Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Manuel Guitián has given us an excellent overview of the current issues related to banking soundness and the interaction between monetary policy and banking soundness.

My contribution is based on my practical experience as a central banker, with the point of departure being that of a small industrialized country. However, having been with the IMF, both as a staff member and later as a board member, I hope to be able to build a bridge between central bank experience and the IMF approach.

I should like first to concentrate on those elements in Guitián’s list of issues that, according to my practical experience, are the key ones and return to a more general assessment at the end of my comments.

The Nordic countries all experienced banking crises in the late 1980s and early 1990s. The problems in Denmark were of a lesser magnitude than those in Norway, Sweden, and Finland. Nevertheless, the problems of the banking sector in Denmark have subsequently been scrutinized by several government commissions with a view to determining how best to deal with banks in distress and how best to regulate the financial sector to avoid future problems.

The Result of Bad Loans

Banking problems are in almost all cases the result of loan losses. This was the reason for the problems in the Nordic countries, and it holds true for banks in all other parts of the world. Guitián refers to the case of Barings Bank. Of course, banks may get into trouble because of excessive risk taking using financial instruments, which is not discovered because of failure or fraud in their reporting systems. However, this is the exception rather than the rule. Also, positions related to financial instruments generally can be closed relatively easily, albeit of course with a loss.

When banking problems of a more systemic nature arise, it is always a matter of significant losses on loan portfolios. In such a situation banks cannot easily adjust their balance sheet structure, as no market will exist for selling loan portfolios.

At the same time it has to be borne in mind that it is the mere essence of banking activity to take credit risks. Banks’ prime task is to extend loans to companies and persons who are not able to attract capital via the capital market because of information problems. Thus, losses on loan portfolios cannot be avoided, no matter how careful the credit assessment has been.

For individual banks, credit losses may be the result of a variety of factors, generally relating to management failures. In my experience, disclosure rules are of limited value in preventing bank failures. In virtually all cases we have experienced, there has been little warning. All had statements from their certified accountants that the capital requirement was met. On-site inspection remains warranted.

When several banks experience trouble at the same time, losses will generally, as noted by Guitián, mirror developments in the overall economy. There is no way of escaping this fundamental relationship. This applies whether the losses are the result of irresponsible policies or the consequence of a desirable policy action.

High Solvency Requirements Are Key

High solvency requirements are the simplest and most efficient way of reducing the risk of banking problems and limiting the cost of solving problems that arise. Ample capital, well above the legal minimum, enables banks to cover losses in tight economic times without facing insolvency. If a bank should lose a large portion of its capital base and no longer be able to meet the capital standards, it should be merged with a sound bank while there is still sufficient equity to pay for the merger. High capital requirements will contribute to the success of such a policy. Of course, capital cannot be raised overnight and is particularly difficult to raise during times of pressure on the banking sector. Thus, high minimum capital requirements should be put into place at a time when the banking sector foresees good earnings.

Large Costs to the Public

No matter the cause, when credit losses of banks become excessive, public intervention will be called for. Most politicians will agree with the textbook statement that banks, like any other kind of enterprise, should be allowed to fail. This is the way to ensure that banks are disciplined by market forces and thus to strike a proper balance with the moral hazard of government involvement. Deposit protection schemes, supervision, and the existence of a lender of last resort are some of the means to maintain public confidence in the banking sector.

However, when a bank gets into trouble, politicians find it very difficult to accept the consequences of market forces: a too-big-to-fail doctrine has long been accepted. Systemic arguments such as that of domino effects on other banks do not generally apply to smaller banks; nevertheless, in many countries, even small banks may be considered “too big to fail.” Losses to depositors cannot readily be accepted, not even when deposit insurance schemes are fairly generous. In addition, a bank failure implies problems for depositors and debtors in meeting their current payment obligations, a subject I shall deal with later in my comments. Thus, there will always be pressure to save a failing bank.

The expenditures associated with the public saving of a bank can be quite large. Adding together all forms of public expenditure in relation to saving banks in the Nordic countries in the recent past yields figures from 0.4 percent of GDP in Denmark to around 4 percent in Norway and Sweden and 8 percent in Finland. It should be noted, though, that the types of financial support differ from country to country and from case to case. Making loans or issuing a guarantee is different from injecting capital or covering losses with direct transfers. Much of the public outlay seems likely to be recovered in some of the countries.

Focus on Transfer of Loans and Deposits

Bank failures should always carry the full consequences for management and shareholders. A firm exit policy is called for. However, in a difficult economic climate, both depositors and debtors tend to be seriously hit by bank failure. One factor is capital loss; however, increasingly, lack of liquidity is becoming the problem.

The core area of banking is the financing of loans with long maturity out of deposits that may be withdrawn on short notice. But a bank is also a crucial element in a modern payment system. Payments are increasingly made by moving deposits or using credit in banks. If a bank goes into bankruptcy, deposits and credits may be locked for some time. This is increasingly considered socially unacceptable.

Thus, in order to maintain market discipline and let filing banks go down, traditional principles have to be adjusted. A too-big-to-fail doctrine has to give way to a too-important-to-fail policy, with rescue dependent on the overall economic setting. As a consequence, traditional lender-of-last-resort policies of a central bank have to be as flexible as ever.

Efforts should concentrate on transferring the deposits and loans of a failing bank to another bank and allowing the remaining shell to go bankrupt, which can generally be done without major ramifications. If the activities of a failing bank are sold immediately, government involvement can be kept to a minimum. This approach has major advantages because of the potential for conflicts between commercial interests and political constraints.

Among the Nordic countries Denmark has adhered most closely to this strategy, but Finland and Sweden have established bad banks, that is, transferred the bank loans to other institutions. Government involvement would be further reduced as assets of bad banks are sold off to other institutions. However, the size of the bad banks, uncertainty about their value, and potential legal risks tend to reduce the price another bank will pay, and bad banks are therefore still on the government books in all three countries.

The IMF Approach and Banking Soundness

Two mantras of the IMF approach are “a stable economic framework” and “case by case.” It is easy to see how a stable economic framework fits into the lessons from the Nordic experience. Indeed, a stable economic framework is the single most important factor in avoiding major swings in the economy and thus in reducing banking problems resulting from problem loans. In such circumstances, high solvency requirements should in most cases keep banks on the safe side. The more sophisticated elements of the Basle Committee rules may not need to be adopted in all countries.

Problems arise if the economy is out of balance at the outset, which is the case in most of the transition economies and other economies with Fund programs. Economic policies (including monetary policy) usually by necessity create volatility. In the short term, the economy is likely to experience a recession, inflation will fall, and relative prices will change. This is almost a recipe for creating bad loans and banking problems. If an economy is facing major problems, there is little that can be done to avoid banking problems. Postponing or stretching economic reform and possibly pursuing a policy of forbearance vis-à-vis the banking sector is likely only to create subsequent problems. It will create the potential for moral hazard problems by keeping banks that are essentially insolvent alive, and will give rise to large swings in the velocity of money as confidence in banks shifts. Thus, the cost may well be larger than the cost incurred by sticking to a normal pace of economic reform.

The problems of the banking sector must be tackled directly. A preestablished strategy for handling such situations is important, especially ensuring that the necessary legal framework is in place for forcing judgment against borrowers. This approach also involves a strategy for depositors and debtors; that is, establishing the extent to which depositors will be compensated for their losses and how liquidity of part of the deposits can be restored. The strategy should be implemented rapidly so that the economy does not experience a liquidity crunch. The problems and their relative importance will differ from case to case; however, for these countries there seems in most instances to be no choice between banking soundness and appropriate monetary policies.

Concluding Remarks

The relationship between monetary policy and banking soundness should normally be a one-way street. The choice of monetary policy strategy will influence how banking soundness is best achieved. Of course, as part of monetary policy formulation, the implications of the situation in the banking sector should be assessed. However, considerations relating to banking soundness should in most instances not influence monetary policy stance.

Coming back to the beginning of Manuel Guitián’s remarks, you will not be surprised that I would rather change the title to “Banking Soundness: Another Dimension of Central Banking.” This is in no way meant to deny the tremendous importance of establishing a competitive and efficient banking sector and a smoothly functioning payments system. Actually, in the past four years I have spent most of my time on these issues. However, they remain of a different order.

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