- William Alexander, Jeffrey Davis, Liam Ebrill, and Carl-Johan Lindgren
- Published Date:
- August 1997
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A framework for assessing restructuring strategies is developed in Chapter 2.
See Lindgren, Garcia, and Saal (1996), Appendix 1.
An assessment of whether some nonviable banks provide services that are considered essential to the efficient Functioning of the economy may be required. There may be eases when a bank may be “too big to fail” without causing significant damage to the economy, however, this concern is evoked far more often than clearly justified.
Common valuation criteria for bank assets will enhance their transparency and transferability.
When available, foreign capital typically goes through the government or under a government guarantee. Private foreign capital has rarely been forthcoming.
Thus, the relative scarcity of runs in modern banking systems reflects government or central bank policies specifically designed to forestall runs. Nevertheless, runs, some limited and others more extensive, have occurred in recent years in Argentina, Bolivia, Bulgaria, Chile, the Czech Republic, Estonia, Hong Kong, Hungary, Japan, Jordan, Malaysia, the Philippines, Taiwan Province of China, Tanzania, Thailand, Turkey and the United Stares (sec Lindgren, Garcia, and Saal (l996). Tables 2 and 3, and Garcia and Saal (1996), Table 1).
Operational restructuring is discussed in more detail in Chapter 2.
Related measures to address solvency and profitability problems in the real and nonbank financial sectors may also be required (see Borish, Long, and Nöel (1995)); these are beyond the scope of this paper.
Proper accounting for the accumulated losses on Loans and other assets and operating deficits of a troubled bank will show that capital is severely impaired or, more likely, negative. The continued operation of such a bank is dangerous: there is no cushion against losses, and owners with no capital at stake have little or no incentive to operate the bank responsibly; they may even loot the bank before control is taken from them.
Further shrinkage of the asset portfolio can help to make the bank more manageable but does not restore solvency.
It should be noted that an asset swap at market value is not a recapitalization, and the problem of loading banks’ balance sheets with nonmarketable, nonearning securities applies here as well as to capital injections.
At the same time, however, ad hoc changes in the tax system designed to provide special assistance to banks as a potential “second-best” solution should be avoided; these would be costly and nontransparent and would divert the tax system from its function of raising revenue efficiently and predictably.
For a discussion of the macroeconomic implications of government expenditure and financing, see IMF (1995b).
A potentially important component of future income is the recovery value of bank assets obtained by the government, or public restructuring agency, during bank restructuring. For example, Sweden (in 1991), recovered substantial income from such bank assets, which thereby greatly reduced the eventual cost of government assistance to the banks. Such substantial cost recovery is, however, the exception rather than the norm.
See Appendix I for a more formal description of the associated debt dynamics.
See Lane (1996) for an analysis of this position.
Bank restructuring often takes place in the context of substantial structural reforms of the financial system and macroeconomic stabilization efforts. The consideration of the impact of bank assistance operations on macroeconomic variables in this section abstracts from the effects of these other factors.
Citing evidence from Eastern Europe, Thorne (1993, p. 998), for example, states that “it is common for these banks … [with a large proportion of nonperforming debt] … to increase the average bank lending rate and bank average spread.” For models linking nonperforming loans and interest spreads, see Montes-Negret and Papi (1996) and Buch (1995).
To the extent that the level of assistance is less than anticipated, the wealth effect will be negative.
To the extent that such flows are sterilized so that there is no overall increase in the NDA of the central bank, external effects will be mitigated.
Appendix I presents the underlying algebra and a more detailed explanation of alternative fiscal responses.
“Strong” in the sense that, the actual primary balance is significantly greater than that required to keep the debt-to-GDP ratio constant (see Appendix I),
Even after financial health has returned, some of the behavioral changes that were induced by a period of banking unsoundness may well persist.
Banks often can stay liquid after they become insolvent, sometimes for an extensive period, because they can use new deposits to cover operational losses and deposit withdrawals.
LOLR lending should be fully collateralized to afford some protection to the central bank.
While GFS excludes such operations from determining the fiscal balance, it provides for their recording as memorandum items.
GFS would consider such operations as deficit-determining items
To preserve continuity. existing bank-restructuring programs could include under “bank assistance measures” only those costs not already encompassed within the overall balance.
The augmented balance concept could, in principle, be extended to capture any quasi-fiscal activities not recorded in the GFS-based balance in addition to those related to bank assistance. A numerical example of the relationship between the augmented and standard fiscal balance for a stylized bank assistance operation is presented in Appendix III,
Determining if a bank is troubled is difficult and should follow the distinction between LOLR lending and solvency support by the central bank discussed above. Certainly, any protracted central bank support should be classified as a fiscal operation.
For more details on treating quasi-fiscal operations see Mackenzie and Stella (1996).
If the public financial institution’s net income is incorporated into the budget, or its marginal rate of profit transfer is positive, its contribution to the fiscal balance should be offset to avoid double counting. The offset would be 100 percent if net income is fully incorporated or the marginal rate of profit transfer is 100 percent.
This requirement in effect clarifies existing GFS recommendations.
If the liabilities are implicitly assumed as part of a government takeover of an insolvent bank, the liabilities should not be recorded in the augmented balance as this would overstate the cost to the government. Rather, an estimate of the bank’s insolvency (i.e., its negative net worth) should be recorded as a memorandum item when the bank is taken over and any subsequent bank assistance measures, such as a bond issuance, should be recorded in the augmented balance when implemented.
Based on Ize (1993).
Assuming no seigniorage.
This appendix was prepared by Claudio Dziobek.
See the U.S. case study in Chapter 3.
See Dziobek (1995) for a survey of restructuring policy instruments.
Capital is also increased by retaining any after tax net income (profits); dividend distributions should not be made until a bank is fully recapitalized.
Long-term loans were extended m banks in Argentina (1994–95), Azerbaijan (1995), Finland (1991), Hungary (1994), and Mexico (1995). Loans in almost all eases carried a market-based interest rate. In an interesting variation, the loans to Finnish banks had an interest rate that increased over time To encourage banks to repay early.
[n the wake of the 1995 Mexican crisis, the capital position of provincial banks in Argentina deteriorated sharply as a result of price declines in the government bonds they held.
In a high inflation environment, special accounting techniques must be employed.
Empirical evidence (set e.g., Kaufman, 1994) suggests that depositor? have been able to distinguish good banks from weak banks in the United States even during the Great Depression. The evidence on this subject is not compelling for other countries.
These precautions were not taken—with disastrous consequences—when thrift institutions were granted forbearance in the United States during the 1980s (United States, Congressional Budget Office (1993)).
Cash purchases of shares were used in Egypt (1991), Finland (1991–94), Mauritania (1993), the Philippines (1986), and Sweden (1991).
In Mexico, for example. the authorities bought 2 pesos of problem loans for every 1 peso contributed in new capital. In Mauritania, government equity injections were accompanied by private equity purchases.
Liabilities can also be reduced by netting deposits against their owners’ non performing loans. I However, the rules for such netting tend to be complex and difficult to administer.
Sweden, which established separate: government-owned AMCs for each of two banks, is a notable exception.
Among the case studies in Chapter 3, only in Hungary were bank assets purchased at below fact-value.
Risk-weighted capital ratios increase partly because government bonds have a lower risk weight under most capital standards than loans. While the Basle standards apply only to bonds of governments of the Organization for Economic Cooperation and Development (OECD), many other governments, sometimes unjustifiably, give a zero weighting to their bonds (Dziobek, Frécaut, and Nieto (1995)).
Assets were transferred in Mexico more than once, hut at fair value and with the addition of private capital into the banks that benefited from the asset transfer.
Defaulting public enterprises received special loans to help service their debt From the government in the Philippines (1986) and the central bank in Hungary (1987). Public enterprises were also similarly assisted in Mexico in 1995. and the Côte d’Ivoire in 1991. Public enterprise debt was guaranteed by the government in Azerbaijan in 1995, and in Moldova in 1994 to assist banks.
After-Tax net income (ATNI) is available to the bank for paying dividends and adding to capital as regained earnings. ATNI = Income + Expense ∔ Taxes.
See Chapter 4.
In the event that political support for a comprehensive restructuring strategy is delayed, supervisor must be prepared to act decisively and compel banks to cease certain operations and being operational restructuring to stem their flow losses.
Branch closures provide one indication of the rationalization of the Swedish system; the number of bank branches in Sweden fell by close to 20 percent from 1990–95.
It may be necessary in some cases to develop alternative arrangements to provide certain services, such as rum] banks, which may warrant government subsidy. Such arrangements should tic transparently budgeted.
It should be noted that immediate privatization of deeply insolvent banks is seldom an option; some degree of restructuring and an established track record are usually prerequisites.
For example, some amount of central planning is necessary even for many market-oriented politics. such as antitrust regulation, and indeed, in the very decision to promote a market-oriented system.
See “United States: Role of the Regulator in Dealing with Moral Hazard” in Chapter 3.
Barth, Bartholomew, and Bradley (1990) demonstrate the cost of delaying the resolution of failed thrifts in the United States.
A comprehensive strategy also prevents a situation in which creditors (and owners) of the most insolvent banks receive better treatment than those involved with banks that develop problems later.
Akerlof and Romer (1993) discuss looting and bankruptcy for profit.
It is particularly important to keep all decisions pertaining to individual banks free from political interference.
See “United States: Role of the Regulator in Dealing with Moral Hazard” in Chapter 3.
In the context of the second restructuring program (1993), the central bank opened a discount window to provide banks with an alternative way to finance short-term liquidity needs. Treasury bills were effectively used as collateral to allow banks to finance temporary liquidity needs.
In 1993, Nordbanken and Gota Bank were merged, retaining the name Nordbanken (Sweden’s fourth largest bank today). The asset-management companies that were created to deal with their nonperforming loans. Securum and Retriva, respectively, were also merged in December 1995.
The Monetary Board is the ultimate supervisory authority and is composed of the Governor of the central bank, a member of the Cabinet designated by the President of the Philippines and seven members from the private sector.
The state-owned banks as a whole accounted for about 55 percent of total banking system assets.
This section was prepared by Gillian Garcia.
The Bank Insurance Fund handled 1,394 bank failures between 1984 and 1992. These banks held $232.4 billion in assets, equivalent to 4.8 percent of the average level of GDP during this period and to 10 percent of insured bank assets in 1984 but to only 6.6 percent in 1992 as the industry grew strongly despite its difficulties.
The least costly form of resolution is that among all possibilities, which involves the smallest present value of expenditures for the FDIC.
From 1980 through 1992, 1,142 thrifts with $389.8 billion in assets failed. These assets were equivalent to 8 percent of average GDP during this period and to 39.9 percent of all of the thrift industry’s assets in 1984 and 47.8 percent in 1992, because the industry shrank markedly in the interim.
The RTC operated from 1989 through 1995.
The larger banks were more buffeted by external shocks than thrifts; they had to contend with the international debt crisis of 1982 and the escalation and subsequent decline in the value of the dollar, which had little or no effect on the thrift industry, whose assets were locally based and denominated in dollars.
The United States suffered nationwide recessions in 1980, 1982, and 1990–92 and a wave of regional recessions.
An institution is market-value insolvent when the market value of its liabilities exceeds that of its assets.
Forbearance was, however, granted to the major international banks regarding their international loans in the mid-1980s.
See Garcia (1987).
Regulatory capture occurs when, instead of protecting the public interest, a regulator serves the interests of the industry that it is supposed to regulate (Stigler (1970)).
Strunk and Case (1988, pp. 138–45) provide data on numbers of supervisors and salaries.
Many securities firms brokered deposits by breaking down large deposits into $100,000 pieces that were then within the limits of deposit insurance coverage and allocating them to different banks and thrifts that offered high rates. Deposit brokering was subsequently limited in FIRREA.
The distinction is particularly relevant for the two largest private banks, which were intervened and subsequently recapitalized through the issuance of additional shares on the Santiago Stock Exchange.
In U.S. dollar terms, the reduction in the value of the debt is lower because of the devaluation of the Chilean peso during that period.
See Table 12 for cost estimates and explanation of the method used.
This section is based on Pazarbaşioḡlu and van der Vossen (1997).
It is likely that the situation is much worse than these figures indicate. The overall health of the banking system is difficult to gauge because many countries are only currently developing asset-classification systems and new accounting practices. The enterprise sector is still undergoing consolidation and restructuring.
Prior to the onset of banking crises, the ratio of nonperforming loans to total loans reached 9.1 percent in Argentina (end-1980), 9.3 percent in Finland (end-1992), 10.6 percent in Mexico (September 1994), 6.4 percent in Norway (end-1991), 7.2 percent in Sweden (end-1992), and 9.3 percent in Venezuela (end-1993).
Estonia and Latvia have already experienced banking sector problems and reacted to effect the necessary liquidation or rehabilitation of the large banks. Lithuania is currently implementing a bank restructuring program following the systemic banking problems experienced in late December 1995.
Although the accuracy of banks’ financial reports, for example, on capital, earnings, and provisions are highly doubtful, the Central Bank of Russia estimates that at the beginning of 1996, 430 banks or 19 percent of the number of active banks were to be considered problem banks.
Interbank exposures have reached high levels in some countries, for example, in Russia, in response to the rapid reduction in central bank credit to commercial and state banks, and the rapid growth in correspondent banking, reflecting weaknesses in central bank-operated payment systems.
This section was prepared by James Daniel.
Data availability made it difficult to include any bank-restructuring efforts that took place before the 1980s.
Within the sample, Argentina, Chile, Kuwait, and Mexico have also gone through a systemic restructuring of their banking systems prior to the experiences studied. In Mauritania, after the unsuccessful episode of bank restructuring in 1989, a comprehensive bank-restructuring program was initiated in late 1993.
It can be viewed as an analysis of panel (pooled time-series and cross-section) data.
The countries that embarked upon bank-restructuring operations during or after 1994 were separately classified as “recent.”
Thus, if all 12 indicators showed improvements, a country would receive a maximum score of 12. A maximum score would indicate that the banking sector had fully recovered from the aftermath of the banking system problems. Clearly, other weighting schemes are possible; however, further judgment would be required to assign weights to different performance indicators. For simplicity, equal weighting was used.
There are, of course, always exceptions. One is Spain, which made extensive use of long- and short-Term central bank financial support. However it did so in close cooperation with the government and the lead restructuring agency (the deposit insurance agency) and placed considerable emphasis on the incentive-compatible design of support. Moreover, the banking community carried part of the financial burden.
No attempt was made to identify systematically the role of other factors, such as adjustment programs taking place or initiated during the bank-restructuring process.
It was not possible to identify bank assistance outlays in budget balances in the survey.
Basle Committee on Banking Regulations and Supervisory Practices (1988) and Basle Committee on Banking Supervision (1991 and 1995).
This does not imply, however, that tax and regulatory treatment need to coincide hilly. As argued below, there may remain aspects in which the financial and tax treatment of banks’ income differ. For a detailed treatment see Dziobek (1996).
See paragraphs 18 to 21 in Basle Committee on Banking Regulations and Supervisory Practices (1988) and amendment in Basle Committee on Banking Supervision (1991).
The Basle Accord considers paid-up share capital and disclosed reserves from posttax retained earnings as tier 1 or core capital; general loan-loss provisions or reserves created against the possibility of future losses are considered tier II or supplementary capital. The KC Directive on the Own Funds of Credit Institutions (Council of the European Communities, 1998a) treats funds for general banking risks (often including general provisions for loan losses) as a separate category, not subject to the constraints applying to “additional capital” (similar to the tier II capital of the Basle Accord). Core capital is deemed to present a higher availability to meet eventual future losses and reflect more, adequately the solvency of the institution than supplementary capital.
For an analysis of issues involved in the definition of income for income tax purposes, see Shome (1995).
Throughout this chapter, the term accrual is defined in relation to the actual or notional market value of an asset. Thus, a loss (gain) is said to accrue whenever the market value of the asset decreases (increases). In contrast, a gain or loss is realized when the asset is actually transacted. This concept of accrual does not always coincide with its legal or accounting counterparts.
Difficulties may arise, however, in the case of refinancing or rollover of a loan—when no actual cash payments are involved—and the loan value could be considered impaired prior to its refinancing.
For a description of valuation techniques see IMF (1996).
In this case, the reserve for loan losses is generally considered tier II capital. Trance, however, allows the use of part of this reserve as tier I capital.
In the United States, the charge-off method was made mandatory for most banks by the 1986 Tax Reform Act The reserve method can still be used by small banks with consolidated assets below $500 million (general reserve method computed as a six-year moving average based on the taxpayer’s experience) and, optionally, in relation to selected sovereign debt (the Allocated Country Risk Reserve). For an analysis of the charge-off method in die United States, see U.S. Department of Treasury (1991).
Hidden reserves are the result of deliberate undervaluation of assets in the balance sheet.
Methods of loan valuation based on present value are still rarely employed for statutory accounting (see Beattie and others 1995).Their development and standardization would represent an important step toward a more accurate measurement of the potential market value of loans.
The argument is entirely similar to that presented in Samuelson (1964) in die context of depreciation allowances.
This counterbalance is likely to be effective in regular runes for most banks. In the case of a failing bank undergoing serious financial difficulties, the incentive to overstate income is likely to outweigh the advantages derived from a lower tax liability.
See, for example, the Basle Accord on capital measurement and capital standards (Basle Committee on Banking Regulations and Supervisory Practices (1988); and Basic Committee on Banking Supervision, (1991) and (1995), and the European Union Directives (Council of the European Communities (1989a), (1989b), and (1993).
This difficulty is compounded by the existence in some countries (e.g., Germany, Switzerland, and Luxembourg) of “hidden” reserves, consisting of the deliberate understatement of the book value of loans and other assets as a form of provisioning. There is now a clear tendency to eliminate or force the disclosure of these reserves and disallow their tax deductibility.