratio of claims from monetary authorities on deposit money banks (IFS line 12E) to total deposits during the period [t, t+3]. Lowering of reserve requirements denotes whether or not authorities lowered reserve requirements in response to the crisis.
17.3.3. Crisis Resolution Policies
Once emergency measures have been put in place to contain the crisis, the government faces the long-run challenge of crisis resolution, which entails the resumption of a normally functioning credit system and legal system, and the rebuilding of banks’ and borrowers’ balance sheets. At this point, the crisis has left banks and nonfinancial firms insolvent and many are in government ownership or under court or regulatory administration. Economic growth is unlikely to resume on a secure basis until productive assets and banking franchises are back in the hands of solvent private entities.
The financial and organizational restructuring of financial and nonfinancial firms during the crisis resolution phase is thus a large task, typically entailing much detailed implementation work in the bankruptcy courts, as well as the use of informal or ad hoc work-out procedures. There are also important trade-offs such as that between speed and durability of the subsequent economic recovery on the one hand and the fiscal costs on the other.
Crisis resolution involves inherently complicated coordination problems between debtors and creditors. The fate of an individual corporation or financial institution and the best course of action for its owners and managers will depend on the actions of many others and the general economic outlook. Because of these coordination problems, as well as a lack of capital and the importance of the financial system to economic growth, governments often take the lead in systemic restructuring, especially of the banking system. In the process, governments often incur large fiscal costs, presumably with the objective of accelerating the recovery from the crisis.
The most recurrent question arising at this time is should an overindebted corporate entity be somehow subsidized or forgiven some of its debt, or should its assets be transferred to a new corporate structure and new management? This question applies to both undercapitalized banks and to overindebted nonbank corporations. The feasibility of making such decisions on a case-by-case basis becomes problematic during a systemic crisis resulting in thousands of insolvencies, and it becomes necessary to establish a systematic approach. General principles have proved elusive and, as well as depending on the scale of the crisis and the quality of existing legal and other governance institutions, to an extent the best answer is likely to depend on the source of the crisis.
Where the problem results from an economy-wide crash, the best prospect for future performance of banks and their borrowing customers may be with their existing owners and managers, given the information and other intangible forms of firm or relationship-specific capital they possess. On the other hand, where bank insolvency has been the result of incompetent, reckless, or corrupt banking or the use of government-controlled banks as quasi-fiscal vehicles or for political purposes, the relevant stock of information and relationship capital is unlikely to be of much social value. Therefore, separating the good assets from their current managers and owners offers better prospects in such circumstances—as well as establishing a better precedent for avoiding moral hazard. Information capital is also likely to be relatively unimportant for real estate ventures, which have been central to many recent banking crises.
The main policy approaches employed in the resolution phase of recent crises include: (1) government-subsidized work-outs of distressed loans; (2) debt forgiveness; (3) the establishment of a government-owned asset management company (AMC) to buy and resolve distressed loans; (4) government-assisted sales of financial institutions to new owners, typically foreign; and (5) governmentassisted recapitalization of financial institutions through injection of funds. We focus on the latter three that deal with bank insolvency.
In an attempt to let the market determine which firms are capable of surviving given some modest assistance, some official schemes have offered loan subsidies to distressed borrowers conditional on the borrower’s shareholders injecting some new capital. Likewise, there have been schemes offering injection of government capital funds for insolvent banks whose shareholders were willing to provide matching funds. To the extent that they are discretionary, schemes of debt relief for bank borrowers carry the risk of moral hazard as debtors stop trying to repay in the hope of being added to the list of scheme beneficiaries.
Debt forgiveness, such as is effectively provided by inflation and currency depreciation, is a more generalized approach to providing debt relief to borrowers. Inflation is also a solution that reduces the budgetary burden. After all, if the crisis is big enough, the government’s choices may be limited by what it can afford. Its capacity to subsidize borrowers or inject capital into banks are constrained by its ability over time to raise taxes or cut expenditures. It is for these reasons that inflationary solutions or currency devaluation have been a feature of the resolution of many crises in the past. Debt forgiveness amounts to generalized debt relief and a transfer of the costs of the crisis to money holders and other nominal creditors. In this case, the banks as well as the nonbank debtors receive relief, without a climate of debtor delinquency being created.
The key advantage of debt forgiveness is its simplicity and speed—it recognizes loan losses up front, thus providing immediate relief to borrowers. At the same time, however, debt forgiveness does not impose losses on borrowers and bank shareholders, thus posing incentive problems. It can also undermine trust in monetary institutions and the rule of law, as it can violate monetary standards and interfere in private contracting. Moreover, its possible implementation needs to be considered in the light of the need to preserve an environment of macroeconomic stability into the future. Whether it works will ultimately depend on the frequency of use and specific circumstances of financial distress. As it creates moral hazard, however, debt forgiveness should only be considered as a last-resort policy.
In contrast, the carving-out of an insolvent bank’s bad loan portfolio, and its organizational restructuring under new management and ownership, represents the alternative pole, appropriate where large parts of the bank’s information capital was dysfunctional. The bad loan portfolio may be sold back into the market, or disposed of by a government-owned AMC. The effectiveness of governmentrun AMCs has been quite mixed: better where the assets to be disposed have been primarily real estate, less good where loans to large politically connected firms dominated (Klingebiel, 2000).
Government itself often retains control and ownership of troubled banks for much of the duration of the resolution phase. Whether or not control of the bank passes into public hands, it should eventually emerge, and at this point it must be adequately capitalized. Depending on how earlier loss allocation decisions have been taken, the sums of money that are involved in the recapitalization of the bank so that it can safely be sold into private hands may be huge. Many governments have felt constrained by fiscal and monetary policy considerations from doing the financial restructuring properly. Putting the bank on a sound financial footing should be the priority. Without this, banks will be undercapitalized, whatever the accounts state, and will have an incentive to resume reckless behavior.
Countries typically apply a combination of resolution strategies, including both government-managed programs and market-based mechanisms (Calomiris, Klingebiel, and Laeven, 2003). Both prove to depend for their success on efficient and effective legal, regulatory, supervisory, and political institutions. Further, a lack of attention to incentive problems when designing specific rules governing financial assistance can aggravate moral hazard problems, especially in environments where these institutions are weak, unnecessarily raising the costs of resolution. Policymakers in economies with weak institutions should, accordingly, not expect to achieve the same level of success in financial restructuring as in more developed countries, and they should design resolution mechanisms accordingly.
We collect information on the following crisis resolution policies.
Forbearance indicates whether or not there is regulatory forbearance during the years [ t, t+3], where t denotes the starting year of the crisis. This variable is based on a qualitative assessment of information contained in IMF staff reports. We consider two forms of regulatory forbearance: banks are permitted to continue functioning despite being technically insolvent or prudential regulations (such as for loan classification and loan loss provisioning) are suspended or not fully applied.
In terms of actual bank restructuring, we collect information on nationalizations, closures, mergers, sales, and recapitalizations.
Large-scale government intervention indicates whether or not there was largescale government intervention in banks, such as nationalizations, closures, mergers, sales, and recapitalizations of large banks, during the years [ t, t+3]. Institutions closed indicates the share of bank assets (in percent) liquidated or closed during the years [ t, t+3]. We also collect information on the number of banks in year t and the number of banks in t+3, where t is the starting year of the crisis. Bank closures indicate whether or not banks were closed during the period t to t+3. We also collect information on the number of banks closed or liquidated during the period t to t+3. We separately collect information on whether or not financial institutions other than banks were closed (other FI closures), and on whether or not shareholders of closed institutions were made whole (shareholder protection).
We also collect information on whether or not banks were nationalized (nationalizations), merged (mergers), or sold to foreigners (sales to foreigners) during the period t to t+ 5. For mergers, we also collect information on whether or not private shareholders/owners of banks injected capital, and for sales to foreigners we collect information on the number of banks sold to foreigners during period t to t+ 5.
Next, we collect information on whether or not a bank restructuring agency (bank restructuring agency) was set up to deal with bank restructuring, and whether or not an AMC (asset management company) was set up to take over and manage distressed assets. In case an AMC was set up, we collect information on whether it was centralized or decentralized.
As part of crisis resolution, systemically important (or government-owned) banks are often recapitalized by the government. Recapitalization denotes whether or not banks were recapitalized by the government during the period t to t+ 3. We also compute an estimate of the gross recapitalization cost (as a percentage of GDP) to the government during the period t to t+ 5. The latter variable is denoted as recap cost (gross). Next, we collect information on the recovery of recapitalization costs. Recovery denotes whether or not the government was able to recover part of the recapitalization cost. Recovery proceeds denotes the recovery proceeds (as a percentage of GDP) during the period t to t+ 5. Recap cost (net) denotes the net recapitalization cost to the government, expressed as a percentage of GDP, computed as the difference between the gross recapitalization cost and recovery proceeds.
On deposit insurance and depositor compensation, we collect the following information from Demirgüç-Kunt,, Kane, and Laeven (2008) and IMF staff reports. Deposit insurance indicates whether or not an explicit deposit insurance scheme is in place at the start of the banking crisis. Note that we ignore deposit insurance arrangements put in place after the first year of the crisis. Coverage limit denotes the coverage limit (in local currency) of insured deposits at the start of the banking crisis. This variable is set to zero if there is no explicit deposit insurance. Coverage ratio is the ratio of the coverage limit to per capita GDP at the start of the banking crisis. This variable is set to zero if there is no explicit deposit insurance. Finally, we collect information on whether or not losses were imposed on depositors of failed banks.
17.3.4. Macroeconomic Policies
Governments also tend to change macroeconomic policy to manage banking crises and reduce their negative impact on the real sector. In addition to crisis containment and resolution policies, we therefore also collect information on monetary and fiscal policies during the first three years of the crisis. Although these measures are somewhat crude, they serve the purpose of providing some sense about the policy stance.
Monetary policy index is an index of monetary policy stance during the years [t,t+ 3], where t denotes the starting year of the crisis. The index indicates whether monetary policy is (1) expansive (+1), if the average percentage change in reserve money during the years [ t,t+3] is between 1 to 5 percent higher than during the years [ t–4, t –1]; (2) contractive (–1), if the average percentage change in reserve money during the years [ t, t +3] is between 1 to 5 percent lower than during the years [ t–4, t –1]; or (3) neither (0). We also report the average change in reserve money (in percent) during the years [ t,t+3].
Fiscal policy index is an index of fiscal policy stance during the years [ t, t+3], where t denotes the starting year of the crisis. The index indicates whether fiscal policy is (1) expansive (+1), if the average fiscal balance during the years [t, t+3] is less than –1.5 percent of GDP; (2) contractive (–1), if the average fiscal balance during the years [ t, t+3] is greater than 1.5 percent of GDP; or (3) neither (0). We also report the average fiscal balance (in percent of GDP) during the years [t, t+3].
Finally, we report whether or not an IMF program was put in place around the time of the banking crisis (IMF program), including the year the program was put in place.
17.3.5. Outcome Variables
In terms of outcome variables, we collect information on fiscal costs and output losses.
Fiscal cost (net) denotes the net fiscal cost, expressed as a percentage of GDP, over the period [t, t+5], where t denotes the starting year of the crisis. We also report the gross fiscal costs, and the recovery proceeds over the period [ t, t+5], which is the difference between the two. Fiscal cost estimates are from Hoelscher and Quintyn (2003), Honohan and Laeven (2003), Honohan and Laeven (2003), IMF staff reports, and publications from national authorities and institutions.
Output loss is computed by extrapolating trend real GDP, based on the trend in real GDP growth up to the year preceding the crisis, and taking the sum of the differences between actual real GDP and trend real GDP expressed as a percentage of trend real GDP for the period [ t, t+3]. We require a minimum of three precrisis real GDP growth observations to compute the trend real GDP numbers. 7
17.4. DESCRIPTIVE STATISTICS
Table 17.4 and Table 17.5 summarize the data collected on crisis containment and resolution policies for a subset of 42 systemic banking crises. The list of crisis countries consists of Argentina (four times), Bolivia, Brazil (two times), Bulgaria, Chile, Colombia (two times), Côd’Ivoire, Croatia, Czech Republic, Dominican Republic, Ecuador, Estonia, Finland, Ghana, Indonesia, Jamaica, Japan, Korea, Latvia, Lithuania, Malaysia, Mexico, Nicaragua, Norway, Paraguay, Philippines, Russia, Sri Lanka, Sweden, Thailand, Turkey, Ukraine, United Kingdom, United States, Uruguay, Venezuela, and Vietnam. Note that the financial crisis in the United Kingdom and the United States is still ongoing at the time of writing of this chapter, so the analysis of crisis containment and resolution policies for these two countries is preliminary and incomplete.
|Variable||Number of Crises||Mean||Sth. Dev.||Minimum||Maximum|
|Start year of banking crisis||42||1995||6.100||1980||2007|
|Currency crisis (Y/N)||42||0.548||0.504||0.000||1.000|
|Sovereign debt crisis (Y/N)||42||0.119||0.328||0.000||1.000|
|Net foreign assets/M2||42||0.174||0.189||–0.351||0.576|
|Peak NPLs (fraction of||40||0.252||0.155||0.040||0.750|
|(fraction of total assets)|
|Bank runs (Y/N)||42||0.619||0.491||0.000||1.000|
|Largest one-month drop in||26||0.112||0.058||0.056||0.267|
|Credit boom (Y/N)||33||0.303||0.467||0.000||1.000|
|Annual growth in private||33||0.083||0.098||–0.199||0.341|
|credit to GDP prior to crisis|
|Deposit freeze (Y/N)||42||0.119||0.328||0||1|
|Duration of deposit freeze||5||40.600||46.030||6||120|
|Coverage of deposit freeze:||5||0.400||0.548||0||1|
|time deposits only? (Y/N)|
|Bank holiday (Y/N)||42||0.095||0.297||0||1|
|Duration of bank holiday||4||4.750||0.500||4||5|
|Blanket guarantee (Y/N)||42||0.286||0.457||0||1|
|Duration of guarantee||14||53.071||33.992||11||109|
|Previous explicit deposit||42||0.524||0.505||0||1|
|insurance arrangement (Y/N)|
|Liquidity support different||18||0.500||0.514||0||1|
|across banks? (Y/N)|
|Collateral required for||15||0.467||0.516||0||1|
|Collateral provided is||13||0.846||0.376||0||1|
|If remunerated, interest at||11||0.636||0.505||0||1|
|market rates (Y/N)|
|Peak liquidity support||41||0.277||0.497||0||3|
|(fraction of deposits)|
|Lowering of reserve||41||0.366||0.488||0||1|
|Banks not intervened despite||37||0.351||0.484||0||1|
|being technically insolvent|
|Prudential regulations suspended||37||0.730||0.450||0||1|
|or not fully applied|
|intervention in banks (Y/N)|
|Fraction of financial||39||0.083||0.117||0||0.500|
|Bank closures (Y/N)||42||0.667||0.477||0||1|
|Other financial institutions||34||0.500||0.508||0||1|
|Were shareholders made||30||0.067||0.254||0||1|
|Did private bank shareholders|
|inject fresh capital? (Y/N)||24||0.667||0.482||0||1|
|Sales to foreigners (Y/N)||37||0.514||0.507||0||1|
|Bank restructuring agency (Y/N)||40||0.475||0.506||0||1|
|Centralized asset management|
|Recapitalization (Y/N) of banks||42||0.762||0.431||0||1|
|Recap level (%)||13||0.078||0.020||0.040||0.100|
|Recap cost to government||32||0.078||0.096||0.002||0.373|
|(gross) (fraction of GDP)|
|Recovery of recap||31||0.516||0.508||0||1|
|Recap cost to government||32||0.060||0.079||0||0.373|
|(net) (fraction of GDP)|
|Deposit insurance (Y/N)||42||0.524||0.505||0||1|
|Coverage limit to per||35||1.142||1.730||0||7.180|
|Were losses imposed on||42||0.310||0.468||0||1|
|Monetary policy index||40||–0.050||0.815||–1||1|
|Change in reserve money (rate)||35||1.681||4.562||–0.070||20.47|
|Fiscal balance (share of GDP)||40||–0.036||0.030||–0.127||0.008|
|IMF program put in place (Y/N)||42||0.524||0.505||0||1|
|Fiscal cost net (share of GDP)||40||0.130||0.133||0||0.551|
|Gross fiscal cost (share of GDP)||40||0.157||0.150||0||0.568|
|Output loss (share of GDP)||40||0.201||0.260||0||0.977|
The selection of crisis episodes is determined by the availability of detailed information on such policies. We rely on a variety of sources, including IMF staff reports and working papers, World Bank documents, and central bank and academic publications. We refer to the electronic version of the database for the exact sources of the data. 8 The electronic version of the database also contains a slightly larger set of variables than that reported here, including a brief description of each crisis, the name of the administering agency of the blanket guarantee (if introduced) and the coverage of the guarantee, and the name of the entity in charge of the AMC (if set up), its funding, and the type of assets transferred to it.
17.4.1. Initial Conditions
Table 17.4 reports summary statistics for the initial conditions variables. We find that the banking crises selected tend to coincide with currency crises, but they rarely coincide with sovereign debt crises. In 55 percent of cases, the banking crisis coincides with a currency crisis, but in only 11 percent of cases does the banking crisis coincide with a debt crisis.
Macroeconomic conditions are often weak prior to a banking crisis. Fiscal balances tend to be negative (–2.1 percent on average), current accounts tend to be in deficit (–3.9 percent), and inflation often runs high (137 percent on average) at the onset of the crisis. However, the role of macroeconomic fundamentals has evolved across generations of crisis. Whereas crises such as Russia in 1998, Argentina in 2001, and most crises of the 1980s were precipitated by large macroeconomic imbalances, and in particular unsustainable fiscal policies, the nature of the east Asian crises had more to do with the maturity composition of debt and foreign exchange risk exposures rather than the level of public debt and fiscal deficit.
Nonperforming loans tend to be high during the onset of a banking crisis, running as high as 75 percent of total loans and averaging about 25 percent of loans. However, it is not always clear to what extent the sharp rise of nonperforming loans was caused by the crisis itself or whether it reflects the effects of tightening of prudential requirements during the aftermath of the crisis. In the case of Chile, for instance, nonperforming loans peaked at 36 percent of total loans only in 1986, several years after the start of the crisis. However, part of the unsound banking practices that led to the Chilean banking crisis was the existence of substantial connected loans, which ranged across banks from 12 to 45 percent of the total loan portfolio (Sanhueza, 2001).
Government ownership of banks is common in crisis countries, with the government owning about 31 percent of banking assets on average. In many cases, government ownership may have become a vulnerability as problems at state-owned banks have been major contributors to the crisis, with many exhibiting low asset quality prior to the onset. In Uruguay, for instance, state-owned banks Republica and Hipotecario—accounting for 40 percent of the system’s assets—exhibited nonperforming loans of 39 percent of total loans as of 2001, compared to 5.6 percent at private banks (IMF, 2003). In Turkey, duty losses at state-owned banks were estimated at 12 percent of GNP as early as in 1999 (IMF, 2000), and state-owned bank Bapindo in Indonesia had experienced important losses as early as in 1994, three years prior to the onset of the crisis (Enoch and others, 2001).
Bank runs are a common feature of banking crises, with 62 percent of crises experiencing momentary sharp reductions in total deposits. The largest one-month drop in the ratio of deposits to GDP averages is about 11.2 percent for countries experiencing bank runs, and is as high as 26.7 percent in one case. Severe runs are often system-wide, but it is also common to observe a flight to quality effect within the system from unsound banks to sound banks that implies no or moderate systemic outflows. During the Indonesian crisis in 1997, for instance, private national banks lost 35 trillion rupiah in deposits between October and December 2007, while state-owned banks and foreign and joint-venture banks gained 12 and 2 trillion, respectively. A similar situation occurred in Paraguay following the intervention of the third and fourth largest banks and the uncovering of unrecorded deposits. Depositors migrated from these banks to those perceived as more solid.
Banking crises are also often preceded by credit booms, with precrisis rapid credit growth in about 30 percent of crises. Average annual growth in private credit to GDP prior to the crisis is about 8.3 percent across crisis countries, and is as high as 34.1 percent in the case of Chile. Credit booms have often been preceded by processes of financial liberalization, such as the one that led to the crisis in the Scandinavian countries in the 1990s (see Drees and Pazarbasioglu, 1998).
Crisis-affected countries often suffer from weak legal institutions, rendering a speedy resolution of distressed assets hard to accomplish. Creditor rights in the selected crisis countries averages about 1.8, ranging from a low of 0 to a high of 4 (the maximum possible score).
In summary, initial conditions are important because they may shape the market’s and policymakers’ response during the containment phase. If macroeconomic conditions are weak, then policymakers have limited buffers to cushion the impact of the crisis and the burden falls on the shoulders of containment and resolution policies. Moreover, sudden changes in market expectations may gather strength rapidly depending on how weak initial conditions of the country are, in particular the macroeconomic setting, the institutional environment, and the banking sector. Take, for instance, the case of Turkey in 2000. The trigger of the crisis was the collapse of interbank loans from large banks to a few small banks on November 20, in particular to Demir Bank, which depended greatly on overnight funding. Turkey was widely known to exhibit macroeconomic vulnerabilities, with inflation hovering around 80 percent per annum during the 1990s, high fiscal deficits, large public debt, high current account deficits, and a weak financial system. Banks had high exposure to the government through large holdings of public securities and sizable maturities and exchange rate risk mismatches, making them highly vulnerable to market risk. When credit lines to Demir Bank were cut, several small banks were forced to sell their government securities. This caused a sharp drop in the price of government securities and triggered panic among foreign investors, a reversal in capital flows, sharp increases in interest rates, and declines in the value of the Turkish lira. Within a few weeks of these developments, the Turkish government announced a blanket guarantee. An opposite example is Argentina in 1995, where the contagion from the “Tequila crisis” was weathered successfully with a substantial consolidation of the banking sector and small fiscal costs, in large part because of the robust macroeconomic performance during the preceding years.
17.4.2. Crisis Containment
Table 17.5 reports summary statistics for the crisis containment and resolution policies of the 42 selected banking crisis episodes.
The data show that emergency liquidity support and blanket guarantees are two commonly used containment measures. Extensive liquidity support is used in 71 percent of crises considered and blanket guarantees are used in 29 percent of crisis episodes. Deposit freezes and bank holidays to deal with bank runs are less frequently used. In our sample, only five cases (or 12 percent of episodes) used deposit freezes: Argentina in 1989 and 2001, Brazil in 1990, Ecuador in 1999, and Uruguay in 2002. In all but one case (Brazil in 1990), the deposit freeze was preceded by a bank holiday. Bank holidays were used in only 10 percent of crises and only in the cases mentioned above. In all episodes where holidays and deposit freezes were used, bank runs occurred. Bank holidays typically do not last long: about five days on average. However, deposit freezes can be in existence for a much longer period, up to 10 years in one case, and about 41 months on average. The longest freeze recorded corresponded to the Bonex plan implemented in Argentina in 1989. 9 After the conversion, the bonds traded with a discount of almost two-thirds and recovered to about 50 percent within a few months. Similarly, in the case of Ecuador, depositors received certificates of reprogrammed deposits, which traded at significant discounts depending on the perceived solvency of the issuing bank. Moreover, bank runs resumed as soon as the unfreezing began (J’me, 2004). It seems that at least in these cases, deposit freezes were highly disruptive, imposing severe losses to depositors, and therefore should be considered only in extreme circumstances. Bank holidays, on the other hand, may be used to buy time until a clear strategy is laid out; they were also used in the United States during the Great Depression in the 1930s.
Unlike the Bonex plan in Argentina in 1989 and the deposit freeze in Uruguay in 2002 (which covered dollar-denominated time deposits at public banks), deposit freezes have generally also covered deposits other than time deposits. The 2001 freeze in Argentina, for example, began with the Corralito, which limited withdrawals up to US$250 a week, prohibited transfers abroad unless trade-related, introduced marginal reserve requirements, and limited transactions that could reduce deposits. However, soon after the Corralito, the Corralon was implemented which reprogrammed time deposits over a five-year horizon. Similarly, in Brazil in 1990, the freeze included M2 plus federal securities in the hands of the public, except balances below NCZ$50,000 for checking accounts and NCZ$25,000 for savings accounts or 20 percent of the balance (whichever was larger) for deposits in the overnight domestic debt market, and 20 percent of the balance for mutual funds. The broadest freeze recorded in our sample was implemented by Ecuador, and included savings deposits above US$500, half of checking account balances, repurchase agreements, and all time deposits.
Blanket guarantees tend to be in place for a long period as well, about 53 months on average. Blanket guarantees are another policy tool that—if successful—may buy some time for policymakers to implement a credible policy package. The use of a blanket guarantee is usually justified on the grounds that if not put in place, the payments system could collapse. Using the dataset presented in this chapter, Laeven and Valencia (2008) examined the effectiveness of blanket guarantees in restoring depositor confidence and found that blanket guarantees are often successful in that sense. However, they also found that outflows by foreign creditors were virtually unresponsive to the announcement of such guarantees, despite being covered in most cases. Regarding the fiscal cost of using guarantees, they found that such guarantees tend to be costly, confirming earlier results by Honohan and Klingebiel (2003), but argue that this result is driven mainly by the fact that guarantees are usually adopted in conjunction with extensive liquidity support and when crises are severe.
Blanket guarantees not only imply fiscal contingencies, but also potential moral hazard problems. Moral hazard arises because banks no longer feel disciplined by depositors to avoid excessive risk taking. With the backing of a blanket guarantee, it is often attractive for banks to engage in risky activities or, in case the bank is distressed, to “gamble for resurrection” while the guarantee is in place. Another consequence of guarantees is that depositors no longer feel the need to screen banks. For instance, following the announcement of a blanket guarantee by the Irish authorities on September 29, 2008, there was a large migration of deposits from the United Kingdom, where a limited guarantee was in place, to banks in Ireland. In light of these moral hazard considerations, blanket guarantees should only be used as a temporary measure.
Peak liquidity support tends to be sizable and averages about 28 percent of total deposits across the 42 crisis episodes considered. Liquidity support is clearly the most common first line of response in systemic crisis episodes, even in the case of Argentina in 1995 when a currency board was in place. This was possible through an amendment of the charter of the Central Bank of Argentina in February 1995, allowing it to lengthen the maturities of its swap and rediscount facilities, with the possibility of monthly renewal, and in amounts exceeding the net worth of the borrowing bank.
In severe crises, there has been a positive correlation of about 30 percent between the provision of extensive liquidity support and the use of blanket guarantees. Blanket guarantees are often introduced to restore confidence even when previous explicit deposit insurance arrangements are already in place (this is the case in about 52 percent of crises where blanket guarantees are introduced). It is worth noting that in some cases, partial guarantees have been introduced to cover only a segment of the market, not all banks.
17.4.3. Crisis Resolution
Table 17.5 reports summary statistics for the crisis resolution policies of the 42 selected banking crisis episodes. Regulatory forbearance is a common feature of crisis management. The policy objective is to achieve a gradual recovery of the banking system over time, or a gradual transitioning toward stricter prudential requirements. The latter is a common outcome whenever modifications to the regulatory framework are introduced. In Ecuador for instance, banks were given two years to fully comply with new loan classification rules, among other requirements. In the 2001 crisis episode in Argentina, the authorities granted regulatory forbearance which included a new valuation mechanism for government bonds and loans, allowing for a gradual convergence to market value. Banks were also allowed to temporarily decrease their capital charge on interest rate risk, and losses stemming from court injunctions 10 could be booked as assets to be amortized over a period of 60 months. Prolonged forbearance occurs in about 67 percent of crisis episodes. In 35 percent of cases, forbearance takes the form of banks not being subject to intervention despite being technically insolvent, and in 73 percent of cases prudential regulations are suspended or not fully applied.
Forbearance, however, does not really solve the problems and therefore a key component of almost every systemic banking crisis is a bank restructuring plan. In 86 percent of cases, large-scale government intervention in banks takes place in the form of bank closures, nationalizations, or assisted mergers. In only a handful of episodes, the system survived a crisis without having at least significant bank closures. For instance, in the case of Latvia, banks holding 40 percent of assets were closed, but no further intervention of the government was implemented. In Argentina, in the 1995 episode, 15 institutions ran into problems: 5 of them were liquidated (with 0.6 percent of the system’s assets), 6 were resolved under a purchase and assumption scheme (with 1.9 percent of the system’s assets), and 4 were absorbed by healthier institutions. However, in addition to that, a significant consolidation process took place through 14 mergers, involving 47 financial institutions. Regarding the treatment of shareholders, they often lose money when banks are closed and are often forced to inject new capital into the banks they own.
Closures have not been limited to banks and have also included nonbank financial institutions. In Thailand, for instance, the problem started with liquidity problems at finance companies as early as March 1997, and 56 of them (accounting for 11 percent of the financial system’s assets) were closed. In Jamaica, a large component of the financial problems was in the insurance sector, whose restructuring cost reached 11 percent of GDP.
Sales to foreigners are often seen as a last resort, though they have become quite common in recent crises. On average, 51 percent of crisis episodes have seen sales of banks to foreigners.
Bank closures seem to be associated with larger fiscal costs (there is a positive correlation between those two variables of 22 percent). However, closures are negatively associated with the issuance of a blanket guarantee, with a correlation of—22 percent. Because the guarantee entails a sizable fiscal contingency, once in place governments may try to avoid closing banks so as to avoid materializing the guarantee. Bank closures seem also positively associated with peak nonperforming loans, with a correlation of about 25 percent. One potential contributing factor to this correlation is that once a bank is closed, its asset quality may deteriorate because in the process any value attached to bank relationships with customers may be destroyed. Borrowers may delay payments or the collection of loans becomes less effective than before, which may also contribute to higher fiscal costs.
Special bank restructuring agencies are often set up to restructure distressed banks (in 48 percent of crises) and AMCs have been set up in 60 percent of crises to manage distressed assets. AMCs tend to be centralized rather than decentralized. The main objective of government-owned AMCs is to accelerate financial restructuring by taking over nonperforming assets from banks. Two examples of successful AMCs are Securum and Retrieva in Sweden, created in 1992 to manage the problem loans of two major Swedish banks, Nordbanken and Gota Bank. Both companies managed to recover substantial amounts of their initial investment by selling off their assets. Factors that contributed to their success include an efficient judicial system, which allowed them to force insolvent debtors into bankruptcy; the real estate-related nature of their assets, which made it easier to restructure; and the strong governance mechanisms and skilled management teams of the companies. However, other countries have found it harder to realize these advantages, in part owing to weak legal, regulatory, and political institutions—often banks’ assets were transferred to the AMC at above-marketvalue prices, resulting in backdoor bank recapitalization and creating moral hazard. Examining the cases where AMCs were used, we find that the use of AMCs is positively correlated with peak nonperforming loans and fiscal costs, with correlation coefficients of about 15 percent in both cases. These correlations may suggest some degree of ineffectiveness in AMCs, at least in those episodes where such companies were established. Consistent with our findings, Klingebiel (2000) studied seven crises where AMCs were used and concluded that they were largely ineffective.
Another important policy used in the resolution phase of banking crises is recapitalization of banks. Measures aimed at quickly improving the capital bases of financial institutions do not directly improve debtor capacity, but make it easier for banks to recognize losses and thereby facilitate corporate restructuring. Governmentassisted recapitalizations can, however, create moral hazard for shareholders, especially if government intervention is small relative to the negative net worth of recipient institutions. Comparing the preferred bank stock programs adopted in the United States (starting in 1933) and Japan (1998) helps to illustrate some of the key issues with recapitalization. Although in both cases policymakers used preferred stock purchases to enhance bank capital, this approach appeared to work better in the United States, where appropriate screening and incentives for participants ensured that only banks worth saving and those that managed their risk and capital structure more prudently received taxpayer funds. 11 Moreover, banks receiving assistance were monitored to ensure that they made proper use of public aid. In Japan, by contrast, virtually every bank of significant size received assistance, though the amounts involved were relatively small. The recapitalization program thus provided a boost to bank capital but did less to foster corporate restructuring or to restart bank lending. 12
In 33 out of the 42 selected crisis episodes, banks were recapitalized by the government. Recapitalization costs constitute the largest fraction of fiscal costs of banking crises and take many forms. In 12 crises, recapitalization took place in the form of cash; in 14 crises, in the form of government bonds; in 11 episodes, subordinated debt was used; in 6 crises, preferred shares were used; in 7 crises, it took place through the purchase of bad loans; in 2 crises, a government credit line was extended to banks; in 3 crises, the government assumed bank liabilities; and in 4 crises, the government purchased ordinary shares of banks. In some cases, a combination of these methods was used. Recapitalization usually entails writing off losses against shareholders’ equity and injecting either Tier 1 or Tier 2 capital or both. Recapitalization programs are usually accompanied with some conditionality. For instance, in the case of Chile, a nonperforming loans purchase program was implemented, and during this period banks could not distribute dividends and all profits and recoveries had to be used to repurchase the loans. In Mexico, PROCAPTE (a temporary recapitalization program) would have FOBAPROA (deposit insurance fund) purchase subordinated debt from qualifying banks, but the resources had to be deposited at the central bank, bearing the same interest rate as the subordinated bonds. Banks could redeem the bonds if their capital adequacy ratio went above 9 percent, but FOBAPROA had the option to convert the bonds into stocks after five years or if banks’ Tier 1 capital ratio fell below 2 percent.
Similar conditionalities were applied to recapitalization programs in Turkey in 2000 and Thailand in 1997. In the former, SDIF (the Turkish deposit insurance fund) would match owners’ contribution to bring banks’ Tier 1 capital to 5 percent, but only for banks with a market share of at least 1 percent. SDIF could also contribute to Tier 2 capital through subordinated debt, to all banks with Tier 1 capital greater than or equal to 5 percent. Similar to the case of Mexico, if Tier 1 capital fell below 4 percent, the subordinated debt would convert into stocks. In the case of Thailand, the recapitalization plan involved Tier 1 capital injections, with the government matching private contributions and the requirement that the financial institution make full provisions upfront, in line with new regulations. Additionally, the government and the new investors had the right to change the board of directors and management of each participating financial institution. The government also had the right to appoint at least one board member to each financial institution. The program also included Tier 2 capital injections equal to a minimum of (1) the total write-down exceeding previous provisioning or (2) 20 percent of the net increase in lending to the private sector, among other criteria.
On average, the net recapitalization cost to the government (after deducting recovery proceeds from the sale of assets) amounts to 6 percent of GDP across crisis countries in the sample, though in the case of Indonesia, it reached as high as 37.3 percent of GDP.
About half the countries experiencing a systemic banking crisis had an explicit deposit insurance scheme in place at the outbreak of the crisis (and several countries adopted deposit insurance throughout the crisis). Losses are imposed on depositors in a minority of cases. Simple correlations show that episodes where losses were imposed on depositors faced higher output losses, with a correlation of about 8 percent.
Regarding monetary and fiscal policies, monetary policy tends to be fairly neutral during crisis episodes, whereas the fiscal stance tends to be expansive, arguably to support the financial and real sectors, and to accommodate bankrestructuring and debt-restructuring programs. On average, the fiscal balance is about –3.6 percent of GDP during the initial years of a banking crisis. The IMF has participated through programs in about 52 percent of the episodes considered.
Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3 percent of GDP on average, and can be as high as 55.1 percent of GDP. Recoveries of fiscal outlays vary widely as well, with the average recovery rate reaching 18.2 percent of gross fiscal costs. Although countries that used AMCs seem to achieve slightly higher recovery rates, the correlation is very small, at about 10 percent.
Finally, output losses (measured as cumulative deviations from trend GDP) of systemic banking crises can be large, averaging about 20 percent of GDP on average during the first four years of the crisis, and ranging from a low of 0 percent to a high of 98 percent of GDP.
17.5. GLOBAL LIQUIDITY CRISIS OF 2007–08
During the course of 2007, U.S. subprime mortgage markets went into meltdown and global money markets came under intense pressure. The U.S. subprime mortgage crisis manifested itself first through liquidity issues in the banking system owing to a sharp decline in demand for asset-backed securities. Hard-to-value structured products and other instruments created during a boom of financial innovation had to be severely marked down because of newly implemented fairvalue accounting rules and credit-rating downgrades. Credit losses and asset write-downs got worse with declining housing prices and accelerating mortgage foreclosures, which increased in late 2006 and worsened further in 2007 and 2008. Profits at U.S. banks declined from $35.2 to $5.8 billion (83.5 percent) during the fourth quarter of 2007 versus the prior year, arising from provisions for loan losses. As of March 2009, estimates of subprime-related and other credit losses or write-downs by global financial institutions stand at over $4 trillion.
We now briefly compare the ongoing global liquidity crisis and its policy responses to the other crises included in our database. Given that the global liquidity crisis is still very much unfolding at the time of writing, this analysis is obviously preliminary and incomplete.
17.5.1. Initial Conditions
At the time of writing this chapter, the underlying causes of the global 2007–08 financial crisis are still being debated, and most likely can be attributed to a combination of factors. However, from the perspective of describing its initial conditions, it is useful to classify the underlying factors in two groups: macroeconomic and microeconomic factors.
The macroeconomic context is characterized by a prolonged period of excess global liquidity induced in part by relatively low interest rates set by the Federal Reserve and other central banks following the 2001 recession in the United States. The excess liquidity fueled domestic demand and in particular residential investment, triggering a significant rise in housing prices which more than doubled in nominal terms between the year 2000 and mid-2006. 13 During this period, the economy faced high current account deficits, reaching 7 percent of GDP in the last quarter of 2005, induced primarily by household expenditure but also by sizable fiscal deficits.
However, microeconomic factors related to financial regulation (and lack thereof) and industry practices by financial institutions also appear to have played a crucial role in the buildup of the bubble. The originate-and-distribute lending model (see Bhatia, 2007, for a description) adopted by many financial institutions during this period seems to have exacerbated the problem. Under this approach, banks made loans primarily to sell them to other financial institutions that in turn would pool them to issue asset-backed securities. The underlying rationale for these loan sales was a transfer of risk to the ultimate buyer of the security, backed by the underlying mortgage loans. These securities could then be pooled again and new instruments would be created and so forth. A mispricing of risk of mortgage-backed securities (MBSs) linked to subprime loans led the market to believe that there was an arbitrage opportunity. Such market perceptions fueled demand for these instruments and contributed to a deterioration in underwriting standards by banks in an attempt to increase the supply of loans to meet the demand for securitized instruments. Regulatory oversight missed the buildup of vulnerabilities induced by this process as risks were expected to be transferred to the unregulated segment of the market. The premise was that heavily regulated banks would only be originators and the ultimate holders of securities were beyond the scope of regulation. In this process, however, spillover effects and systemic risks seem to have been neglected by regulators, and the regulated segment ended up being significantly affected. The crisis reached a global dimension as it became apparent that foreign banks, mainly European, had also played a significant role in the demand for mortgage-related (and in particular subprime mortgages-linked) securities. For U.K. banks, this shock coincided with a homegrown housing bubble.
In addition to a move toward the originate-and-distribute lending model, many banks, particularly in the United Kingdom, increasingly relied on wholesale funding. As the crisis unfolded, banks that relied heavily on wholesale markets for their funding, such as Northern Rock in the United Kingdom, were hit particularly hard, causing stress in global money markets. Given ongoing concerns with counterparty risk, notably regarding adequacy of banks’ capital, money market strains have continued.
At first glance, the buildup of this crisis episode in the United States and the United Kingdom does not seem to differ significantly from the traditional boombust cycles observed in the other crisis countries in our database. Many of these historical crisis episodes experienced buildups of asset price bubbles, and in particular of real estate bubbles, often originating from financial liberalization. In many cases, deregulation of financial systems led to rapid expansion of credit, but with deficiencies in risk management and pricing as the financial system was evolving and prone to abuse. In the case of the United States, it was not financial liberalization in the conventional sense, but financial innovation of financial instruments which the market and regulators did not fully understand. Supported by these new financial products and asset securitization, mortgage credit markets expanded rapidly only to virtually collapse in some segments as the financial crisis unfolded. In 30 percent of the episodes included in our database, the crisis was preceded by a credit boom. In the cases of the United States and the United Kingdom, however, although credit rose rapidly“mortgage lending in particular”the pace of expansion did not satisfy our criteria to be labeled as a credit boom.
What is different from many previous financial crises, especially in developing countries, is that the United States and the United Kingdom have thus far not suffered from a sudden stop of capital flows, which has caused major economic stress in other countries. The dollar did depreciate against the euro in the years preceding the 2007 turmoil, but demand for U.S. assets did not contract sharply, possibly because of the dollar’s use as a reserve currency. Also, the speed and breadth with which stress in U.S. mortgage markets has spread to other continents, financial institutions (notably securities firms), and financial markets (notably money markets) seems to have been fueled by uncertainty about the unfolding of the subprime crisis, as it became more clear that risk had been mispriced and exposures had not been transparent.
Average house prices in the United States reached a peak around mid-2006 and began to decline after the initial signs that a financial crisis might be around the corner. Losses at financial institutions began to appear as early as February 2007 with HSBC Finance, the U.S. mortgage unit of HSBC, reporting over $10 billion in losses from its U.S. mortgage lending business. The bad news continued in April 2007 with the bankruptcy filing of New Century Financial, one of the biggest subprime lenders in the United States, followed by the rescue of two Bear Stearns hedge funds in June 2007. Problems further intensified when on August 16, 2007, Countrywide Financial, the largest mortgage lender in the United States, ran into liquidity problems because of a decline in value of securitized mortgage obligations, triggering a deposit run on the bank. The Federal Reserve“intervened” by lowering the discount rate by 0.5 percent and by accepting $17.2 billion in repurchase agreements for MBSs to aid liquidity. On January 11, 2008, Bank of America bought Countrywide for $4 billion. Up to this point, containment policy in the United States was limited to alleviating liquidity pressures through the use of existing tools.
During this time, the United Kingdom experienced its own banking sector problems in light of tight conditions in money markets. On September 14, 2007, Northern Rock, a midsized U.K. mortgage lender, received a liquidity support facility from the Bank of England, following funding problems related to turmoil in the credit markets caused by the U.S. subprime mortgage financial crisis. Starting on September 14, 2007, Northern Rock experienced a bank run, until a government blanket guarantee “covering only Northern Rock” was issued on September 17, 2007. The run on Northern Rock highlighted weaknesses in the U.K. financial sector framework, including the maintenance of adequate capital by financial institutions, bank resolution procedures, and deposit insurance (IMF, 2008). Commercial banks in the United States did not seem to have experienced runs among retail customers, but as mentioned earlier, many institutions faced significant stress in wholesale markets. The blanket guarantee issued on Northern Rock was perhaps the first significant step away from the usual tools employed to resolve liquidity problems. However, unlike in other episodes where a blanket guarantee was used, this time it was introduced at an early stage. In our sample, 29 percent of episodes used a blanket guarantee. However, in the majority of them, they were put in place in the midst of a financial meltdown. 14 In the Asian countries for instance, blanket guarantees were announced when markets were under significant stress and the crisis was already of systemic proportions with widespread runs throughout the financial system.
The next significant policy measure adopted by authorities in both countries was an increase in the range of tools available to provide liquidity. The Federal Reserve introduced the Term Securities Lending facility in March 2008 by which it could lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the program in place) by a pledge of other securities, including federal agency debt, federal agency residential MBSs, and nonagency AAA-/Aaa-rated private-label residential MBSs. Similarly, it increased its currency swap lines with other central banks in an attempt to reestablish calm in money markets. The Bank of England took similar steps on April 21, 2008, when it announced it would accept a broad range of MBSs under the new Special Liquidity Scheme and swap those for government paper for a period of one year to aid banks experiencing liquidity problems. The scheme enabled banks to temporarily swap high-quality but illiquid mortgage-backed assets and other securities. These steps are common measures in other episodes documented, where central banks usually increase the tools to provide the system with additional liquidity at both longer and more flexible terms.
Following the Federal Reserve’s announcement of the expansion of liquidity facilities, a major event took place: the collapse of Bear Stearns, the fifth largest investment bank at the time. Mounting losses arising from its mortgage exposure triggered a run on the bank requiring an emergency financial assistance from the government and purchase by JP Morgan Chase—with federal guarantees on its liabilities—in March 2008. It was a rather controversial measure because Bear Stearns was not subject to regulation by the Federal Reserve, yet the Federal Reserve’s guarantee on its liabilities was crucial to avoid the firm’s bankruptcy. 15 Because of large counterparty risk, it was believed that an intervention was justified. Although there was no explicit blanket guarantee announced on Bear Stearns, there was a de facto protection of all its creditors. Shareholders of Bear Stearns, however, did suffer significant losses.
The containment measures employed thus far by the U.S. and U.K. authorities to deal with the ongoing financial turmoil are not that different from those employed in previous crisis episodes. Almost all crises have used generous liquidity support to deal with illiquid banks. What is different in the current episode is that such liquidity support is extended not only to commercial banks but also to investment banks. Blanket guarantees are also not uncommon, though thus far they have mainly been used in developing countries to deal with systemic financial crises where depositors have lost confidence in banks’ ability to repay them.
It is too early to assess how the crisis will be resolved because it is still ongoing and its adverse implications have not been fully materialized. However, some insights can be extracted from events thus far.
Between January 2008 and February 2009, 41 commercial banks failed in the United States, and each of these bank failures was handled through traditional purchase and assumption schemes with a de facto protection of all depositors. This is no different from what has been done in the case of bank failures in the past. A large fraction of failures included in our database was handled in such a way, with only 31 percent of episodes imposing losses on depositors. Failures are likely to rise as the Federal Deposit Insurance Corporation (FDIC)’s watch list of troubled banks grew to 252 banks by the end of 2008. The largest commercial bank failure thus far is that of IndiMac, a bank with $19 billion in deposits that was taken over by the FDIC in July 2008.
The most notable failures so far, however, have been those of three major U.S. investment banks: Bear Stearns, Lehman Brothers, and Merrill Lynch. Bear Stearns collapsed on March 16, 2008, after facing major liquidity problems’ its sale to JP Morgan went through after the Federal Reserve Bank of New York agreed to take over Bear Stearns’ $30 billion portfolio of MBSs. Lehman Brothers filed for Chapter 11 bankruptcy protection on September 14, 2008, after failed attempts to sell the bank to private parties. Merrill Lynch was acquired by Bank of America on September 15, 2008. Equally important has been the nationalization of the insurance giant AIG, whose interconnectedness with the banking system through counterparty risk could have caused a major wave of failures. As of early 2009, the government has injected more than $100 billion into the insurance firm.
Another significant event has been the placement under conservatorship of Fannie Mae and Freddie Mac, the two largest U.S. housing governmentsponsored entities (GSEs). As part of the plan announced on September 7, 2008, the Federal Housing Finance Authority was granted direct oversight of the GSEs, the U.S. Treasury was given authority to inject capital into the GSEs in the form of senior preferred shares and warrants (whereas dividends on existing common and preferred stock have been suspended), and senior management and the boards of directors at both enterprises were dismissed. Effectively, this entailed a nationalization of the two entities. The U.S. Treasury was also granted temporary authority to purchase agency-backed MBSs, and a short-term credit facility was established for the housing GSEs. The rescue of Fannie Mae and Freddie Mac came shortly after legislation approved late July 2008 that gave the U.S. Treasury the power to use public funds to recapitalize them. The bill also contained a tax break of as much as $7500 for first-time homebuyers, created a new regulator to oversee Fannie Mae and Freddie Mac, and allowed the Federal government to insure up to $300 billion in refinanced mortgages. These measures came after severe declines of stock prices of Fannie Mae and Freddie Mac following market perceptions of a significant capital shortfall.
In October 2008, after a first round of hesitation, the U.S. House of Representatives voted in favor of the Stabilization act to bail out the U.S. financial sector in the amount of US$700 billion. Though the act was initially sold as a government program to purchase distressed financial assets, it has since been recast as a program to recapitalize financial institutions by directly injecting capital. Recapitalization measures have been widely used, with 76 percent of episodes covered implementing them, but in most cases such measures were implemented only after major insolvency problems at banks. It is too early to tell what will be the amount of U.S. taxpayer money involved in the rescue of Fannie Mae and Freddie Mac. In the United Kingdom, recapitalization costs of the banking system have escalated substantially since the initial 0.2 percent of GDP used to capitalize Northern Rock, with the government acquiring large stakes in some of the country’s major banks. For example, by end-2008, the U.K. government owned 95 percent of the capital of Royal Bank of Scotland, the largest bank in the country.
The crisis at Northern Rock, which was triggered by illiquidity but where solvency concerns led to a loss of depositor confidence, was contained at first through a government guarantee on deposits, but when a private-sector solution on acceptable terms was not identified by the government, the bank was nationalized on February 22, 2008. Nationalizations are last-resort measures commonly used in previous crises, with 57 percent of episodes in the sample using them. However, they have been more common in developing countries where it may be hard to find new owners for failed banks. Other U.K. banks that have reported major losses have sought private-sector solutions to restore bank capital, mostly by attracting new capital from existing shareholders through rights issues, but also through asset sales and a reduction in dividends. Another mortgage lender experiencing stress, Alliance & Leicester, was bought in July 2008 by the Spanish bank Banco Santander.
A noteworthy difference with previous crisis episodes is the role that sovereign wealth funds have played in this crisis in terms of providing new capital to restore banks’ capital positions to health. Globalization in conjunction with asset securitization has provided an international dimension to this crisis, by allowing many investors around the world to take a piece of the U.S. mortgage pie. Sovereign wealth funds have injected capital in major banks in both the United States and the United Kingdom as part of their recapitalization efforts.
The final costs of this crisis will not be known for some time. The United States has thus far assigned $700 billion, or about 4.9 percent of U.S. GDP, for bank restructuring and recapitalization. This is not an outlier when compared to fiscal costs associated with government action to resolve financial crises of the past. Our data on previous financial crisis episodes puts the fiscal costs associated with resolving financial crises in the average country at 16 percent of GDP. Although this average includes some small and emerging economies, the fiscal cost is equally high among advanced economies, about 15 percent of GDP on average. About half (or 8 percent of GDP) of these fiscal outlays relate to costs associated with government-assisted recapitalization of banks. The remainder relate mainly to costs associated with government asset purchase and debtor relief programs. There is much variation in this number, though, as the severity and management of crises have varied a great deal. The crisis management packages in countries as diverse as Finland, Japan, Korea, Mexico, and Turkey all cost the taxpayer a multiple of the current U.S. bailout plan, ranging from 13 percent of GDP in Finland to as high as 32 percent in Turkey. Countries like Norway and Sweden fared much better with costs to the taxpayer of 3 and 4 percent of GDP, respectively.
Of course, the current U.S. financial crisis is still ongoing and the ultimate fiscal costs could be much higher. Recent bailouts of individual financial institutions and extensions of government guarantees for deposits and money market funds have already added significant contingent fiscal liabilities. As the crisis has spread around the globe, other countries, particularly in Europe, have followed suit with policy actions that add to fiscal costs, varying from the announcement of a blanket guarantee on bank liabilities in Ireland to a comprehensive bailout package for major financial institutions in the United Kingdom.
A key driver of this variation in ultimate fiscal costs is the speed with which governments act to resolve the crisis. Speed is of the essence and is often accomplished through a comprehensive package of simple assistance measures to borrowers and banks that is politically acceptable.
Also, although the upfront cost of interventions is high, if done right, the government would not be left empty-handed. If the government purchases bad assets, these assets may recover in value, and if the government takes equity stakes in banks, the value of these stakes may increase in the years to come. The ultimate cost to the taxpayer is likely to be smaller.
Surely, any bailout plan involves a transfer of wealth from creditors to debtors, from those that behaved prudently to those that took excessive risks. However, the consequence of no action is likely to be worse. What starts as a crisis of confidence in the financial system often spreads quickly to the real economy, negatively affecting household wealth. Declines in banks’ net worth, which may result in bank failures, reduce their ability to supply loans to households and firms, and at a minimum increase the cost of borrowing. At the same time, initial declines in economic activity that begin as a normal recession become larger as declines in borrowers’ income and net worth destroy bank net worth, creating a vicious cycle of wealth destruction that in the past has often led affected economies into deep recession. It is for this reason that financial crises call for swift policy responses. Sound policies today can avoid even larger fiscal and economic costs tomorrow.
In summary, there is much similarity in the handling of today’s crisis compared to that of previous experiences with crisis management. Authorities have, with some delay, embarked on large-scale interventions, ranging from providing generous liquidity support to bank recapitalizations and asset purchases. Banking systems are being restored to health through a combination of bank recapitalizations, mergers and acquisitions, asset purchases, and guarantees. As in earlier episodes, government interventions have not been limited to the financial sector, but include a wide range of measures aimed at boosting consumption and investment, including measures to support the housing market and lending to the corporate sector. The sheer scale of intervention, including the (partial) nationalization of financial institutions, may be unprecedented, with the possible exceptions of the Japanese crisis of the 1990s and the U.S. Great Depression, though it is too early to draw up a complete comparison.
How can policymakers respond to financial stress, including the current global financial turmoil, in a way that ensures that the financial system is restored to health, while containing the fallout on the economy, and avoiding the creation of long-term moral hazard problems? Well-timed interventions aimed at financial institutions and borrowers can help restore balance sheets and incentives, mitigate the negative shock of a financial system under stress on the economy, and help to restart productive investment. But in applying these interventions, governments frequently face trade-offs. The key challenge is to restore financial intermediation while keeping assistance costs down, avoiding misallocations of capital, and maintaining proper incentives going forward.
This chapter presents a new database on the timing and resolution of banking crises. It demonstrates that governments have employed a broad range of policies to deal with financial crises. They typically start with regulatory forbearance and generous liquidity support to banks. Forbearance, however, does not really solve the underlying problems of too little bank capital, and therefore, a key component of almost every systemic banking crisis is a bank restructuring plan. All too often, government intervention in financial institutions is delayed because regulatory capital forbearance and liquidity support are used for too long to deal with insolvent financial institutions in the hope that they will recover, ultimately increasing the stress on the financial system and the real economy.
Central to identifying sound policy approaches to financial crises is the recognition that policy responses that reallocate wealth toward banks and debtors and away from taxpayers face a key trade-off. Such reallocations of wealth can help to restart productive investment, but they have large costs. These costs include taxpayers’ wealth that is spent on financial assistance and indirect costs from misallocations of capital and distortions to incentives that may result from encouraging banks and firms to abuse government protections. Those distortions may worsen capital allocation and risk management after the resolution of the crisis. For example, government recapitalizations of insolvent banks may lead shareholders of the bank to “gamble for resurrection” at the expense of the bank’s other stakeholders. More generally, government bailouts generate moral hazard as they increase the perception that bailouts will occur next time around. Although policymakers should take these trade-offs into account when crafting their bailout plans, they do not have the luxury of waiting for the perfect solution. The economic cost of no action can be enormous, lending support to large-scale fiscal outlays to encourage investment and restore financial markets to health.
The data show that fiscal costs associated with banking crises can be substantial and that output losses are large. Although countries have adopted a variety of crisis management strategies, we observe that emergency liquidity support and blanket guarantees have frequently been used to contain crises and restore confidence, though not always with success. Our review of past experiences of financial system distress and the current episode of financial turmoil suggests that the effectiveness and cost of policy responses depend on four key dimensions.
First, having a sound framework for assuring financial sector stability helps prevent and contain financial stress. Key elements of this framework include precrisis sanctions on undercapitalized financial institutions that pose systemic risks; legal and institutional mechanisms to deal quickly with weak financial institutions, such as bank-specific bankruptcy regimes; tools and processes for closing and rapidly reopening a bank; and an effective deposit insurance scheme.
Second, a swift response may help minimize the impact on the real economy. All too often, regulatory capital forbearance and liquidity support have been used to help insolvent financial institutions recover, only to realize that the delay in intervention increases the stress on the financial system and the real economy. To avoid this, policymakers should force recognition of losses at an early stage and take steps to ensure that financial institutions are adequately capitalized.
Third, the adverse impact of financial system distress on the real economy may have to be contained through measures that directly support firms and households’ for example, through targeted debt relief programs to distressed borrowers and corporate restructuring programs.
Fourth, steps should be taken to limit costs and moral hazard implications of these policy responses. It is key that shareholders first absorb the losses by writing down their equity capital. In case of large losses, creditors should contribute too by reducing and restructuring their claims. Borrowers will also have to absorb some of the costs, especially if they have engaged in reckless borrowing. Mechanisms that link government support (such as preferred stock purchases) to privately raised capital could also help identify those banks that are truly worth saving and limit distortions for the future arising from moral hazard.
Policy responses to financial crises normally depend on the nature of the crises, and some unsettled issues remain. First, fiscal tightening may be needed when unsustainable fiscal policies are the trigger of the crises, though crises are typically attacked with expansionary fiscal policies. Second, tight monetary policy could help contain financial market pressures. However, in crises characterized by liquidity and solvency problems, the central bank should stand ready to provide liquidity support to illiquid banks. In the event of systemic bank runs, liquidity support may need to be complemented with depositor protection (including through a blanket government guarantee) to restore depositor confidence, although such accommodative policies tend to be very costly and need not necessarily speed up economic recovery.
Our preliminary analysis based on partial correlations indicates that some resolution measures are more effective than others in restoring the banking system to health and containing the fallout on the real economy. Above all, speed is of the essence. As soon as a large part of the financial system is deemed insolvent and has reached systemic crisis proportions, bank losses should be recognized, the scale of the problem should be established, and steps should be taken to ensure that financial institutions are adequately capitalized. A successful bank recapitalization program tends to be selective in its financial assistance to banks, specifies clear quantifiable rules that limit access to preferred stock assistance, and enacts capital regulation that establishes meaningful standards for risk-based capital. Government-owned AMCs appear largely ineffective in resolving distressed assets, largely because of political and legal constraints. Next, the adverse impact of the stress on the real economy needs to be contained. To relieve indebted corporates and households from financial stress and restore their balance sheets to health, intervention in the form of targeted debt relief programs to distressed borrowers and corporate restructuring programs appear most successful. Such programs will typically require public funds, and tend to be most successful when they are well-targeted with adequate safeguards attached.
Future research based on this dataset needs to investigate in more detail how policymakers should respond to financial system stress in a way that ensures that the financial system is restored to health while containing the fallout on the economy. Such research should establish to what extent fiscal costs incurred by accommodative policy measures (such as substantial liquidity support, explicit government guarantees, and forbearance from prudential regulations) help to reduce output losses and to accelerate the speed of economic recovery, and identify crisis resolution policies that mitigate moral hazard problems going forward.
Future research should also review and draw lessons from policy responses to the current global financial turmoil. Our preliminary assessment is that policy responses to today’s crisis have much in common with those employed in previous crisis episodes, though it is too early to draw any conclusions on the effectiveness of these responses.
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This chapter is a slightly revised version of IMF Working Paper 08/224 (2008).
The authors thank Olivier Blanchard, Eduardo Borensztein, Martin Čihák, Stijn Claessens, Luis Cortavarria-Checkley, Giovanni Dell’Ariccia, David Hoelscher, Simon Johnson, Ashoka Mody, Jonathan Ostry, and Bob Traa for comments and discussions, and Ming Ai, Chuling Chen, and Mattia Landoni for excellent research assistance.
We define bank runs as a monthly percentage decline in deposits in excess of 5 percent. We add up demand deposits (IFS line 24) and time, savings, and foreign currency deposits (IFS line 25) for total deposits in national currencies (except for the United Kingdom, Sweden, and Vietnam, where we use IFS 25L for total deposits). We define extensive liquidity support as claims from monetary authorities on deposit money banks (IFS line 12E) to total deposits of at least 5 percent and at least double the ratio compared to the previous year.
In some cases, nonperforming loans are built up slowly over time and financial sector problems arise gradually rather than suddenly. Japan in the 1990s is a case in point. Although nonperforming loans had been increasing since the early 1990s, they reached crisis proportions only in 1997. Also, initial shocks to the financial sector are often followed by additional shocks, further aggravating the crisis. In such cases, these additional shocks can sometimes be considered as being part of the same crisis. Latvia is a case in point. Latvia experienced a systemic banking crisis in 1995, which was followed by another stress episode in 1998 related to the Russian financial crisis.
Note that estimates of output losses are highly dependent on the method chosen and the time period considered. In particular, our measure tends to overstate output losses when there has been a growth boom before the banking crisis. Also, if the banking crisis reflects unsustainable economic developments, output losses need not be attributed to the banking crisis per se.
Whenever general government data were not available, central government data were used.
Regulatory forbearance often continues into the resolution phase, though it is generally viewed as a crisis containment policy.
As a result, we do not have output loss estimates for many transition economies that experienced crises in the early 1990s.
The electronic version of the banking crisis database is available at http://www.luclaeven.com/Data.htm and http://www.imf.org/external/pubs/ft/wp/2008/data/wp07124.zip.
The freeze converted time deposits—except for the first US$500 and special accounts such as charitable foundations and funds that could be proven were meant to be used in tax or salary payments—into dollar-denominated bonds at the exchange rate prevailing on December 28, 1989. The measure was announced on January 1, 1990, after the exchange rate dropped from 1800 australs per dollar to over 3000 between December 28 and 31, 1989.
In 2002, the Argentinean government introduced an asymmetric pesofication of assets and liabilities of banks. However, the exchange rate used for deposits—ARG$1.4 per US$1—was substantially below market rates. Depositors initiated legal processes and some obtained additional compensation through court injunctions.
This is not to say that other aspects of Japan’s bank restructuring program were not successful. The example merely illustrates that one aspect of this program was less successful. A subsequent preferred stock program in 1999, that was much larger in size, was successful in recapitalizing banks.
Bank recapitalization approaches are often influenced by a country’s insolvency regime for financial institutions, which in many countries today still does not allow for speedy resolution, but rather leads to a prolongation of problems. Another lesson for successful bank recapitalization is that bank capital regulations and rules need to be enforced rigorously, including if necessary by limitations on dividends.
Measured as the percent change in the Case-Shiller 20-city composite index between January 2000 and its peak in July 2006.
Mexico is one example in which an implicit blanket guarantee was already in place before the crisis, namely since end-1993. However, the guarantee was reaffirmed in end-1994, during the burst of the Tequila crisis.
The case is to some extent similar to the failures of Sanyo Securities and Yamaichi Securities in the Japanese crises (see Nakaso,2001). Both did not fall under the scope of the deposit insurance system but were supervised by the Ministry of Finance. However, the collapse of Sanyo caused the first default ever in the Japanese interbank market, resulting in a sharp deterioration in market sentiment. Yamaichi, on the other hand, was unwound gradually.