VIII Conclusions and Lessons
- Leslie Teo, Charles Enoch, Carl-Johan Lindgren, Tomás Baliño, Anne Gulde, and Marc Quintyn
- Published Date:
- January 2000
The Asian experience with bank restructuring has already produced valuable lessons, many of which will evolve as the process continues. In particular, many “conclusions” at this time are actually interim assessments, as it will take several years before the restructuring of the financial and corporate sectors will be completed and the full economic implications of different measures become apparent.
More than any other recent financial crisis, the one in Asia has highlighted the linkages between financial sector soundness and macroeconomic stability. Highly leveraged corporate sectors with large amounts of unhedged foreign currency debt, much of which is short-term, and domestic bank borrowing, fed by large capital inflows during years of exceptional economic growth and exchange rate stability, created major vulnerabilities. The crisis highlights the danger that formally or informally pegged exchange rates may lull investors into ignoring currency risks (see Figure 8). Following the shocks to market expectations caused by exchange rate devaluations and widespread doubts about private sector solvency, the size and speed of the impact on the financial systems was unprecedented. Foreign banks cut their credit, asset prices collapsed, leading to major wealth losses, and real demand contracted sharply. The close integration of the Asian economies in world financial markets helped to spread the crisis to other countries in the region and to the rest of the world. Close attention should be paid to prudential supervision of foreign currency exposures and risks, especially when exchange rate regimes are inflexible.
Figure 8.Nominal Exchange Rate
Source: IMF, International Financial Statistics.
Why did the financial sector crises take everyone by surprise? There were clear signals of overheating, such as prolonged rapid credit expansions, asset price inflation, and overcapacity in key sectors, although the underlying deterioration in banks’ loan values and capital adequacy ratios were not yet reflected in their balance sheets. Meanwhile, the buildup of corporate indebtedness, unsustainable banking practices (such as directed, connected, and insider lending) and weaknesses in prudential regulation and supervision were known to policymakers and market participants. The fact that all these factors were largely overlooked by most private sector and published official analyses—both at home and abroad—was probably related to the long-running success of those economies. In any event, greater disclosure of macroprudential and microinstitutional indicators and greater transparency of monetary and financial policies could have strengthened market discipline and policy effectiveness and could have helped to expose some vulnerabilities much earlier.
Compared with the three crisis countries, Malaysia and the Philippines had been pursuing policies before the crisis that clearly lessened the damage. Both countries, which had undertaken bank restructuring and structural reforms in the 1980s, avoided a full-blown crisis. Malaysia’s traditional policies of limiting short-term foreign borrowing, encouraging foreign direct investment inflows, and relying on equity capital prevented the corporate sector from building up the large unhedged foreign exchange exposures and very high debt equity ratios that were so damaging in the crisis countries. These policies notwithstanding, Malaysia also faced substantial financial sector distress. In general, the crisis highlights the benefits of having developed money, bond, and equity markets. Developed capital markets would reduce corporate leverage and improve corporate governance; the reduced reliance on bank financing would make the system more resilient to shocks. The development of bond markets—especially for government bonds—would also facilitate financial sector restructuring.
The first priorities in the crisis countries were to stop excessive central bank credit expansion to insolvent institutions, stabilize the financial system, and prevent capital flight. To achieve this and to prevent bank runs, the governments needed to offer blanket guarantees for depositors and most creditors, close the worst institutions, and introduce credible macroeconomic stabilization and bank restructuring plans. These measures were successful in stopping the domestic deposit withdrawals, particularly after the credibility of the guarantees had been tested, but were less effective in securing rollover of foreign liabilities. To achieve the rollover, other measures, such as the debt renegotiation in Korea, were needed. The experience of the crisis countries suggests that in a systemic crisis, a blanket guarantee, rather than a limited deposit guarantee, is needed to restore confidence in the financial system.
While closing the most insolvent institutions was considered necessary, it also became clear that any closing of financial institutions and sharing of losses with private sector creditors is an extremely difficult task to manage. Closing deeply insolvent institutions provides a way to cease central bank support, allows loss sharing with creditors, removes excess intermediation capacity, and frees resources to deal with remaining institutions. Decisions to close may have to rely on liquidity “triggers” until banks’ loan-losses are recognized in their accounts. Any closing of financial institutions must be accompanied by a well-managed information campaign to support the policy, explain the reasons for bank closings, and reassure the public.
In all countries, except initially in Indonesia, the central banks were able to sterilize their liquidity support to individual banks, since deposits withdrawn from weak banks were largely deposited in other domestic banks perceived as being safer. To absorb excess liquidity of the latter and stem capital outflows, interest rate increases for short-term central bank instruments were necessary. This recycling was successful in all countries, except in Indonesia, where economic and political turmoil made the situation unmanageable during the first six months. Nonetheless, in all countries, exchange rates initially depreciated sharply due to concerns about creditworthiness and solvency of domestic counterparties and to uncertainties about policy implementation.
A slowdown in real credit growth to the private sector should not have come as a surprise. In addition to a sharp fall in credit demand, owing to overcapacity in the real sector and bleak short-term economic prospects, bankers became more cautious, as borrowers’ creditworthiness deteriorated, reflecting in particular the large foreign exchange component of their debt. This slowdown seems to be more explained by structural factors than by an excessively tight monetary policy. Any policies to stimulate bank lending should be used cautiously so as not to worsen banks’ conditions; for example, excessively low interest rate margins will be deterrents to new lending and further undermine banks’ solvency and recapitalization. Lending cannot be expected to normalize until the corporate sector has regained its profitability and repayment capacity and banks’ capital bases have been restored.
In broad terms, the strategies for systemic restructuring have sought to restore the financial systems to soundness as soon as possible. The process involves the introduction of the necessary legal, institutional and policy frameworks for dealing with nonviable financial institutions, strengthening viable ones, and resolving value impaired assets in the system. Systemic bank restructuring is a complex multiyear microeconomic process, which in the aggregate has major macroeconomic effects. No two situations are the same, and specific measures, pace, and effectiveness of implementation have varied between the different countries depending on the specifics of the problem, laws and institutions in place at the outset, and the sometimes strong preferences of the authorities for certain solutions. For example, there have been major differences in the ability of each government to endow official agencies involved in the restructuring with sufficient operational authority, financial independence, protection from lawsuits, and means to attract necessary expertise.
Key principles for the restructuring process in the three crisis countries have included strict criteria to identify viable and nonviable institutions and to remove existing owners from insolvent institutions. Private capital injections have been encouraged or required under binding memoranda of understanding schemes that also foster operational restructuring. To complement domestic equity investment in banks and to bring in international expertise, the three crisis countries liberalized their foreign ownership rules for the financial sector. To encourage new private equity investment, public solvency support also has been offered under strict conditions.
Successful implementation of systemic bank restructuring demands that national authorities take full responsibility of all the aspects of the program. Given the microeconomic nature of financial restructuring and the need for well-coordinated interplay between so many different government institutions, the process can be successful only if the authorities themselves take full control of the implementation process. However, because systemic banking crises occur very infrequently and require skills not readily available in most countries, access to international expertise can be particularly helpful. Thus, the IMF, the World Bank, and other international and bilateral agencies have provided advice and shared experiences from other countries that have dealt with similar problems. The institutions have also helped countries obtain the necessary expertise from the public and private sectors to assist in the restructuring.
A realistic valuation of financial institutions’ assets is essential to measure net worth, yet extremely difficult in cases of severe corporate and financial distress. The valuation of nonperforming loans is particularly hampered by the lack of clear market values and continuously changing economic conditions. To better support the valuation process, all countries tightened their rules for loan classification, loss provisioning, income recognition, and collateral valuation, and have substantially strengthened their supervisory scrutiny of compliance with such rules by bankers and auditors. Asset valuation is a key element in computing banks’capital adequacy requirements, which have been the basis for their recapitalization plans. In this connection, all the countries seek to bring their capital adequacy requirements into full compliance with international standards by the end of the restructuring process. In doing so, banks have been given time, according to transparent rules, to gradually restore their severely eroded capital bases. Recent developments suggest that transparency in loss recognition practices has helped in the issuance of new private bank equity.
Management of nonperforming loans and other value-impaired bank assets is one of the most critical and complex aspects of bank restructuring. There is no single optimal strategy for all circumstances but rather a combination of options that may vary over time and for each bank, depending on factors such as the nature of the problem assets, their overall size and distribution, and legal and governance constraints. The strategy will need to consider the speed of disposition of the assets, whether or not to use a centralized process, which also involves ownership choices.
Countries have taken different views on the role of asset management companies. Indonesia, Korea, and Malaysia have opted for centralized public asset management companies that buy assets from private banks to help banks clear their balance sheets. Thailand has aggressively liquidated the impaired assets of closed institutions through a central agency but does not permit public sector purchases of impaired assets from private banks; the Thai authorities are instead encouraging each bank to establish its own asset management company. The key issue in asset purchases by an asset management company is realistic valuation, so as to ensure that it does not become a tool for the indirect bailout of existing shareholders, thus undermining the incentives for private sector recapitalization and proper governance of asset management companies and banks. The sale of banks’ assets to an asset management company forces immediate recognition of the value of the loan. This may deter such sales in cases where banks have been carrying these loans at inflated values.
The use of vast amounts of public resources has been necessary to help restructure the financial system. This affects medium-term fiscal sustainability in the three crisis countries. An estimate of the exact cost of the crisis is not possible, as the costs are still emerging and the corporate debt restructuring process is far from completed. The outlays initially took the form of central bank liquidity support, but have been gradually identified as solvency support and been refinanced by public or publicly guaranteed debt. Only the carrying costs of the latter have been brought into the government budgets so far. The ultimate public sector costs will be reduced by proceeds from asset sales and bank privatizations. Moreover, more rapid and sustained economic growth as a result of a restructured, more efficient, and profitable financial system will yield additional tax revenue.
The problems in the financial sector also reflected profound problems in the corporate sectors. Solving the banking and the corporate sector crises therefore must go hand in hand. Resolving banking problems requires not only bank recapitalization, but also broad-based corporate debt restructuring. At the same time, resolving corporate sector turmoil, in turn requires properly functioning banks as a counterpart. Widespread corporate weaknesses and insolvencies are much more difficult and time-consuming to deal with than bank restructuring. Bankruptcy and other laws, which were either not in place at the onset of the crisis or inadequate, as well as judicial systems, are now being reformed to speed up corporate debt restructuring. Nevertheless, lags in corporate reform are slowing progress in bank restructuring.
Bank restructuring provides a key lever for corporate restructuring. Tighter and better enforced prudential regulations can induce the financial restructuring of corporations, especially those that are highly leveraged. Moreover, banks can play a lead role in inducing corporate restructuring, particularly if they have strong government support to do so, as is the case in Korea.
The IMF programs designed to deal with the problems of crisis countries in Asia have centered on structural reforms of the financial sectors since it was clear that macroeconomic measures alone would be insufficient. This represented a major departure from a traditional IMF-supported adjustment program. Program design and implementation allowed IMF staff to share with the authorities broad experiences from systemic crisis management in other countries. At the same time, the magnitude, depth, and local circumstances of each country required quick and innovative responses and a major deployment of IMF staff and experts in close cooperation with the World Bank. The structural components and conditionality of IMF- and World Bank-supported programs were clearly instrumental in implementing the authorities’ restructuring programs.
The different country experiences have provided IMF staff with important lessons in actual crisis management. The crisis experiences have confirmed that all major elements of the IMF’s Toward a Framework for Financial Stability, prepared in 1997 and published in 1998, remain valid (see Folkerts-Landau and Lindgren, 1998). The crisis has again highlighted the main vulnerabilities identified in that paper: problems of valuing bank loans (identified as “the Achilles’ heel” of effective corporate governance, market discipline, and official oversight) and therefore banks’ net worth; design of lender-of-last-resort facilities; deposit guarantee schemes and exit procedures; and importance of supervisory authority and capacity. Areas in which that paper could be expanded would be more in-depth analysis of the macroeconomic environment as a source of financial sector vulnerability and the relationship between the financial and real sectors.
Could the crisis have been prevented? In each country, alternative courses of policy that would have been preferable can be identified—but this is to give hindsight too much of a role. In the financial sector itself, more transparency of macro- and microeconomic data and policies clearly would have helped in bringing matters to a head earlier, which could have lessened the depth of the crisis. Policies to foster corporate governance and lower corporate leverage would also have helped. Better regulatory and supervisory frameworks would have helped, for example, in detecting and correcting problems such as excessive real estate lending and the proliferation of financial institutions. However, even if the Basel Core Principles (of April 1998) had been in place, bank supervisors probably would have been unable to take restrictive action, since the underlying problems were masked by the economic boom. For similar reasons, there was no way for fiscal policies to anticipate the size of the fiscal contingent liabilities building up in the financial systems. In particular, foreseeing the sudden and massive erosion of loan and asset values that took place once market sentiment changed and the exchange rates collapsed would have been very difficult.
Comprehensive reforms of legal, institutional, and administrative frameworks have been initiated with the aim of introducing international standards and best practices. Such reforms encompass modernization of financial sector laws and prudential regulations, including operational procedures for exit of problem banks. Reforms also include a strengthening of supervisory powers, procedures, and capabilities with the aim of bringing about better risk management in banks. Another key area of reform is new laws and procedures for corporate bankruptcy and governance.
The above reforms are facilitated by the broad-based international efforts under way to implement new standards, codes, core principles, and best practices. International initiatives have been undertaken to improve financial sector architecture, surveillance over national and international financial markets, dissemination of data, macroeconomic vulnerability indicators, and prudential regulations and supervision of international lenders. This last initiative, led by the Basel Committee on Banking Supervision, aims at revising, among others, solvency requirements and country risks.
National authorities may also draw other lessons from the crisis in terms of countercyclical prudential policies and more supportive macroeconomic policies. Banks’ net worth, including capital and reserves, should be built up in times of economic booms so that a cushion is available to deal with inevitable downturns. Such prudential policies are often referred to as countercyclical, and could include a strengthening of requirements regarding liquid assets, collateral margins, capital adequacy ratios, and general loan-loss provisioning in good times— when the future bad loans are extended. It should also be stressed that prudential policies are not substitutes for a proper mix of macroeconomic policies.
The experience of the crisis countries illustrates once more the importance of prompt and decisive action to deal with banking problems, including preemptive bank restructuring actions, and the dangers of waiting for the situation to reverse itself. Preventive action, notably in prudential regulation and supervision and in the form of more transparency, would have improved bank governance and market discipline and helped prevent weaknesses from building up. Early action also could have reduced the magnitude of the portfolio losses and the need for liquidity and solvency support. Conversely, once credible programs were put in place with broad domestic and international support, the crisis became manageable and provided a foundation for economic recovery: the scale and complexity of the problems would have made it difficult to address them without such support. This also suggests the importance of countries obtaining international assistance early in the process, in which the IMF and the World Bank play key roles.