Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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In discussing how to keep the banking system sound, Lindgren focuses on four basic areas: bank governance, market discipline, official oversight, and macroeconomic stability. The first three elements are much in the domain of bank supervision, while the last one may be regarded as a prerequisite for banking soundness. In my discussion, I will comment on the first three from the standpoint of a banking supervisor.

Lindgren stresses that the primary responsibility for keeping individual banks sound lies with their owners and managers, and his emphasis on bank governance is well placed. It is generally acknowledged that poor management is the leading cause in most bank failures. In bank supervisors’ language, bank governance is the first line of defense against risks. After all, no outside forces, either market discipline or official supervision, can substitute for bank governance. However, market and official oversight can help foster good bank governance. At a minimum, they should not serve to undermine bank governance. Unfortunately, too often there are forces that are not wholly conducive to providing the right incentive for good bank governance. For instance, certain journals still rank international banks by the volume of their total assets rather than their overall performance, thus providing stimulus for banks to scramble for market share at the expense of prudence. And inappropriately designed lender-of-last-resort and deposit protection schemes more often than not give rise to moral hazard and adverse selection problems, particularly to those responsible for bank governance. In addition, while fit-and-proper testing of owners and managers is a must in the licensing process, it could provide inadequate incentive if it were made a one-time affair. It is more important to ensure that owners and managers remain fit and proper throughout the banks’ operation. One way of achieving this is to have in place clearly specified regulations barring those with a track record of having ruined a bank—either through noncompliance, outright incompetence, or fraud—from employment in the financial industry for reasonably long periods or even for life. I would argue that in the case of state-owned banks, whose managers care more about their positions than profits, such measures add teeth to the fit-and-proper test, although they are expected to work for private banks as well.

Implication of Data Problems

Lindgren brings to our attention the implications of data problems. Owing to the inherently opaque nature of banks’ credit data, outsiders are not able to monitor banks effectively. Adding to this information asymmetry are the negative externalities of a bank’s failure. The cost to society is invariably greater than that to the bank itself. These effects combined carry the seeds for market failure in disciplining banks, thus effectively establishing the public-good nature of banking supervision. And it is well known that in order for the market to work, a well-developed legal framework and clearly defined accounting standards must be in place, just to mention the most important prerequisites. Lindgren is obviously mindful of the limitations of the market in disciplining banks and in forcing exit of insolvent banks, for he recognizes that even in the most advanced market economies there are failures in internal governance and market discipline and that prudential regulation and supervision still have important roles to play to safeguard the soundness of the banking system as a whole. For instance, public disclosure of information, while helpful, may not work if certain conditions are not met. I will come back to this theme later.

This leads to the role of official oversight, which, if appropriate, can complement bank governance and market forces in maintaining a sound banking system. In a system where the majority of banks are not sound to start with and market forces are not developed, official oversight carries a greater share of responsibility than otherwise. Care must be taken, however, not to overregulate or to engage in more stringent supervision than necessary. And in the process, official oversight should try to work through banks’ internal governance and market forces by providing the right incentive structure and avoiding moral hazard and adverse selection problems. These are so well covered by Lindgren that it is not necessary to belabor them.

It is obvious that in order for all forces to work toward maintaining the soundness of the banking system, there must be proper incentives. This is the common theme throughout Lindgren’s paper, even though sometimes implicitly.

Having dealt with those general issues, it is worthwhile to comment on a few specific matters raised by Lindgren, again from the perspective of a bank supervisor. My purpose is not to raise a dissenting voice but rather to add balance and to reiterate some key points made by Lindgren.

Critical Issues

First, I share the view that a strict exit policy is as important as, if not more important than, an entry policy, and that the orderly exit of unsound banks is an effective weapon in the arsenal of bank supervisors. I can testify to this argument, having just witnessed the positive waves caused by the closure of a large financial institution in China. The very possibility of failure removes a long-held belief that no state-owned financial institutions would be allowed to go under. However, an important assumption of Lindgren is that the banking system is sound to start with. While this assumption may be realistic for most advanced market economies, it is a luxury for the emerging-market economies in general, and those in transition in particular. For them, the thorny issue is how to get on to the path of a sound banking system. In such cases, the right approach is to launch bank restructuring, which is a topic beyond his paper and this seminar. But the general issue of forbearance remains valid for our discussion. One can neatly argue in favor of prompt corrective actions against insolvent banks, for it is simple logic that eliminating unhealthy ones would make the average population healthier. However—earlier in the seminar when Mr. Mehran and I were indulging in the medical analogy—the banking profession is not about terminating patients’ banks, it is about how to cure them. And in reality, the distinction between insolvency and illiquidity is blurred by data problems, so one runs into the danger of forcing solvent but illiquid banks into bankruptcy. The argument that to allow insolvent banks to continue operation would only multiply the resolution cost in the long run is a valid one, but in practice this is easier said than done. To carry the medical analogy further, amputating a limb that may be saved is worse than the pain of letting a wound heal gradually. In the context of a transition economy, some banking problems can be traced to inappropriate government policy, such as unjustifiably heavy taxation on banks and inadequate loan loss provisioning rules, or to the customer base—such as the state-owned enterprises. Without addressing these deep-rooted causes, restructuring banks would be a recurring process, for it would be like scratching the boot to relieve an itch on the leg. Inevitably, the answer to the question of whether or not a bank should fail involves a value judgment.

Second, the issue of disclosure has so far been the most controversial of all subjects in banking supervision. Lindgren argues forcefully that effective market discipline requires that financial information be disclosed promptly and that it present a true picture of the value of the bank, based on generally accepted accounting standards and on proper valuation procedures for loan portfolios and other assets and liabilities. I read this as a highly qualified statement. Without generally accepted accounting standards and proper valuation procedures for loan portfolios and other assets, disclosure will not present a true picture of the value of a bank. Particular care must be taken in handling disclosure issues in the case of state-owned banks in transition economies. The unwavering confidence of the general public in such banks is a valuable intangible asset. Inappropriate disclosure may destroy this confidence and even precipitate bank failures. Even if the disclosed information is true, it may be misinterpreted owing to the lack of ability on the part of the general public to interpret such information. Here again one runs into a public good—the processing of certain bank information may incur economies of scale and therefore is best performed by bank supervisors on behalf of the public. Lindgren’s dissatisfaction with the track record of external auditors in disclosing bank problems reinforces this point, but this is not to say that disclosure should be abandoned altogether. Certain qualitative information—such as a bank’s license and credit rating, if any—can and should be disclosed, just as certain aggregate information should be disclosed by the supervisors for peer comparison. Disclosure is a double-edged sword and can work miraculously if skillfully used.

Third, I could not agree more with Lindgren when he advocates the need for strong banking supervision. He rightly says that the supervisory authority should have sufficient capacity, authority, and independence. Now that risk-based supervision, rather than the traditional concentration on compliance, is seen as crucial in maintaining bank soundness, a strong and competent banking supervisory authority is extremely important in all types of economies. With respect to China, this means streamlining the supervisory structure, compiling prudential regulations, reinforcing the traditionally strong on-site examination army, and building up a modern off-site surveillance system. But above all else, the training and retaining of qualified bank supervisory staff is an urgent and most challenging task. After all, as was said during the recent ninth International Conference of Banking Supervisors, bank supervision can be only as effective as the supervisors.

Let me conclude by saying that the credibility issue is a very real one for bank supervisors, just as it is for monetary policy. As in the case of macroeconomics policy, optimal supervisory policy is “time-inconsistent,” to borrow academic jargon. Even if announcements are made ex ante that unsound banks will not be bailed out by the authorities, market participants know that once a bank gets into trouble, it is not optimal for the authorities to stick to the preannounced policy. This gives rise to moral hazard problems, and it points to the need for rule-based supervision and for taking discretion power out of the hands of the bank supervisors to the extent possible. Recognition of the credibility issue should help bank supervisors think twice before reneging on their commitments and should strengthen their determination to build up a track record.

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