Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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CEYLA PAZARBAŞIOĞLU

I enjoyed reading this very interesting paper. It is clear that Japan offers a very valuable case study to draw lessons on financial crisis management. I will first offer comments on the paper and then give my views on the subject of identifying early warning indicators of financial crises.

The factors that caused and intensified Japan’s banking crisis remind us of those that were observed in the crises experienced in some other developed countries, such as the Nordic countries (Finland, Norway, and Sweden). There are many common threads that link the experiences of these different countries in two different corners of the world—even the timing of the events are not that far off. These include increased indebtedness of the financial and real sector after capital liberalization, strong emphasis on collateral-based lending, and concentration of loans to the real estate sector. The end to credit rationing and the subsequent unleashing of pent-up demand induce major changes in bank behavior. In particular, price competition increases, leading to adverse selection and risky lending. Coupled with insufficient risk management systems and inadequate corporate governance, such behavior leads to increased vulnerability of the financial and real sectors. This type of typical boom-bust cycle usually ends in (1) a credit crunch and funding problems for nonfinancial entities; and/or (2) a capital crunch and funding problems for financial institutions.

Time and again, we see examples of financial and real sector crisis in the aftermath of the deregulation of an inefficient, inadequately supervised financial system characterized by overcapacity. The end result usually is a crisis-induced restructuring of the financial and real sector. Unfortunately, though, the costs of such restructuring runs very high and sometimes even carries a global contagion risk. The latter seems to have been true for Japan as the Japanese financial problems likely contributed to the eruption of the crises in several of the East Asian countries.

Importance of Prompt Diagnosis

As mentioned in the paper, the Japanese financial crisis has been much more protracted and costly—arguably these two features are highly correlated. The direct costs of the financial crisis alone have already added up to close to 15 percent of GDP. One important lesson from the Japanese financial crisis is that the intricate corporate governance links and the slow and guarded response of the Japanese authorities seem to have magnified the direct and indirect costs of the financial crisis. Early diagnosis and decisive prompt corrective action are key in designing an appropriate restructuring strategy and thus minimizing the costs of such restructuring. Thus, a careful analysis of the Japanese experience provides valuable lessons.

Early Warning Signals

A main thesis of the paper is that in addition to economic and market indicators, bank-specific factors play an important role in the different stages of a financial crisis. In particular, changes in bank behavior can provide early clues to the development of problems in the financial sector. Table 13.3 provides a list of vulnerability indicators.

Table 13.3.Vulnerability Indicators: A Dynamic Assessment
1.Financial Sector Indicators (Institution- and Sector-Based)
Asset Classification System (on individual institution and aggregate

sector basis) Sectoral distribution

Use of collateral

Purpose of borrowing

Regional distribution

Performance of assets

Unrealized gains/losses from assets

Liability Classification System

Sectoral distribution Volatility

Maturity structure

Cost structure

Size structure

Liquidity characteristics

Leverage and Profitability Indicators
2.Market Information Stock prices (EDP models)

Corporate bond spreads

Credit ratings
3.Expectations of Market Participants

Private business outlook surveys

Diffusion index (lending attitude of depository institutions judged by borrowers)

Central bank statements

The paper identifies several sector-specific factors influential in the formation and deepening of the Japanese financial crisis:

  • collateral-backed lending and excessive concentration of loans to real estate related sectors;
  • inadequate credit risk management;
  • evaluation of capital, taking into account unrealized gains on securities;
  • interbank relationships, links between banks and corporate sector, links between banks and other financial institutions;
  • problems in writing off loans;
  • insufficient disclosure, poor accounting and valuation principles; and
  • volatile funding structure; excessive dependence on interbank loans and foreign sources.

A paper by Gonzalez-Hermosillo, Pazarbaşioğlu, and Billings (1997; from herein referred to as GPB) on the Mexican financial crisis of the mid-1990s also finds that there are stark differences in the behavior of problem banks and sound banks before and during crisis periods and that the interlinkages with economic and financial conditions determine the contagion impact. GPB argue that the degree of soundness of banks, or their probability of failure, is determined by bank-specific factors as well as by macroeconomic conditions, and by the overall fragility of the banking system when systemic risk is present. Bank-specific variables are largely conditioned by the microprudential guidelines applicable to banks, while the state of the economy and the shocks affecting it define the macroprudential setting in which banks operate. Thus, while microprudential risks are reduced by an appropriate legal framework and adequate banking supervision capabilities, macroprudential risk is minimized by the maintenance of transparent, predictable, and stable macroeconomic policies.

While a macroeconomic shock would not discriminate among banks, the effects on individual banks would be commensurate with their exposure to the specific macroeconomic shock. International experience suggests that a negative macroeconomic shock may put the stability of the financial system at risk. Findings of GPB give support to the view that rapid growth in bank lending may make the banking sector increasingly exposed to destabilizing shocks. Furthermore, the results suggest that adverse macroeconomic shocks will shorten the survival time of fragile banks (i.e., those with a deteriorating financial condition) and that contagion effects can play an important role in influencing both the likelihood and the timing of failure.

The results of the full GPB model suggest that bank-specific variables and banking sector variables are important determinants of the likelihood of failure. With respect to bank-specific variables, higher values for the share in total loans of nonperforming loans, and unsecuritized loans as well as higher interbank deposits, are associated with a higher probability of failure. In terms of banking sector variables, an increase in the share in GDP of loans, as well as in the contributions to the deposit insurance fund, are positively correlated with a higher likelihood of failure.

It is worth noting that the results indicate that the factors that determine the likelihood of failure differ significantly from the factors that determine the timing of failure. In particular, the macroeconomic factors play a pivotal role in influencing the time to failure. High real interest rates as well as a depreciation of the exchange rate imply a decrease in the survival time of a bank. Similar to the findings on the likelihood of failure, an increase in the ratio of nonperforming loans to total loans decreases survival time. According to the estimation results, the higher the share of housing loans in total loans, the higher is the survival time of a bank (possibly due to the loan restructuring programs). Size has a positive coefficient, implying that the larger the bank, the longer is the probability of survival.

With regard to banking sector variables, an increase in the riskiness of the banking sector as a whole (a proxy for contagion effects) decreases the survival time of an individual bank. Similarly, an increase in the ratio of loans extended by the banking sector to GDP decreases banks’ probability of survival.

Bank Restructuring

A wide range of countries have experienced banking system problems and their approaches to systemic bank restructuring have varied substantially. Based on the experience of 24 countries, a paper by Dziobek and Pazarbaşioğlu (1998) provides a summary of policies judged to be successful in a wide range of circumstances. The countries in the sample were ranked by relative progress in resolving banking sector problems—that is, data on banking performance and changes in financial system intermediation capacity were used to group countries into three broad categories. The next step was to relate the performance rankings obtained to the institutional and regulatory measures that the countries used in their restructuring operations, assess the impact of accompanying macroeconomic policies, and examine the extent to which the use of particular restructuring instruments contributed to success. The main findings are summarized below.

Successful bank restructuring implies a prompt corrective action and a comprehensive approach not only addressing the immediate stock and flow problems of weak and insolvent banks, but also correcting shortcomings in the accounting, legal, and regulatory framework while improving supervision and compliance. Operational restructuring is a necessary condition for banks to return to profitability and sustained solvency. Management deficiencies were identified as a cause of the banking problems in all sample countries and progress in bank restructuring is highly correlated with whether or not these were addressed.

The central bank must stand ready to provide liquidity support during restructuring to viable banks. However, the central bank should not provide long-term financing to banks, nor should it be involved in commercial banking activities, as this leads to quasi-fiscal costs and creates conflicts with its monetary policy objectives.

While bank restructuring programs may be initiated and successfully carried out during a time of economic stagnation, positive economic growth helps banks to resume lending and return to profitability.

Reference

    Gonzalez-HermosilloBrendaCeylaPazarbaşioğlu and RobertBillings1997Determinants of Banking System Fragility: A Case Study of Mexico,Staff PapersInternational Monetary Fund Volume 44 (September) pp. 295314.

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    DziobekClaudia and CeylaPazarbaştoğlu1998“Lessons from Systemic Bank Restructuring” Economic Issues No. 14 (Washington: International Monetary Fund).

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