12 Fiscal Support in Financial Sector Restructuring: Analytical Issues
- Omotunde Johnson
- Published Date:
- April 2002
Financial sector distress, or the threat thereof, may warrant intervention by the public sector. Because of the public good character of financial sector soundness and confidence in the financial system, markets may fail to respond appropriately to financial sector distress and associated systemic consequences, which may entail high social costs. Specifically, public intervention may be justified when the functioning of the payment system and financial intermediation are threatened, including when “bank runs” spread outside insolvent banks and deprive even solvent banks of liquidity or when credit extension dries up because of bank failures.
Public intervention can come in various forms. A general distinction can be made between preventive measures—such as prudential regulations, bank supervision, or deposit guarantees—and reactive measures—such as short-term liquidity support or long-term systemic restructuring processes that preempt or follow the outbreak of a banking or, more broadly, a financial sector crisis. The type and magnitude of public intervention determines which agencies participate in the process and how the financial and other burdens of the intervention are shared among them.
This paper focuses on fiscal policy in connection with public support of the financial (banking) sector. Following an overview of relevant analytical issues—ranging from the role and design to the consequences of fiscal support in financial sector restructuring—two case studies are presented. A final section summarizes and draws some conclusions.
Role of Fiscal Support in Systemic Restructuring
Systemic bank restructuring is typically based on a comprehensive multiyear strategy that might include the following elements: (1) diagnosis; (2) triage (i.e., the division of financial institutions between those that need no help, those that are worth helping, and those that are beyond help);1 (3) exit of institutions beyond help; (4) recapitalization (financial restructuring) strategy for institutions that are worth helping; (5) operational restructuring strategy; (6) management and recovery of nonperforming assets, supported by loan workouts; (7) equitable cost-sharing arrangements and containment of public sector costs; and (8) strengthening of prudential supervision.2
This specification encompasses several distinct aspects of the restructuring strategy, and it can be used to delineate th\e role of fiscal support. Elements (1) and (2) are analytical in character, and their implementation requires chiefly the employment of appropriate technical expertise. Elements (3), (5), (6), and (8) are, in turn, of an organizational nature, and their implementation requires the identification or establishment of appropriate agencies, possibly involving fiscal authorities, as well as the agreement on the division of responsibilities among them.3 Finally, parts of (4), (7), and also (6) refer to the financial aspect of systemic restructuring; the role of fiscal policy relates chiefly to this aspect.
Fiscal policy would be expected to take responsibility for operations that serve a fiscal aim, such as provision of public goods, elimination of externalities, and transfer of income. Operations such as the provision of short-term liquidity support to a viable bank would thus be left to markets or the lender of last resort. However, liquidity support to an insolvent bank is a characteristically fiscal operation as neither the markets nor the lender of last resort would be expected to engage in such support.4
The delineation of responsibilities among different authorities may be difficult in a financial crisis, where prompt action by the public sector is beneficial and often critical. While the lender of last resort would normally extend liquidity support to viable banks only, the urgency of the support may prevent the conduct of proper solvency analyses of banks. In such cases, the “best practice” would require that any lender of last resort support to banks that later turned out to be insolvent be converted into fiscal support.5 Although such early support can create a fiscal liability that is not incurred by the fiscal authority, it may nevertheless contribute to reducing the total cost by limiting the depth of the crisis.
Design of Fiscal Support
Objectives of Fiscal Support
Drawing on practical experiences with systemic restructuring, the following can be listed among the intermediate objectives, or design criteria, of fiscal support: (1) cost efficiency, (2) equitable loss sharing, (3) prevention of recurrence, (4) facilitation of a sound macroeconomic environment, and (5) transparency.6 These issues are reviewed briefly below, with a particular focus on the prevention of moral hazard problems, which encompass objectives (2) and (3). The macroeconomic impact of fiscal support will be dealt with separately in the next subsection.
Cost efficiency relates to the restructuring method chosen and the burden-sharing arrangements employed. The liquidation of an unviable bank, privatization of a troubled state-owned bank, and the facilitation of mergers and acquisitions among banks all generally result in lower direct fiscal costs than the recapitalization of a bank;7 therefore, cost efficiency considerations suggest that the latter be used selectively and subject to clear financial criteria. In the case of liquidations, cost efficiency can be enhanced by vigorous recovery of assets which, along with the burden-sharing arrangements, is discussed in connection with moral hazard problems below.
The concept of costs covers, broadly speaking, all statutory, discretionary, and contingent costs to the public sector arising from the restructuring process. These costs come in the form of recapitalization of troubled but potentially viable institutions, deposit guarantees, compensation for deposit absorption, and outlays related to the restructuring of the ownership of financial institutions.8 Expected recapitalization gives rise to contingent costs, which may or may not become actual liabilities. Deposit guarantees may give rise to both contingent and actual costs, and these costs may be covered in part or entirely from a deposit insurance fund, should one exist. In the absence of such a fund, or to the extent that the assets of the fund fall short of its liabilities, fiscal costs may arise. Furthermore, surviving banks that agree to take on deposits of failed banks typically require compensation for the absorption of new liabilities. Finally, public funds may be used to facilitate the rationalization of ownership structures through acquisitions of banks by other banks or through mergers among banks.
Transparency promotes good governance and facilitates macroeconomic management following a systemic restructuring operation. Public knowledge about the purpose, design, and implementation of a systemic restructuring operation is a prerequisite for public scrutiny and acceptance of the operation. Transparent recording of fiscal support promotes fiscal discipline and accountability, which are necessary because of the often large amounts of public money used.9 Moreover, a well informed private sector is more likely to respond rationally and predictably to the policy interventions that are made.
Avoidance of Moral Hazard
Because of the potentially significant and long-lasting negative effects of a financial sector crisis—possibly involving the contagion of the crisis to healthy institutions, credit crunch, and the collapse of economic activity—the public sector might justifiably be expected to intervene in the face of a crisis. This expectation is equivalent to a perception of the existence of a public insurance against financial crisis.
This implicit insurance against financial crisis is, like any insurance contract, susceptible to the problem of moral hazard. By creating the expectation of public support in case of illiquidity or even insolvency, it alters the incentive structure that determines the behavior of financial institutions. In normal times, the expectation of public support in a crisis situation might encourage excessive risk taking to enhance income. In anticipation of a crisis, the inclusion of public support in financial institutions’ profit maximization process may in fact accelerate the outbreak of a crisis. Finally, in times of crisis, financial institutions may attempt to maximize the receipt of public sector financial support rather than focus on comprehensive and sustainable restructuring of their operations.
Although moral hazard cannot be completely avoided, a systemic restructuring operation can be designed so as to reduce the problem. In this regard, key measures include equitable distribution of costs as well as prevention of the recurrence of similar crises.
Equitable Distribution of Costs
The stakeholders of a bank among whom the financial costs are to be shared include the bank’s owners, depositors and other creditors, borrowers and other debtors, and the public sector.10 The extent to which a particular stakeholder will suffer depends mainly, but not exclusively, on the status of the stakeholder. Nevertheless, necessary conditions for equitability in the distribution of costs include (1) those responsible for the distress pay up before any public money is contributed, and (2) no stakeholder benefits from the bank’s distress.
The optimal burden sharing among the stakeholders depends on whether the bank is deemed unviable and unworthy of fiscal support or viable and worthy of fiscal support. If a bank is liquidated, moral hazard problems arise unless its owners lose their entire stake. If, on the other hand, a bank is rehabilitated, the owners may be able to retain part of their stake if the net worth of the bank remains positive. However, if the net worth of a bank becomes zero or negative prior to rehabilitation, owners would be expected to participate in the cost-sharing with their entire stake.
The treatment of deposits outside statutory deposit insurance schemes can be a difficult issue from the moral hazard viewpoint. While it can be argued that such deposits resemble equity to the extent that depositors have accounted for the relevant risks, including the risk of insolvency of the bank, the protection of deposits reduces the risk for bank runs and is, moreover, politically attractive. Therefore, the treatment of unguaranteed deposits depends on the case-specific trade-off between equitable burden sharing and the risk of contagion.
Creditors other than depositors are typically somewhere between owners and depositors in the burden-sharing scheme, depending on the type of the claim that these creditors hold vis-à-vis the bank.11 The more their claim resembles an equity stake, the larger the share of their stake that would be expected to go against restructuring costs. Hence, holders of subordinated debt are like owners because their stake is subject to similar risks as an equity stake, while liabilities to the central bank resemble deposits.
Nonperforming loans (bad borrowers) are generally the main reason for a bank’s distress. To maximize the recovery of nonperforming loans and other assets, many countries have incorporated a separate asset management company in their restructuring strategies.12 Although desirable from the moral hazard viewpoint, the establishment of an asset management company may entail significant costs as the administrative, human capital, and legal requirements for efficient asset recovery are large while the payoff is uncertain.
To the extent that the costs are not covered by the bank’s owners, creditors, and debtors, the public sector has to contribute financial resources. As the use of public funds in the restructuring process is unavoidably associated with moral hazard, it is critical that the risk for similar crises in the future be minimized.
Prevention of Recurrence
As preventive measures aim to keep the financial sector sound and stable, many of them fall within the competency of the monetary rather than fiscal authorities. Examples include the design and implementation of prudential regulations and the supervision of banks and other financial institutions. Nevertheless, the appropriate design of the fiscal aspects of a systemic restructuring operation can also contribute to the prevention of similar crises in the future.
Fiscal support can include several preventive features.13 First, the support could be accompanied by an announcement that the current operation is one-off and will not reoccur. It is, however, questionable whether such an announcement can be credible. Second, by serving to limit the public intervention, the strength and effectiveness of the restructuring operation itself can dampen the expectations of future support. Most important, operational and structural measures outside the narrowly defined fiscal package can be aimed to strengthen private ownership, corporate governance and management, as well as competition in both real and financial sectors, and thereby contribute to the prevention of future crises. Indeed, as a banking crisis most often originates from nonperforming assets, the soundness of the real sector is the best guarantee against bank distress.
The role of deposit guarantees deserves a special mention.14 While potentially effective in preventing liquidity problems due to bank runs, deposit guarantees are a possible source of moral hazard problems by reducing depositors’ monitoring of banks and inducing banks to offer above-market interest on deposits in the face of a liquidity crisis, and impose a large contingent liability on the budget. To limit the moral hazard problem and fiscal impact while preserving some of their stabilizing effect, deposit guarantees are customarily capped. Only with a crisis imminent and a high probability of large-scale bank runs have blanket guarantees in some cases been extended (e.g., Korea and Thailand in 1997 and Indonesia in 1998), often covering all creditors. While arguably more powerful than capped guarantees in preventing bank runs, blanket guarantees pose an even greater fiscal threat by increasing the size of the contingent liability at a time when the probability of a crisis is already high. Moreover, the extension of a blanket guarantee makes the equitable sharing of costs more difficult by leaving all (or most) creditors outside the cost sharing process.
Instruments for Fiscal Support
A broad distinction can be made between nonmarket instruments and market-based instruments (Figure 12.1). Nonmarket instruments include interest and exchange controls, directed lending to priority sectors, limits on competition, and regulation of banking activities. While many nonmarket measures are monetary in character, some of them, notably directed lending, may have quasi-fiscal features. Recent recapitalization operations have relied more on market-based instruments than nonmarket instruments.
Figure 12.1.Taxonomy of Financial Sector Restructuring Instruments
Market-based instruments can be further classified into financial, operational, and structural instruments.15 Financial instruments are used to extending financial support to banks in order to improve their balance sheets directly or indirectly through the income statement. Operational instruments, in turn, aim to support a bank more indirectly by addressing operational inefficiencies and deficiencies in management and internal governance. Finally, structural instruments are used to change the market structure so as to establish or restore competition.
Fiscal instruments are generally financial rather than operational or structural in character. The various fiscal instruments that can be used to strengthen a bank’s capital base, asset structure, liability structure, and income position are reviewed below.
Capital base. Both cash and government bonds can be used to strengthen either Tier I capital (common or preferred stocks) or Tier II capital (subordinated debt). The strengthening of Tier I capital has some distinct advantages as it improves capital ratios (both by increasing equity and decreasing the risk-weighted value of assets), does not involve immediate servicing costs, can facilitate the strengthening of Tier II capital from private sources, and creates scope for credit extension, thus reducing the risk of a credit crunch.16 Whether the government should obtain common or preferred stocks depends on its desire to take over the control of the bank.
In addition to equity injections by cash or bonds, government guarantees on a bank’s assets and income increase measured capital. They are, however, a less transparent way of extending fiscal support than equity injections. Asset guarantees increase their market value, while income guarantees enhance retained earnings. Although guarantees carry no up-front cost to the government, they create a contingent fiscal liability; therefore, a fee for government guarantees is often imposed on the receiving bank.
Asset rehabilitation. To improve the asset side of a bank’s balance sheet, the government can exchange the bank’s nonperforming assets against cash or government bonds or, more indirectly, assume debts owed to the bank or grant the bank’s debtors loans or transfers that allow them to service their debts. Nonperforming assets purchased by the government are often transferred to an asset management company whose task it is to recover them to the maximum possible extent.17
The bank’s net worth is unaffected by assets swaps at market value. In contrast, asset swaps at above-market value (e.g., at face value) as well as unrequited cash or bond issues both increase the bank’s net worth. However, asset swaps at above-market value lack transparency and unrequited transfers can be questioned on cost-efficiency grounds.
Liability reduction. The government can assume part of a bank’s liabilities or convert public enterprises’ deposits into equity, thus indirectly recapitalizing the bank. Liability assumption is typically accompanied by the issuance of cash or government securities to the bank’s creditors or to third parties (e.g., other banks) that absorb these liabilities. It has been argued that liability reduction may actually be more cost effective than asset rehabilitation to the extent that it reduces the bank’s size and downsizing improves its viability.18
Income enhancement. In principle, the income and liquidity position of a bank could be enhanced, for example, by tax breaks (both explicit and implicit—e.g., higher remuneration of required reserves), subsidized lending, or placement of government deposits. These measures are, however, nontransparent, tilt the playing field, do not address the fundamental stock (balance sheet) problem, and complicate macroeconomic management. On a positive note, an appropriately designed system of loan-loss provisioning may improve banks’ income position by reducing their income tax burden.19
Characteristics and Impact
The design of the recapitalization operation has a potentially large impact on the incentive structure in the banking sector. Distortions can arise, most importantly, as a result of unequal treatment of banks and certain characteristics of fiscal instruments. As to the equality of treatment among banks, any recapitalization operation is potentially unfair as the recapitalization needs of banks vary, starting from zero. To tilt the playing field as little as possible, all banks in need of support would need to be recapitalized to the same level (in terms of capital-to-asset ratio), not exceeding the average level among banks that do not need support.20 Furthermore, the government’s asset swaps give rise to inequalities if they lower the share of nonperforming assets in supported banks below the share prevailing in unsupported banks.21
Distortions can also be associated with certain characteristics of support instruments, notably the negotiability of recapitalization bonds. While the negotiability of recapitalization bonds is a potentially beneficial feature in encouraging market development for government securities and facilitating the liquidity management of a supported bank, it creates a temptation for the management of the bank to “gamble for recovery” by liquidating the bond and investing the proceeds in a risky object.22 The same argument applies for recapitalization by cash injections as well as for asset swaps. Recapitalization by nonnegotiable bonds and asset swaps for nonnegotiable securities may therefore be preferable at the initial stages of the restructuring process when the operational restructuring of banks has not yet proceeded so far as to establish a sound and responsible management for the bank.
The design of fiscal support instruments, particularly debt instruments, pertains integrally to the government’s overall debt strategy. Specifically, the maturity and duration23 of bonds issued generate a certain debt retirement profile, which may impact both cost efficiency and allocative efficiency by, for example, requiring abrupt fiscal expenditure cuts to make room for lumpy amortization payments.
Consequences of Fiscal Support
Macroeconomic Impact of Fiscal Support
In a standard static open economy macroeconomic model, a fiscal expansion (i.e., an injection of liquid resources into the economy) will increase aggregate demand under perfect capital mobility if the exchange rate is fixed, and under imperfect capital mobility if monetary policy is not used to neutralize the expansionary fiscal intervention. Unless the fiscal expansion is offset by either its contractionary interest rate and exchange rate impact or active monetary policy measures, the magnitude of the fiscal impact is larger the more mobile capital is. In contrast to cash injections, the timing and magnitude of the macroeconomic impact of bond injections depend on the characteristics of bonds—for example, maturity, negotiability, and pricing in connection with asset swaps.
The analysis of the aggregate demand impact of fiscal support to the banking sector can be refined to include wealth effects. If the fiscal support is nonstatutory and unanticipated, the rescue and recapitalization of a bank will imply a positive wealth shock to the owners and creditors of the bank and, to the extent that the wealth gain is spent rather than saved, boost aggregate demand. Also, should banking sector distress and restructuring lead to less rather than more vigorous attempts to collect performing or nonperforming receivables, debtors will experience a positive wealth shock. However, to the extent that the fiscal support is statutory (e.g., explicit deposit insurance) or otherwise anticipated, there is no wealth and associated aggregate demand effect.24
The aggregate demand impact of fiscal support will also reflect banks’ pricing behavior and expectational effects. Whether interest spreads rise or fall following a restructuring operation depends on changes to banks’ pricing behavior. This behavior depends on the intensity of competition in the financial markets as well as on the efficiency of banks’ operations. Interest spreads are therefore likely to fall following competition and efficiency-enhancing systemic and operational restructuring, while rising spreads are likely to result from increased concentration and absence of operational restructuring.25
Expectational effects, including the possibility of moral hazard problems, may have macroeconomic consequences. Inequitable and nontransparent cost-sharing arrangements, absence of operational restructuring in the banking sector, and lack of structural measures to strengthen the real sector of the economy all contribute to the emergence of expectations of protracted or recurring public interventions in the financial sector.
Fiscal Vulnerability and Sustainability
Fiscal vulnerability “reflects a situation where a government is exposed to the possibility of failure to achieve its aggregate fiscal policy (or macro-fiscal) objectives.”26 Four sources of fiscal vulnerability can be distinguished—namely, the weakness and/or incorrect specification of the initial fiscal position; sensitivity of short-term fiscal outcomes to risks; medium- and long-term fiscal sustainability problems; and structural or institutional fiscal weaknesses.
Specific vulnerabilities related to potential financial sector distress include the presence of contingent and implicit fiscal liabilities as well as quasi-fiscal activities through the financial sector. Contingent fiscal liabilities include explicit statutory government guarantees on, for example, banks’ assets and liabilities, notably statutory deposit insurance schemes. Implicit liabilities, while not statutory, are outlays that the government is expected to make to prevent bank runs, contagion, and credit crunch. Such outlays consist of various types of restructuring costs, discussed above, that are expected to materialize in case of a crisis. Finally, quasi-fiscal operations, including ongoing central bank support of financial institutions that goes beyond temporary bridge financing for liquidity purposes, weaken the fiscal position and restrict the potential ability of the budget to extend stability-preserving support in case of a crisis.
A financial sector restructuring operation encompasses significant fiscal vulnerabilities from short-, medium-, and long-term perspectives.27 In addition to the direct crowding-out effect of restructuring outlays on other fiscal expenditures, uncertainties related to the character, magnitude, timing, and impact of fiscal support complicate fiscal management and the pursuit of fiscal objectives other than those related to financial sector support. While the exact magnitude of fiscal support may remain uncertain, it might be known to be large enough to raise questions as to both macroeconomic stability and medium-term debt sustainability.
From a medium- and long-term perspective, the sustainability of the public debt position constitutes the main source of fiscal vulnerability. Restructuring outlays increase explicit government indebtedness, and whether the related future debt servicing costs are manageable or not determines the sustainability of the post-support fiscal position. If the presupport fiscal situation is only marginally sustainable, increased indebtedness as a result of the support implies the need to increase fiscal savings (reduce fiscal dissavings) compared to the presupport situation so as to restore sustainability.28
Structural weaknesses in fiscal and macroeconomic management can aggravate fiscal vulnerability in connection with financial sector support. Weak institutional capacity to participate in the design and implementation of a restructuring operation complicate the achievement of cost efficiency and transparency as well as the avoidance of moral hazard problems. Moreover, the failure to meet the broader stability and efficiency objectives due to, for example, insufficient coordination of macroeconomic policies following a financial sector crisis will have fiscal repercussions and thereby further increase vulnerability.
Case Studies: Korea and Thailand
Recent financial crisis resolution and financial sector restructuring operations in Korea and Thailand provide illuminating examples of the issues covered in the previous section.29 While the financial sector restructuring processes are still ongoing in both countries, it is already clear that the role, design, and impact of fiscal support differ significantly between them. This reflects, in part, a difference in restructuring strategies: while Thailand has opted for a more market-based and decentralized debt restructuring and bank recapitalization strategy,30 several banks have been nationalized and asset management has been centralized in Korea.
In addition to this difference in strategies, some key modalities of the role, design, and consequences of fiscal support differ between Korea and Thailand. Notably, while fiscal policy played the main financial role in both cases, the operative role of the fiscal authority was limited in Korea compared to Thailand. Also, because of the different restructuring strategies, the instrumentality of extending fiscal support differed between the countries. Finally, the magnitude and macro-fiscal impact of the operation has been larger in Thailand than in Korea, reflecting the relative depth of the crisis. The details of the various aspects of fiscal support are summarized in Table 12.1 and discussed in the remainder of this section.
|Role of fiscal support|
|Fiscal authority lead in crisis resolution||No||Yes1|
|Fiscal authority lead in restructuring||No||Yes1|
|Fiscal liquidity support extended||No||Yes2|
|Fiscal recapitalization support extended||Yes||Yes|
|Objectives (cost-efficiency; transparency; avoidance of moral hazard)|
|Insolvent banks bailed out||Yes||Yes|
|Liquidity support at below-market interest rate||Yes||Yes3|
|Fee charged for guarantees||No||Yes|
|Blanket guarantees time-bound||Yes||No|
|Use of public funds for purchases of bad assets||Yes||Yes|
|All fiscal costs reflected in fiscal accounts||No||No|
|Shareholders’ equity written down||Yes||Yes|
|Recapitalization also from private resources||Yes||Yes|
|Support tied to operational restructuring||Yes||Yes|
|Parallel corporate sector restructuring||Yes||Yes|
|Instruments for fiscal intervention|
|Fiscal liquidity support||No||Yes2|
|Tier I capital: common stock||Cash through KDIC; government guaranteed 5- to 7-year KDIC bonds (negotiable)||FIDF converted some LOLR (cash) support into equity|
|Tier I capital: preferred stock||Cash and 5- to 7-year KDIC bonds (negotiable)||10-year government bonds (negotiable)|
|Tier II capital||Government-owned stocks in public enterprises||10-year government bonds (nonnegotiable)|
|Other||Both asset and liability guarantees; asset purchases and rehabilitation (KAMCO); indirect asset support (subsidized lending to small and medium-sized enterprises); loan-loss provisions fully tax deductible.||Only liability guarantees; asset purchases and rehabilitation; income support; loan-loss provisions fully tax deductible.|
|Fiscal policy expansionary in first full fiscal year after crisis||Yes||Yes|
|Financial sector support (interest cost) main factor behind deficit increase||Yes||Yes|
|Financial sector support (capital cost) main factor behind public debt growth||Yes||Yes|
Jointly with BOT.
By fiscalizing part of the costs of FIDF operations.
Initially to 16 percent of finance companies.
Jointly with BOT.
By fiscalizing part of the costs of FIDF operations.
Initially to 16 percent of finance companies.
Role of Fiscal Support in Crisis Resolution and Restructuring
The financial crises of 1997-98 in Korea and Thailand were systemic in character and public sector intervention was therefore warranted. Although the rapid introduction of blanket guarantees in the second half of 1997 mitigated bank runs and the empirical evidence on the occurrence of a credit crunch is mixed,31 the banking sector was nevertheless under obvious systemic distress as its capital adequacy, measured as the ratio of capital to risk-weighted assets, fell in both countries effectively below the 8 percent recommended by the Basel Committee.
In Thailand, the role of the fiscal authority and fiscal policy was active in both crisis resolution and systemic restructuring of the financial sector. Following the floating of the Thai currency (baht) in early July 1997, the Ministry of Finance (MOF) shared the lead with the Bank of Thailand (BOT) in responding to the crisis. In August, they jointly announced a set of confidence strengthening measures, including a guarantee covering all depositors and nonsubordinated creditors of open banks, as well as the extension of both liquidity and solvency support through the Financial Institutions Development Fund (FIDF). A Financial Sector Restructuring Agency (FRA) was created, but its role was limited by emergency decrees issued in October to the liquidation of the 56 finance companies whose closure was announced by the MOF and FRA in December. The Thai Asset Management Corporation (TAMC) was established to deal with any residual FRA and FIDF assets,32 and financial institutions were encouraged to set up private asset management companies. In August 1998, a high-level Financial Restructuring Advisory Committee (FRAC) was set up to advise the leadership of the MOF and BOT on issues related to the restructuring process; however, even the FRAC fell short of becoming an independent and over-arching financial sector restructuring agency.
Fiscal policy carried the main responsibility for financing both the crisis resolution and restructuring operations, although there was no explicit delineation of financial responsibilities among the Thai authorities. The initial liquidity support that was extended through the FIDF was covered in part by government bonds issued to the FIDF and, at a later point, government bonds were issued to cover part of the losses of FIDF. In addition, the publicly funded part of the recapitalization of viable institutions, both directly and indirectly through the FIDF, was done through government bonds.
In contrast to Thailand, the operative role of the fiscal authority in the Korean financial crisis was limited as the crisis response and restructuring functions were assumed by other, partly newly created, authorities.33 Already during the buildup of external pressures following the Thai crisis, the Bank of Korea (BOK) took the lead in extending foreign exchange liquidity support to banks. The independence of the BOK was significantly strengthened in December 1997; the role of the Korean Asset Management Company (KAMCO) was expanded to allow it to purchase bad assets from all financial institutions, and all financial sector supervision activities were concentrated in a Financial Supervisory Service and its policy formulating wing, the Financial Supervisory Commission (FSC), which were explicitly separated from the government. Within the FSC, a Structural Reform Unit was established to oversee and coordinate the whole restructuring process. Furthermore, deposit insurance was concentrated in the newly established Korea Deposit Insurance Corporation (KDIC), the coverage of which was extended to most liabilities of commercial and merchant banks.34
While the BOK was responsible for extending liquidity support, the financial burden of the restructuring process was carried mainly, but not exclusively, by fiscal policy. The operations of KAMCO (i.e., purchases of bad assets) were financed by loans from the government, BOK, and Korean Development Bank as well as by bond issues guaranteed by the government. The operations of KDIC were financed by bond issues that were guaranteed by the government.35 Recapitalization injections consisted of bonds guaranteed by the government and, to a small extent, cash.
Design of Fiscal Intervention: Objectives
As to restructuring methods in Thailand, a majority of finance companies was liquidated, but all troubled commercial banks were initially recapitalized using ultimately fiscal (FIDF) resources. The August 1997 package of confidence enhancing measures included the suspension of the activities of 58 finance companies that were deemed potentially or actually insolvent and, based on due diligence and rehabilitation plans, 56 of them were closed by the FRA and MOF in December. Because of fear of deepening the crisis, no commercial bank was allowed to fail and the BOT led the FIDF-financed recapitalization operation, which resulted in the effective nationalization of six banks in early 1998.
In connection with the announcement of another restructuring package in August 1998, the use of public funds for recapitalization purposes was explicitly limited to viable finance companies and commercial banks. Nationalized finance companies and those commercial banks that were taken over by the FIDF were slated for later—but at the time unspecified—privatization, merger, or liquidation. Two banks were subsequently merged into existing state-owned banks, and a new bank was created by merging 1 intervened bank and 12 finance companies. The privatization of banks was initiated in 1999.
The establishment of private asset management companies to deal with commercial banks’ bad assets was encouraged, but the FRA disposed of the remaining assets of the closed finance companies. However, the TAMC had to step in as a bidder of last resort in the auctions of the lowest quality assets, which therefore remained on public sector books albeit not in the fiscal accounts.
From the fiscal, cost efficiency viewpoint, the Korean restructuring strategy had certain similarities with that of Thailand. As in Thailand, while allowing some financial institutions to fail (small merchant banks and investment trust companies in the case of Korea), the government took over and recapitalized (two) commercial banks that were deemed insolvent but systemically important; in addition, public funds were used in Korea to facilitate mergers of other banks into two banks with government majority ownership as well as to acquire minority stakes in several commercial banks. As in Thailand, when shifting the attention from crisis resolution to systemic restructuring efforts in the summer of 1998, the Korean government announced that the use of public funds would henceforth be limited to recapitalization operations and purchases of bad assets under specific conditions, aimed to ensure the financial viability of such operations.
Neither in Korea nor in Thailand have all inherently fiscal and quasi-fiscal operations been fully and transparently incorporated into publicized fiscal accounts.36 In Thailand, government bonds were issued to “fiscalize” part of the costs of FIDF operations and to provide direct recapitalization support. The interest payments (“carrying costs”) on these bonds have been incorporated into the government’s accounts, but the “capital costs” have not. Moreover, asset sales by the FRA and TAMC’s purchase of residual assets of the FRA, while inherently fiscal operations, will probably be reflected in fiscal accounts only at the time of TAMC’s liquidation.37 In Korea, government guarantees were given to bond issues by KAMCO and KDIC, and government bonds were issued to extend direct budgetary recapitalization support. The government bears the interest costs of all these bonds,38 and these interest payments are recorded as budgetary expenditure under net lending to KAMCO and KDIC. However, as in Thailand, the capital cost of fiscal support remains outside the budgetary accounts, as do asset recoveries by KAMCO.
Avoidance of Moral Hazard
Apart from measures that are primarily monetary in character (e.g., intensified bank supervision and caps on deposit rates offered), several aspects of fiscal support served the purpose of limiting moral hazard in both countries. First, equitable cost sharing was facilitated by a writing down of shareholders’ equity before using public funds to recapitalize financial institutions as well as by requiring that public recapitalization support was complemented by recapitalization from private sources. Second, although the introduction of blanket guarantees could be criticized as excluding troubled institutions’ creditors from burden sharing, the blanket guarantee was at least time bound until end-2000 in Korea; however, in Thailand it was open ended.39 Third, to prevent the recurrence of similar financial crises, public support was accompanied by both operational restructuring of financial institutions (including the removal of old management in insolvent banks) and structural reforms in the corporate sector.40
Design of Fiscal Intervention: Instruments
A broad distinction is made between instruments used to extend liquidity support, to extend direct recapitalization support, and those for other purposes.41
The modalities of liquidity support differed considerably between Korea and Thailand. First, while the extension of the bulk of the liquidity support in Korea was limited to the first couple of months of crisis (November and December 1997), the time span in Thailand was considerably longer, stretching from mid-1997 to mid-1998. Second, as mentioned above, liquidity support in Korea was extended by the monetary authorities alone, while in Thailand it took the form of loans from the FIDF, which were partly financed from fiscal resources. Third, the maturity of liquidity support was considerably longer in Thailand, with more than 90 percent still outstanding in mid-1999 (reflecting the conversion of initial liquidity support into equity); in contrast, in Korea 90 percent had been repaid by then. A common feature for both countries was the extension of liquidity support at a below-market interest rate.
Similarly, as detailed in Table 12.1, there were important differences in the instrumentality of (direct) fiscal recapitalization support. Both Tier I and Tier II capital support was provided from fiscal resources in both countries, but the instruments for extending the support differed. In Korea, both cash and government bonds were used to acquire both common and preferred stock, while in Thailand, cash was used to acquire common stock (reflecting the conversion of initial liquidity support into equity), and bonds were used to acquire preferred stock. In both countries, the bonds issued in support of Tier I capital were negotiable. As for Tier II support, the Korean government exchanged quoted stocks of public enterprises in its possession against Tier II capital, while in Thailand the government used non-tradable 10-year bonds.42
Finally, financial support other than liquidity and direct recapitalization support also took different forms:
Liability-side guarantees were time bound in Korea as explained above, but not so in Thailand. As liability-side guarantees were full in both countries, excluding only equity in both countries and subordinated debt in Thailand, no direct debt assumption (liability reduction) was necessary. Asset-side guarantees in Korea included, notably, an informal guarantee of loans made in foreign currencies and a guarantee of loans extended to small and medium-sized enterprises. In Thailand, apart from interbank credits covered by the blanket guarantee, no direct asset-side guarantees were extended. Guarantees included off-balance-sheet items (such as derivative instruments) in Thailand but not in Korea. To at least partly cover the contingent cost of guarantees, the government of Thailand charges the recipient institutions an annual fee of 0.4 percent of the covered liabilities.
In Korea, KAMCO bought bad assets initially from all banks and at substantial discounts,43 paying for them with its own government-guaranteed bonds and cash. In Thailand, TAMC purchased bad assets from intervened institutions (and residual assets from FRA and FIDF) at market price, making the payment in the form of five-year bonds that did not carry an explicit government guarantee.44
In Thailand, the government provided income support, and hence indirect recapitalization support, through profit and loss sharing arrangements as well as through tax exemptions in connection with corporate debt restructuring (sales of NPLs to private majority bank-owned AMCs). In Korea, the government extended subsidized loans to small and medium-sized enterprises to indirectly strengthen banks’ assets.45 Loan-loss provisions were made fully tax deductible in both countries.
Macroeconomic and Fiscal Impact
This section offers a qualitative and descriptive overview of the impact of the fiscal support operations in Korea and Thailand. The data material needed for quantitative analysis is scant as the restructuring processes extend over no more than two full fiscal years so far.
The visible recorded fiscal positions appeared strong in both countries prior to the outbreak of the crises (Table 12.2). By end-1996, central governments had recorded surpluses since 1993 in Korea and since 1990 in Thailand, averaging 0.2 percent and 2.7 percent of GDP, respectively. The picture was similar at the general government level, with the Korean general government on average at balance through 1996, and the Thai general government running a surplus of 2.2 percent of GDP. At the outset of the crisis, public sector debt, which was predominantly domestic, was 9 percent of GDP in Korea and 15 percent of GDP in Thailand.46
|Of which: carrying costs of financial sector support||…||…||−0.3||−0.8|
|Of which: carrying costs of financial sector support||…||−0.7||−1.9||0.5|
Central government; excluding privatization proceeds but including carrying costs of financial sector support. For Thailand, data are given for the fiscal year (October-September).
Central government; excluding privatization proceeds but including carrying costs of financial sector support. For Thailand, data are given for the fiscal year (October-September).
However, the visible fiscal position masked significant vulnerabilities that accumulated both prior to and immediately following the outbreak of the crises. First, the export-oriented growth strategy had involved active government intervention in the form of extensive quasi-fiscal activities such as directed and subsidized lending, which had led to heavily leveraged corporate sectors and vulnerable financial sectors, particularly in Korea.47 Second, explicit and implicit credit guarantees, apart from compromising market discipline and distorting resource allocation, had created large contingent and implicit fiscal liabilities.48 Third, sub-market rate liquidity support from the BOT to 66 finance companies in the first half of 1997 constituted a quasi-fiscal operation the cost of which remained absent from the visible fiscal position. Fourth, following the outbreak of the crisis, both Korea and Thailand announced a blanket guarantee to protect financial institutions’ creditors, thus increasing the size of contingent fiscal liabilities.
Initial Impact and Magnitude of Fiscal Support
Following the outbreak of the crisis, fiscal policy was tightened in both Korea and Thailand, both to support external adjustment and to make room for fiscal outlays in support of the financial sector.49 However, at the outset of the sharp decline in output that started already in 1997 in Thailand and in 1998 in Korea, fiscal policy was quickly geared toward stimulating aggregate demand.
The recorded fiscal cost of financial sector support consisted of both interest costs and social safety net costs, which rose following bank closures and layoffs. Considering only the former (as the latter are difficult to break down between financial sector related and other), the fiscal impact of financial sector support in the first full fiscal year following the crisis was significantly larger in Thailand than in Korea. As Table 12.2 shows, only a tenth of the fiscal deficit in 1998 in Korea originated from financial sector support; in Thailand, the share was close to half in 1997/98. This difference is explained by the fact that the magnitude of up-front liquidity support was rather large in Thailand, while in Korea the bulk of fiscal support consisted of solvency support, extended only after the initial crisis resolution efforts.
A set of estimates of the fiscal cost of both liquidity and solvency support extended so far is presented in Table 12.3. According to these estimates, the (gross) magnitude of fiscal support had come close to 20 percent of GDP in Korea by mid-1999 and exceeded 25 percent of GDP in Thailand by end-1998. These estimates are, however, subject to significant uncertainty.
|(including deposit guarantee)||83||8|
For Thailand as of end-1998.
As of October 1999 for Korea and end-1998 for Thailand.
By government guaranteed KDIC bonds.
By government guaranteed KAMCO bonds.
For Thailand as of end-1998.
As of October 1999 for Korea and end-1998 for Thailand.
By government guaranteed KDIC bonds.
By government guaranteed KAMCO bonds.
Out of these outlays, only interest costs are explicitly recorded in the fiscal accounts. The fiscal support in Korea was fairly evenly distributed among recapitalization support, asset purchases, and asset swaps, while the initial support in Thailand in 1997 took the form of liquidity support, most of which was later converted into equity as the recipient institutions turned out to need solvency support as well. In addition, direct recapitalization support was extended in Thailand starting in 1998.
On the receipt side, asset recoveries by KAMCO had amounted to 1.8 percent of GDP through mid-1999. The face value of these assets was equivalent to 3 percent of GDP, and KAMCO had paid 1.7 percent of GDP for them, thus making a profit of 0.1 percent of GDP on asset recovery. In total, KAMCO had spent the equivalent of 4 percent of GDP by mid-1999 to purchase assets with a face value of 10 percent of GDP. In Thailand, the FRA has liquidated the assets of the closed finance companies, recovering half, or 4 percent of 1998 GDP, of their face value. Of this amount, two-thirds have been sold to the private sector while TAMC has acquired one-third.
Fiscal support to the financial sector was not the sole reason for the rapid accumulation of public debt. In Korea, gross public debt rose from 9 percent at end-1996 to 30 percent of GDP at end-1999, and in Thailand the increase was from 15 to 56 percent of GDP in the same period. Fiscal support in financial sector restructuring accounted for between two-thirds and three-quarters of the increase in public debt.50
An indication of what debt accumulation in this order of magnitude implies for the medium- to long-term fiscal outlook can be obtained from a stylized example that shares some relevant characteristics with Korea and Thailand. Assume that an economy starts off with fiscal balance and no public debt; assume, furthermore, that a financial crisis necessitates the extension of fiscal support to the financial sector amounting to 20 percent of GDP, financed by bond issues. If the underlying fiscal policy (i.e., fiscal policy excluding any restructuring outlays) remains cyclically neutral (with cyclical fluctuations in the overall balance canceling out in the long run), the debt stock grows autonomously by the excess of the real interest rate above the real growth rate;51 hence, a primary fiscal surplus is needed to stabilize and reduce the debt stock. To reduce the debt stock back to zero in T years, the average primary surplus (Ps) has to equal
Psd(T)=0 = (r - g) * d + d/T = (r - g) * 20 + 20/T,
where r denotes the real rate of interest, g the real growth rate, and d the debt stock (in relation to GDP). For example, with a 1 percentage point difference between real interest and growth rates, the elimination of the debt stock in 20 years would necessitate an average primary surplus of 1.2 percent of GDP. On the other hand, should the real interest and growth rates be equal (as might be expected to be the case in the long run), an average primary surplus of 1.0 percent of GDP suffices to eliminate the debt stock in 20 years.
This stylized framework serves to underline the point that a restructuring operation similar in magnitude to those in Korea and Thailand has far-reaching implications for fiscal policy. The elimination of the debt stock arising from the restructuring operation would necessitate—all other things held constant—a significant fiscal adjustment effort over a couple of decades. Current IMF staff projections for both Korea and Thailand indicate, however, that the improvement in economic conditions following the resolution of the crises will contribute significantly to a strengthening of the fiscal positions, thus lessening the need for active fiscal policy measures to generate primary surpluses.
The exact time profile of fiscal support’s cash impact depends on the instruments used to extend the support. As shown in Table 12.1, cash resources with an immediate first-round aggregate demand impact were injected into the economy in both countries—in Korea to purchase both common and preferred stocks and in Thailand to extend liquidity support as well as to purchase common stock (albeit indirectly as initial lender-of-last-resort support was later converted into equity). Government bonds issued for solvency support mature in 2003-05 in Korea and around 2008 in Thailand, unless redeemed prior to maturity. Finally, the cash impact of other fiscal operations, including guarantees, asset purchases and swaps, and income support to financial institutions, is either continuous (income support) or unknown, depending on other economic developments and policy decisions regarding, for example, the liquidation of AMCs.
The cash impact of these support instruments will obviously affect the formulation of fiscal policy more generally. In addition to a “permanent” increase in the level of interest payments, which necessitates an equal increase in the primary surplus so as not to compromise medium-term fiscal sustainability, the redemption of bonds will create potential for large shifts in the fiscal stance. In order to avoid frequent and/or large tax policy changes, which tend to be distortionary, expenditures will have to carry the burden of adjustment to the lumpy amortization payments that will occur over the medium term or, to the extent possible given the market conditions, part of the bonds will have to be rolled over.
Summary and Conclusions
Both practical experiences and theoretical considerations offer the following suggestions on the role, design, and consequences of fiscal support in financial sector restructuring.
- Fiscal support is warranted when financial sector distress threatens macroeconomic stability.
- The main role of fiscal policy in financial sector restructuring is to extend nonmarket financial support to institutions in need of and worth supporting in a cost-efficient, transparent, and equitable way and so as to minimize the risk of moral hazard problems.
- Cost efficiency depends on the restructuring instruments and methods chosen (liquidations, privatizations, and mergers and acquisitions being generally cheaper than recapitalization) and burden-sharing arrangements in place. Transparency requires a full recording and reporting of not only fiscal support transactions but its strategy as well. Moral hazard can be addressed through an equitable distribution of restructuring costs and the implementation of measures to prevent the recurrence of financial sector crises.
- Fiscal support can be extended using balance-sheet and/or income support instruments, the former being preferable on transparency and efficiency grounds. Fiscal instruments per se do not address underlying structural problems, which often require accompanying operational and structural reforms.
- The macroeconomic impact of fiscal support depends on a range of country-specific factors, including the openness of the economy, monetary and exchange rate policies, structure and efficiency of financial markets, expectations about public intervention, and choice of support instruments as well as initial and medium-term fiscal vulnerabilities.
Using this framework to compare the Korean and Thai experiences highlights several important differences, but also similarities, between the two countries.
- The role of the fiscal authority and fiscal policy in Korea was limited largely to the extension of recapitalization support, while in Thailand the fiscal authority assumed a more active, operative role in financial sector crisis resolution and restructuring in addition to extending financial support.
- Both in Korea and Thailand, the fiscal support contained elements that compromised cost efficiency (e.g., bailouts of insolvent banks and subsidized liquidity support) and transparency (all fiscal transactions not recorded and reported). On the other hand, both restructuring operations included important elements to avoid moral hazard (shareholder bail-ins, and operational and structural reforms in financial and corporate sectors).
- Starting from a visibly strong but inherently vulnerable fiscal position, the financial sector support operations were important, but not the only, factors behind a large and rapid increase in public debt. While the fiscal situation appears sustainable in both countries, a long period of primary surpluses would be necessary if the stock of restructuring related debt were to be eliminated. Fiscal planning and management will be complicated if large magnitudes of support instruments are allowed to mature simultaneously.
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AlexanderWilliamJeffrey M.DavisLiam P.Ebrill and Carl-JohanLindgreneds. 1997Systemic Bank Restructuring and Macroeconomic Policy (Washington: International Monetary Fund).
BaliñoTomás and AngelUbide1999 “The Korean Financial Crisis of 1997: A Strategy of Financial Sector Reform,” IMF Working Paper 99/28 (Washington: International Monetary Fund).
BurnsideCraigMartinEichenbaum and SergioRebelo1999 “Prospective Deficits and the Asian Currency Crisis,” Policy Research Working Paper No. 2174 (Washington: World Bank).
DanielJames A.1997 “Fiscal Aspects of Bank Restructuring,” IMF Working Paper 97/52 (Washington: International Monetary Fund).
DanielJames A.Jeffrey M.Davis and Andrew M.Wolfe1997 “Fiscal Accounting of Bank Restructuring,” IMF Paper on Policy Analysis and Assessment 97/5 (Washington: International Monetary Fund).
DanielJames and MatthewSaal1997 “Macroeconomic Impact and Policy Response,” in Systemic Bank Restructuring and Macroeconomic Policyed. by WilliamAlexander and others (Washington: International Monetary Fund).
DziobekClaudia1998 “Market-Based Policy Instruments for Systemic Bank Restructuring,” IMF Working Paper 98/113 (Washington: International Monetary Fund).
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EnochCharlesGillianGarcia and VasudevanSundararajan1999 “Recapitalizing Banks with Public Funds: Selected Issues,” IMF Working Paper 99/139 (Washington: International Monetary Fund).
EscolanoJulio1997 “Tax Treatment of Loan Losses of Banks,” in Systemic Bank Restructuring and Macroeconomic Policyed. by WilliamAlexander and others (Washington: International Monetary Fund).
GarciaGillian1997 “A Framework for Analysis and Assessment,” in Systemic Bank Restructuring and Macroeconomic Policyed. by WilliamAlexander and others (Washington: International Monetary Fund).
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Daniel and Saal (1997), Dziobek and Pazarbaşioğlu (1997), Nyberg (1997), and Enoch, Garcia, and Sundararajan (1999), argue that a separate (and temporary) restructuring agency should be assigned the lead in formulating the restructuring strategy and supervising its implementation.
Liquidation of an unviable bank may, however, prove expensive where there is publicly financed deposit insurance
From an operational viewpoint, the group of a bank’s stakeholders also includes its management and to the extent that a poor management is responsible for financial distress, it should obviously be replaced.
Enoch, Garcia, and Sundararajan (1999) discuss the pros and cons of centralized asset management units.
See Garcia (1997); and Enoch, Garcia, and Sundararajan (1999). A specific problem is that while the government’s equity holding is intended to be temporary, capital instruments redeemable by the government do not qualify as Tier I capital according to the Basel Committee’s classification. Therefore, either the stocks held by the government must be redeemable by the bank with the government’s consent or the government has to unload its holdings in a secondary market.
For a comprehensive survey of issues related to the tax treatment of loan losses, see Escolano (1997). Importantly, supportive tax treatment of loan-loss provisions creates incentives for banks to recognize their losses in a timely manner.
The duration of a financial instrument denotes the average maturity of the cash flows generated by the instrument, weighted by the magnitude of the cash flows.
Empirical evidence suggests that spreads are likely to narrow following a successful financial restructuring (Daniel, 1997).
On the other hand, successful financial sector restructuring might reduce fiscal vulnerability, particularly if conducted at a sufficiently early stage of distress.
Unless otherwise indicated, the factual information in this section draws on Lindgren and others (1999).
Less so for finance companies, as explained below.
The FIDF acquired shares in those financial institutions that had received solvency support from its funds.
While they were distinct from fiscal authorities, they nevertheless undertook some inherently fiscal policy actions.
However, all costs were recorded in the fiscal programs under IMF arrangements and this information was made publicly available.
The attachment of financial statements of bank restructuring institutions such as asset management companies to the budget documents discussed and approved by parliament would enhance transparency.
The modalities of the blanket guarantees differed slightly between Korea and Thailand. While depositors were fully covered in both countries (in Thailand even the depositors of the 56 closed finance companies were covered), other non subordinated creditors were fully covered in Thailand but only partly in Korea. See Enoch, Garcia, and Sundararajan (1999).
The purchase price was set at 45 percent of the book value of the underlying collateral for secured loans and 3 percent for unsecured loans.
However, the impact of this measure on banks’ balance sheets is expected to be minor.
Public debt covers central government debt in Korea, and central government and public enterprise debt in Thailand.
Lane and others (1999) report that in Korea the average corporate debt-to-equity ratio was 395 percent and in Thailand 450 percent, which were far above ratios observed elsewhere in Asia and the world.
Burnside, Eichenbaum, and Rebelo (1999), go so far as to conclude that these guarantees created large “prospective” fiscal deficits, and the expectation of their monetization led to the collapse of the fixed exchange rate regimes and contagion across economies.