Financial Risks, Stability, and Globalization


Omotunde Johnson
Published Date:
April 2002
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I have learned to see the world with new eyes. Insolvencies are dynamic occurrences. The concept that current taxpayers can shift the costs of resolving insolvencies to future taxpayers has been presented.

But is this the real world? Can this concept be applied to business or banking? Do we have the option to use taxpayers, money now or postpone the default to future taxpayers? Isn’t the question of using taxpayers’ money one of last resort? Are major players thinking only about costs and benefits when they are deciding to take over an insolvent corporation or recapitalize it?

As a computer scientist, I am familiar with mathematical concepts. But I doubt that you can explain the real world with formulas. I was asked to comment on this paper as a bank supervisor, not as a member of the economic division. Of course, I am employed by a central bank but my work as a bank supervisor begins at an earlier stage. I would like to point out the preventative measures that can be taken and are taken in my own jurisdiction to prevent the case of a “too big to fail” or “too big to rescue.”

Some jurisdictions have taken alternative actions to prevent systemic risk from emerging due to a “too-big-to-fail” scenario. In Australia and Canada, for example, local decision makers have taken concrete actions to prevent a “too-big-to-fail” situation from arising by not allowing mergers among some of their largest banks when their analysis has indicated that the size of the proposed newly created banks would risk causing susceptibility to systemic turbulence within their markets. Another viewpoint in dealing with mergers is to sometimes force banks to merge but, then again, as Professor Kane notes, there are costs and benefits that fully informed creditors would consider in deciding whether to recapitalize or liquidate an insolvent corporation.

One of the pillars of our market economy is the fact that entrepreneurs are personally responsible for their business activities. Generally, this principle also applies to banks. However, banks, as financial intermediaries and providers of financial services, play a special role in an economy. A crisis of one major bank, let alone the whole banking system, would have a serious impact on economic activity, and this also applies to the real sector. But, then again, the special role of banks must not be interpreted to mean that bank boards can count on government support in emergencies. If they could, the risk of a precarious situation in the banking sector would increase even more. This would create a moral hazard, which would result in banks taking excessive risks in order to obtain higher returns, in the belief that they could rely on government support in the event of a failure.

Banking supervisors must try to prevent both scenarios from happening—serious external effects of bank insolvencies and moral hazard. The crisis in Southeast Asia has shown that government guarantees and expectations of international assistance—which were met in the end—can lead to serious misalignments in a crisis situation. (To quote the former president of the Bundesbank, Hans Tietmeyer: “Do not display too much money in the shop windows.”).

Avoiding crises must be the prime concern. Efficient banking supervision can make an essential contribution to this objective. Supervisors should be guided by the principle: “As much entrepreneurial leeway as possible, yet as much state supervision as required.” There have been some recent proposals by the Group of Thirty (G-30) to confer more supervisory tasks to the private sector. In principle, increased mutual monitoring among the banks, and hence a strengthening of market discipline, is a welcome idea. Nevertheless, conceptual and practical problems should not be overlooked. For instance, more self-regulation by the market participants implies a transfer of legislative powers, but it does not mean that responsibility for resolving systemic crises would also shift to the private sector.

State supervision will remain necessary as long as systemic risks exist that cannot be limited sufficiently through preventive measures or eliminated within the context of market control. Besides, the self-regulation model, among others, assumes that the financial sector is highly transparent for the market—for example, regarding in-house procedures, which is hardly feasible.

Allow me to briefly outline the German prudential approach.

  • Banking supervision is guided by the principle that a bank’s management is responsible for its business decisions. Therefore, banking supervision in Germany does not actively intervene in banking activities—that is, by making specific recommendations.
  • From the central bank’s perspective, I would like to stress that it cannot be the task of a central bank to bail out insolvent credit institutions. The Ministry of Finance would be responsible for that, if tax revenue was required for assistance measures. But even cases where financially sound institutions merely have liquidity problems should, if possible, be resolved with the help of private or semi-private lenders before reaching the gates of the central bank. The Liquidity Consortium Bank1 in Germany is such a “lender of penultimate resort.” In addition to the three categories of credit institutions,2 the Bundesbank also has a stake in this Consortium Bank and it provides refinancing against collateral. Apart from that, the Bundesbank has not committed itself in a binding manner to take action in the event of a crisis. It also would be desirable if a liquidity consortium bank or comparable institutions were established in other European countries.
  • If it were not possible for the creditworthiness of an institution to be restored either by other institutions or with the help of a deposit guarantee scheme, having that institution exit the market would, in general, be a feasible consequence. However, if such a step posed a serious threat to the stability of the banking system—that is, if the institution in question were “too big to fail”—a joint solution would have to be found by all the private market players and public bodies concerned. Already, the number of institutions we must consider to be too big to fail has risen in the recent past and further mergers will cause this number to keep rising. Mergers of global players do not only raise new questions in banking supervision. They also pose the risk that size leads to moral hazard effects. For precisely this reason, each crisis must be assessed individually. The key principle is that the government’s response must not be predictable and private market players should be involved in potential rescue operations to the greatest possible extent.
  • The recent financial crises have been drawing attention increasingly to international crisis management. In my opinion, the aforementioned principles should be applied in this context, too: there should be no explicit or implicit government guarantees regarding the solvency of the respective banking system; temporary liquidity crises should be resolved, wherever possible, before government intervention becomes necessary; and the private sector should be comprehensively involved both in crisis management and in loss sharing.
  • International support measures must always remain an exception and never become the rule. Under no circumstances should private investors be able to rely on public bodies to assume their losses in the end. Instead, I believe it would be desirable to create an international liquidity safeguarding fund made up of the major global players, which also would have the most to gain from a largely deregulated and sound financial system. This will not be an easy undertaking, since there seems to be few incentives, other than overall industry reputation, for a bank to assume other institutions’ risks. Nevertheless, this road should be taken in order to strengthen market discipline. I believe that membership in a club comprising the major global players would be a special quality that could actually become attractive for those institutions. Besides, it seems quite conceivable that banking supervision might be willing to grant those institutions more self-regulatory powers.

The case of the Long-Term Capital Management hedge fund proves that the private sector can find solutions without having recourse to public funds. At the time of LTCM’s problems, the Federal Reserve Bank of New York was only acting as an intermediary to bring national and international financial institutions together, which then provided the necessary funds.

The same principle applies both nationally and internationally: moral hazard problems can only be prevented by emphasizing and requiring that responsibility be taken by financial market participants, and by limiting the intervention of public bodies. Avoiding moral hazard will also increase the stability of the system and improve crisis management.


Privately owned bank for crisis management. The central bank is also one of the shareholders.


Credit banks, saving banks, and credit and loan associations.

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