Financial Risks, Stability, and Globalization
Chapter

1 Financial Risks, Stability, and Globalization Overview of Issues and Papers

Author(s):
Omotunde Johnson
Published Date:
April 2002
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Among the major objectives of public policy worldwide have been financial system stability and efficiency. Several experiences of financial crises in the 1990s have reinforced the view that, in the design and implementation of policies for effective macroeconomic management, it is important to pay serious attention to risk, efficiency, and governance in financial systems and markets.

For instance, the manner in which the payment system works has importance for the financial sector as a whole—for it influences the speed, financial risk, efficiency, and reliability of domestic and international transactions. The payment system also acts as a conduit through which financial and nonfinancial firms and other agents affect overall financial system stability. Moreover, the payment system affects the effectiveness of monetary policy, including via its impact on the transmission process in monetary management, the pace of financial deepening, and the efficiency of financial intermediation. Thus, monetary and financial sector authorities have typically been active in promoting sound and efficient payment systems and in seeking ways to reduce related systemic risks.

Similarly, recent experience has brought home the importance of the links between banking system soundness and the effectiveness of macroeconomic policy, particularly monetary policy. A sound financial system will contain, predominantly, banks with adequate capital to withstand the most probable adverse shocks, and will have staff skilled in assessing conditions and coming up with solutions to manage liquidity, credit, market, and other risks. Hence, as part of improving the functioning of the financial system, measures are often taken, where deemed necessary, to strengthen the banking system. Such measures could, for example, involve strengthening licensing and reporting requirements as well as the regulatory and the official banking supervision framework; and developing and maintaining a strict exit policy in order to weed out weak banks on a timely basis. In the process, particular attention may need to be paid (within individual banks) to reducing the stock of nonperforming loans and also to improving risk management methods and procedures, internal controls, auditing and accounting, and operational efficiency. Thus, a concern for enhancing the effectiveness of monetary policy leads quickly to an interest in policies to promote banking system soundness.

Such considerations have led to a number of initiatives in recent years, at both the national and international level, and some of these initiatives have reinforced earlier actions in the same direction. In particular, there have been, and continue to be, concerted efforts to (1) better understand financial risks; (2) provide, in socially efficient ways, appropriate incentives to the private sector, including via the regulatory environment, to contain the financial risks; (3) develop early warning signals of financial crises; (4) introduce policies to protect the economy against instability arising from capital mobility; (5) design efficient policies to dampen the macroeconomic (and indeed welfare) effects of crises; and (6) build international consensus on a broad range of standards, which would promote financial stability, to be met by financial firms, systems, and regulators. These issues are quite complex, and their diversity has tended to bring together individuals and organizations with many different interests and specialization. The seminar participants whose proceedings are being published in this volume reflect this diversity. The book, thus, focuses on risk management and governance in financial institutions, financial crises and contagion, selected policy issues, and international cooperation.

Stanley Fischer, the IMF’s First Deputy Managing Director at the time of the seminar, sets the tone in his opening remarks by describing the IMF’s changing role in the financial sector, indicating the growing importance of international standards in this area, and touching on a number of other issues that the IMF and its members are addressing as understanding of the central role of the financial sector increases. Fischer notes that the crises that swept emerging market nations in recent years left no one in any doubt about the importance of a strong and well-regulated financial sector in dealing with cross-border capital flows. In reexamining the IMF’s proper role in the wake of these crises, he thinks it fair to ask how the institution should incorporate structural and other policies into its normal activities without moving too far away from its central mission in macroeconomic policy. Fischer underscores the rationale for the IMF’s involvement in financial sector issues: namely, that the effectiveness of IMF-supported economic policies depends enormously on the state of the financial sector.

Risk Management and Governance in Financial Institutions

Section II of the book includes four papers on selected issues in risk management and governance in financial (mainly banking) institutions. Two of the papers are on broad topics that are currently widely debated, namely (1) internal rating models and processes of banks, and (2) how to balance alternative approaches to regulation and corporate governance in financial firms. The third paper addresses a much narrower technical issue, namely, the measurement of credit exposure when credit quality is correlated with market prices, an issue of importance in the measurement and management of credit risk. The fourth paper highlights the role and perspective of insurance in the development of financial services.

Internal Processes

Bank regulation and supervision in the traditional sense establish uniform prudential rules and guidelines for financial firms of a certain type. These rules and guidelines are typically stated as minimum requirements, and individual institutions can adopt, if they so wish, rules and guidelines that are somewhat stricter. An issue worth attention arises when the financial firms (banks in the case of bank supervision) find the minimum standards set by regulators too high, unnecessary, and rather costly to meet.

In particular, with regards to capital requirements to meet credit, market, and other risk categories, the amount of total capital that is optimally desired will depend on the risks as properly measured. Hence, one may question whether a standardized approach to minimum capital requirements makes sense or whether instead each financial firm should be given the opportunity to develop its own internal solutions (taking into account its particular circumstances), which could, among other things, be used in setting the regulatory minimum capital applicable to each financial firm.

A difficulty, perhaps, is that the consensus to “a” standardized approach can be said to be evolving under the institutional and organizational framework of the Basel Committee on Banking Supervision, but internal rating models and processes are being developed by banking firms themselves. Luckily, the models are all influenced by a common analytical base in finance theory and financial economics.

In Chapter 3, David Stephen and Michael Fischer describe internal rating processes and models at Credit Suisse/First Boston (CSFB) and the issues that CSFB has faced in design and implementation. They note that the most important objective of internal models is to provide banks with a sound basis for determining the level of risk and the creditworthiness of each counterpart. In their view, internal rating models should foster consistency, transparency, and objectivity in credit ratings. An appropriate risk management system could comprise quantitative models as key elements of a process (building databases; validation and benchmarking; testing; and maintenance, review, and audit).

A number of issues come up in any discussion of the use of internal models versus the use of a standardized framework (particularly one developed via international consensus), and these issues also were raised in the discussion of the Stephen-Fischer paper. (See, for example, the comments of Huw Evans and Paolo Marullo Reedtz.) Importantly, banks must have adequate resources (analytical capacity, database, and infrastructure) if they want to develop and maintain internal rating models and processes that regulators can trust for use in setting minimum capital requirements. An implication, perhaps, is that use of both a standardized approach, on the one hand, and internal models and processes, on the other, could work together in setting regulatory capital requirements within a given country. That is, in the case of some banks, use of their internal ratings and other internal information systems could greatly assist supervisors in tailoring capital requirements more closely to the actual risks faced by the banks in their activities.

As emphasized by participants at the seminar, as far as the banks’ own credit systems are concerned, whatever the nature of the modeling, credit culture is important. A “good” credit culture can work well even with the use of simple models. Indeed, the evidence of some recent crises indicates that many banks that did not get into serious financial trouble used very simple but sensible rules in making credit decisions.

To facilitate satisfactory supervisory assessment of internal rating systems, appropriate methodologies and procedures must be developed. For this and other reasons, there is a view that the banks and the supervisors concerned need to agree on the appropriate “backtesting” (both techniques and frequency) of internal models.

Internal rating systems often use the rating systems of major international rating agencies as benchmarks. Hence, the two sets of ratings could have similar strengths and weaknesses. But Stephen and Fischer, in their response to criticisms of Evans and Marullo Reedtz (see their comments), underscored that the international rating agencies have good information (including what may be considered inside information), which helps make their ratings valuable as benchmarks. Even more relevant, the internal rating models of CSFB may replicate the ratings of the international rating agencies but CSFB’s final internal ratings are not necessarily the same as those of the international rating agencies. The final ratings affect credit decisions at CSFB.

Chapter 4 turns to the important issue of credit exposure when credit quality is correlated with market prices. This correlation between market and credit risk could give rise to what is dubbed “wrong-way exposure” in the paper by W. Trevor Uhl and Charles R. Monet, indicating a negative correlation between the counterparty’s exposure size and credit quality (that is, exposure increases at the “wrong” time). Note that in a “right-way” relationship the expected exposure would increase as the creditworthiness of the counterparty improves. Uhl and Monet model market and credit risk in an integrated fashion—expected exposure is estimated conditional on counterparty default—in order to have better estimates of the amounts exposed to counterparties. For those unfamiliar with the research in this area, the comments by Jeffrey A. Brown and Liliana Schumacher are extremely useful in clarifying major technical points of the Uhl and Monet paper.

A solution to the problem addressed by the Uhl and Monet paper is important for the pricing of risk: the pricing of wrong-way deals should be adjusted to account for the much higher credit exposure. Related to this, it is also important for determining capital adequacy in a case where a firm deals in swaps, forwards, and other derivative contracts. Hence, for these types of contracts both regulators and developers of internal rating processes recognize the need for capital requirements to reflect the impact on credit exposure of market forces. The seminar participants agreed that this was an area requiring a lot more research to arrive at a more general theoretical approach than the one contained in the Uhl and Monet paper.

From a practical perspective, there was some interest in how wrong-way credit exposure was (or could be) incorporated in the internal rating process. Stephen and Fischer gave an example of an approach that CSFB had found useful. The approach involved identifying cases in which wrong way exposure was likely to occur and then micro managing the credit process in such cases. This, in turn, implied restriction of credit and greater monitoring and collateralization.

Regulatory Regime and Strategy

An important general concern of public policy is having in place an appropriate regulatory regime and a consistent regulatory strategy to promote safety, efficiency, and stability in the financial system. Such a regime, among other things, will balance regulatory rules, supervisory review, and market discipline. One natural approach is to begin with a view of the components of a regulatory regime and to think of them as inputs to be combined in an optimal way to design and implement an appropriate regulatory strategy.

This is essentially David Llewellyn’s approach in Chapter 5. He argues that there are seven major components of a regulatory regime and the objective of public policy should be to optimally combine these components to design and implement an appropriate regulatory strategy. The seven components are (1) rules established by regulatory agencies; (2) monitoring and supervision by official agencies; (3) the incentive structures faced by regulatory agencies, consumers, and banks; (4) market discipline and monitoring; (5) intervention arrangements in the event of compliance failures; (6) corporate governance arrangements in financial firms; and (7) the disciplining and accountability arrangements applied to regulatory agencies. Llewellyn stresses the complementarity of the seven components and argues that the optimum mix would change over time as market conditions and compliance culture change.

Within the regulatory regime, trade-offs emerge at two levels. First, in terms of regulatory strategy, a choice must be made about the balance of the various components and the relative weights. Second, there are trade-offs relating to how the components of the regime may be causally related. For instance, while regulation may be viewed as a response to market failures, weak market discipline, and inadequate corporate governance arrangements, causation may also operate in the other direction so that these other mechanisms weaken in tandem with increasing emphasis on regulation.

Llewellyn argues that several problems emerge with a highly prescriptive approach to regulation. For example, the risks under consideration may be too complex for simple rules; prescriptive rules may prove inflexible and not sufficiently responsive to market conditions; and the rules may have perverse effects in that they are regarded as actual rather than minimum standards. He stresses that a central issue is the extent to which regulation differentiates between different banks according to their risk characteristics and their risk analysis, management, and control systems.

With respect to incentive structures, Llewellyn argues that a central role for regulation is to create appropriate incentives within regulated firms so that the incentives faced by decision makers are consistent with financial stability. At the same time, regulation should refrain from blunting the incentives of other agents (such as rating agencies, depositors, shareholders, and debt holders) that have a disciplining role vis-à-vis banks.

An important theme of Llewellyn is that regulation can never be an alternative to market discipline. On the contrary, regulation needs to reinforce, not replace, market discipline within the regime.

On the question of intervention by regulatory agencies in the event of either some form of compliance failure within a regulated firm, or when financial distress occurs with banks, he argues in favor of a rules-based approach to intervention rather than discretion.

Given the broad scope of the paper and the clarity with which the ideas were presented, Llewellyn’s paper attracted much debate along familiar lines. All in all, the participants agreed that regulators should not rely solely on rules, as market discipline was often at least as important as—and sometimes even more so than—regulation. Not surprisingly, the debate over the issue of how quickly the scales should be tilted in favor of market discipline, if at all, was spirited but with no clear consensus, reflecting the diverse circumstances of countries, especially with respect to the development and sophistication of their markets and market processes. As Llewellyn notes in his paper, market discipline works effectively only on the basis of full and accurate information disclosure and transparency. In addition, one could probably posit that the more sophisticated the pool of those who could monitor the management of banks and other financial firms—namely owners, bank depositors and customers, rating agencies, and other banks in the market—the more effective one would expect the forces of market discipline to be. On the other side of the coin, and reinforced in the context of the discussion of Edward J. Kane’s paper (Chapter 11), participants agreed that regulators must be made accountable so that their decision making truly reflects the public interest. Hence, the incentive structure within regulatory agencies is very important.

How one determines, in practice, the balance between regulation, on the one hand, and market discipline, on the other, was of major interest among the participants at the seminar. Some participants noted that, at the same time that countries around the world were beginning to emphasize the important role of market discipline for good governance in financial institutions, public authorities around the world—as well as the activities of international organizations in their standard-setting activities—were stressing regulatory rules, standards, and codes. In the end, participants agreed with Llwellyn that the relative weights will indeed vary from one country to another, depending on their particular circumstances. Some of the determining factors are the available expertise within banks and within regulatory agencies, the nature of the risks faced by the banks in the system, and the relative efficiency of domestic markets.

Insurance

Section II ends with a fourth paper on a frequently neglected sector in the discussions on risk measurement and management: the insurance industry. In that paper, originally delivered as a luncheon speech, Orio Giarini underlines the importance of the insurance industry in the financial sector—in risk management and risk transfer. He notes that governments have increasingly come to realize that promoting an efficient private insurance system is important in ensuring a sound financial system.

Financial Crises and Contagion

Financial crises, as Koichi Hamada states in Chapter 7, are sudden and precipitous movements of financial variables, especially those movements that are unexpected and unidirectional. Financial crises and the way in that they relate to financial risks are of great interest to policymakers: the crises have welfare effects and public policy initiatives could help reduce the financial risks in the system. The private sector also is interested in financial crises and how they relate to both financial risks in the system and the public policy initiatives and measures to contain those risks and to address emerging financial crises.

Welfare Costs

Section III contains two papers that illustrate some of the important and interesting issues that arise in the context of financial crises and contagion. One paper discusses the welfare costs of systemic risk, financial instability and financial crises, while the other paper gives one private sector perspective on assessing the ability of a financial system to withstand stress.

Koichi Hamada, in his paper on the welfare costs of systemic risk, financial instability, and financial crises (Chapter 7), demonstrates the immense difficulties in trying to be concrete and precise and the consequent dilemma faced by public policy. He illustrates, under some simplifying assumptions, that the welfare loss (especially in terms of output and employment) from a systemic crisis will depend on the probability of the crisis occurring, the duration of the crisis, the recovery rate of defective claims and other damages, and the availability of facilities to dampen the disruption (such as lender-of-last-resort facilities). Pointing out that the welfare cost of a financial crisis would depend on the monetary regime, Hamada proceeds to give a brief and general description of how to look at the welfare costs of financial crises under different monetary regimes and “situations” that are currently highly topical, including currency board and dollarized systems. His underlying message is that there are opportunity costs of adopting a particular monetary regime. The implication is that in assessing the welfare costs of financial crises, countries should try to isolate those costs traceable to the monetary regime they choose.

As Johnson points out in his comments, the welfare costs of financial crises would depend on other country-specific factors as well, such as the degree of integration in financial markets, interlinkages in the payment system, and concentration in the financial sector. In addition, the interaction of these factors with the degree of liberalization in financial markets, including international capital mobility, in determining the probability and severity of financial crises for any given set of preventive measures is also a constant issue for public policy. Johnson goes on to elaborate on a public policy challenge in this area—namely, to design policies that are welfare-enhancing both to reduce the risks and to contain any financial crises that nevertheless emerge.

In his comments, Heikki Koskenkylä uses the example of Finland to give a useful discussion of some measurable contributors to the welfare costs (namely, lost output, increased unemployment, and public sector financial support). But he notes that these are not necessarily the net costs to the economy. Because of the prompt and stringent policies applied in the case of Finland, the economy started a process of restructuring; it received a real boost from the crisis. Hence, for instance, the efficiency of the entire corporate sector has improved enormously. Without implying that the crisis did not have a real cost to the economy, Koskenkylä’s major point is that the net cost of the crisis to the Finnish society was much less than the “gross” figures indicate.

Koskenkylä’s last point provoked a lot of discussion at the seminar. Participants agreed with the need for caution in estimating net costs of financial crises. Indeed, it was suggested by some participants, in line with Koskenkylä’s points, that some of what appears as costs can be seen as investments. For example, troubled banks typically can place the blame on distortions and misallocation of resources; the policies and some of the gross costs are designed to improve resource allocation and productive investments in the future. The weeding out of inefficient banks and enterprises could also be viewed as a kind of “creative destruction” process.

For many participants, Koskenkylä’s point underscored the role of prompt and sensible public policy response to financial crises. Participants concurred that, given the potential welfare costs of financial crises, countries should build up their capacity to sense areas of vulnerability and to develop measures for handling crises as they arise, in order to reduce the severity and duration of the crises. The need for vigilance was perhaps most critical for banking system crises, which can be especially serious and often result from major reallocation of resources associated with social costs that were not easily recoverable. In addition, financial crises often result from macroeconomic shocks with adverse effects on real output that, in turn, provoke the financial crises with which the authorities must wrestle.

Vulnerability to Stress and Banking Crisis

From a private sector perspective, Christopher Mahoney argues, in Chapter 8, that there are four factors that could help identify vulnerability to stress: systemic insolvency (the proportion of a system’s banks that are insolvent); lack of accounting transparency (opaque or bogus accounting); poor quality of supervision (lax supervision); and funding instability (excessive reliance upon hot money or noncore funding). He argues that those four factors are necessary but not sufficient to cause banking crises. These four factors plus two additional ones—(1) the abrupt introduction of credit risk, via market discipline, into a weak but previously riskless financial system, and (2) an external payments crisis—would be sufficient to cause banking crises. The situation is aggravated when the two latter factors coincide. Indeed, he argues that lately the introduction of market discipline has often tended to coincide with external payments crises.

From Mahoney’s perspective, market discipline should come after a period during which prudential supervision has resolved the system’s solvency and transparency problems and not before. He concludes that, to avoid crises, policymakers should avoid the introduction of market discipline at a time when the banking system is under pressure. Policymakers should also take steps to reduce their economy’s vulnerability to external pressures. In this context, he argues, the appropriateness of macroeconomic policy and the adequacy of a country’s liquidity position are critical.

While agreeing with Mahoney’s four factors for assessing the vulnerability of financial systems to stress, Lex Rieffel, in his comments, adds two more—namely, management style and the macroeconomic environment. More importantly, perhaps, he takes issue with the two conditions identified by Mahoney as sufficient to cause banking crises. Rieffel argues that there are many more than two things that are sufficient to cause the loss of confidence that produces a financial crisis. More of these factors may be political rather than economic. As Rieffel puts it, “a crisis starts when someone ‘pulls the plug.’” For instance, the government may decide not to tolerate loose lending practices or foreign creditors may decide that a boom is coming to an end. By implication, proactive investor relations programs explicitly designed to detect signs of anxiety among investors and lenders and to provide information that help sustain their confidence may be of great value to countries that rely substantially on flows of private capital to finance their growth.

Another discussant, Charles Enoch, also takes issue with Mahoney’s main argument regarding the sufficient conditions for financial crisis and notes that a policy prescription of Mahoney’s analysis would be that countries are urged to be very cautious in liberalization. For instance, for Enoch, it is difficult to argue that, among the transition economies, those that liberalized furthest and fastest experienced the biggest banking crises. More generally, he says, in a world where countries must be able to demonstrate macroeconomic flexibility (for instance, in response to external shocks), having a weak and unliberalized banking system is not going to be helpful. He believes that national authorities cannot—and should not try to—protect themselves against banking crises by proceeding slowly with liberalization. Liberalization and globalization are with us for good, unless a country takes a very different route and cuts itself off from the major trends in the world economy. This makes it all the more urgent that, where relevant, countries accelerate efforts to improve accounting standards, quality of supervision, and legal reform. These infrastructural developments are no longer technical afterthoughts; they are now central for economic policymaking. Finally, Enoch suggests an additional element beyond those identified by Mahoney in assessing the ability of a financial system to withstand financial stress—namely, use of macroprudential indicators (see Chapter 18).

Others expressed concerns during the seminar on market discipline and Mahoney’s critique of it. There was a view that, perhaps, there was no real disagreement because Mahoney’s criticism was directed at the “injudicious” introduction of market discipline, which would merely imply that in the transition to market discipline, sequencing and timing should not be ignored and require careful analysis. The analogy with discussions of capital account liberalization was noted. In line with Enoch’s comment, some argued that it would be a mistake to propose that market discipline is an independent cause of financial crises. It was also remarked that the problems of the banking system often originated from fundamental (including structural) problems in the real sector. Hence, there was no point introducing market discipline or other measures to address the problems of the banking system without also introducing reforms in the real sector. Another interesting view expressed during the seminar was that the activities of rating agencies—considered important agents of market discipline—sometimes could provoke or aggravate a financial crisis by revealing damaging information, especially downgrades of a country’s banks, thereby causing panic.

Domestic Monetary and Financial Policy Issues

A number of domestic policy issues related to financial system stability are addressed in this volume. In particular, there are issues related to monetary and financial policies to prevent crises (including those that arise as a result of capital mobility), early warning signals to policymakers of emerging crises and the value of prompt response, capital forbearance, and fiscal support for banks during crises.

Monetary and Financial Policies

In Chapter 9, Andrew Powell argues that emerging market economies should pursue safety-first strategies in their monetary and financial policies. He examines three important policy areas—namely, exchange rate regimes, liquidity policies, and banking sector policies—to illustrate the implications of a safety-first strategy. In each case, he describes how Argentina is effectively applying such a safety-first approach.

As regards exchange regimes, he contends that the state of the current debate on exchange rate arrangements appears to remain as controversial as ever. He argues that one way forward to obtain a safety-first strategy—which at the same time would be acceptable to the world community—would be to take seriously the view that the choice of exchange rate regime should remain the choice of the country and that a set of supporting policies or “standards” should be adopted depending on that choice. This approach would involve establishing a set of guidelines to rule out inconsistencies between the exchange rate system and the monetary rule (or other aspects of policy). According to Powell, an obvious starting point would be the well-known one that countries can only choose between two of the following: (1) a fixed exchange rate, (2) an independent monetary policy, and (3) an open capital account. In addition, he discusses a more controversial proposal that, at least for countries with small and poorly developed domestic capital markets, there is a potential inconsistency between (1) floating exchange rates, (2) independent monetary policy, and (3) open capital accounts.

Powell contends that, especially because they face a tighter tradeoff between monetary and financial stability, emerging market economies should consider establishing a systemic liquidity policy regardless of the exchange rate regime. For instance, a systemic liquidity policy could entail a rule that foreign reserves cover public sector debt coming due within one year, 100 percent of base money, and 20 percent of bank deposits. Since liquidity shocks are not perfectly correlated across countries, efficiency could be enhanced by having multilateral agencies (especially the IMF) complement liquidity policies.

As regards banking sector policies, Powell discusses the BASIC system of banking sector oversight pursued in Argentina. BASIC itself stands for Bonds—that is, the obligation of banks to issue bonds as specified by regulation, forcing them to the market and subjecting them to ratings and analysis by investors—(external) Auditing, Supervision, Information, and Credit rating. With respect to information, the Central Bank of Argentina, for instance, publishes every month the balance sheets, performance ratios (including earnings, costs and efficiency, and details of nonperforming loans), regulatory ratios (including provisioning, capital, and liquidity positions), and other relevant information for the banks in the system. In the case of credit ratings, banks are currently required to obtain one rating, which should come from an authorized international rating agency.

Role of the Central Bank

Malcolm Knight, in his luncheon speech published here as Chapter 10, discusses the role of the central bank in fostering financial system stability, in general, and the experience of the Bank of Canada, in particular. He differentiates four types of policies for creating the appropriate framework for financial system stability—namely, (1) a policymaking authority that develops and implements the framework of laws and regulations governing the operation of the financial system; (2) a supervisory authority; (3) a system (typically a deposit insurance system) that limits risks to retail depositors without creating generalized guarantees; and (4) a central bank to act as monetary authority and lender of last resort to the financial system. In Canada, the Department of Finance is responsible for policymaking; the Office of the Supervisor of Financial Institutions is the supervisory authority at the federal level; the Canadian Deposit Insurance Corporation manages the deposit insurance system; and the Bank of Canada is responsible for monetary policy, the lender-of-last-resort function, and oversight of systemically important clearing and settlement systems.

Capital Forbearance

Several policy issues arise with respect to optimal intervention in the face of financial crises, and recent experience indicates that the design of intervention policies can be quite complex. As Llewellyn, for instance, argues in Chapter 5, the way intervention is conducted in the event of bank distress (e.g., whether or not forbearance is permitted) may have adverse incentive effects on the behavior of banks and the willingness of markets to monitor and control banks’ risk-taking. Apart from such well-known moral hazard, intervention in the event of crises can entail significant budgetary costs, as illustrated by Koskenkyla for the case of Finland. Keeping in mind the importance for policymakers to promote social efficiency, Chapters 11 and 12 address some broad analytical issues related to the policy stance on forbearance and fiscal support.

We have already indicated that Llewellyn argues in favor of rules as opposed to discretion in such decision making: this would mean that, in the event of bank distress, intervention should be circumscribed by clearly defined rules, leaving intervention agencies with no discretion about whether, how, and when to act. Edward Kane’s paper (Chapter 11) seems to support the view that capital forbearance should not be tolerated as a rule. Kane begins by reviewing the costs and benefits that fully informed creditors would consider in deciding whether to recapitalize or liquidate an insolvent corporation. The greater the cost of identifying and contracting with an effective set of managers to take over the firm, and the greater the opportunity cost to creditors of reoptimizing their portfolios to accommodate or eliminate their liquidity claim on the restructured enterprise, the greater the chances that closure and liquidation may be the best option for the creditors. But there are also costs to liquidation. In particular, the greater the transaction costs of liquidating the firm’s tangible assets and the greater the intangible going concern value that would be sacrificed in closing the firm, the more likely the chance that the recapitalization option is superior.

Kane goes on to identify the additional concerns and conflicts of interest that incompletely informed taxpayers face when government regulators with short horizons manage the insolvency of giant banks. In this context, regulatory decisions may exhibit dynamic inconsistency because opportunistic forbearance offers personal and bureaucratic rewards and officials who confront bank insolvency in a timely way are threatened with substantial reputational and career penalties. In that case, the socially optimal takeover point, which should be the one guiding regulators, would be replaced by the “incentive-conflicted takeover point” that incorporates the influence of regulators’ private interests. The model also indicates that dynamically inconsistent capital forbearance could emerge because current taxpayers believe they can shift the costs of resolving bank insolvencies to future taxpayers.

Tomás J. Baliño, in his comments, argues that there have been many cases where the authorities have justified a government takeover and the provision of public funds with the argument that otherwise a large bank would have been closed, with ensuing large social costs. But there have not been many cases of creditors agreeing to take over and restructure a troubled bank. There could be many reasons for such differences in behavior, and an incentive-conflicted maximization process of the government agents is only one. Other reasons include the possibility that transactions costs are prohibitively high for the private sector; the government incorporates social benefits that the private creditors ignore; the government has superior information regarding the bank’s true prospects; or the risk preferences or rates of discount between the government and the private sector differ. In addition, in grave crisis situations requiring prompt action, the regulator, being less risk averse and perhaps having better information than the creditors, can act more rapidly and increase social welfare.

The comments of Baliño and others in the seminar discussion point out that there are many factors operating to control any incentive-conflicted behavior that has adverse effects on social welfare. The value of the human capital of government agents would suffer if problems emerge in banks under their supervision, even if this happens after they have left public service. Also, in today’s world, there are strong forces in favor of enhanced transparency and data dissemination standards that would, for example, impel revelation of banks’ true condition and the government’s liabilities. Such disclosure can result in pressures on regulators to act more in the interest of social welfare in assessing pleas for forbearance.

In his comments, Andi Kloefer also indicates that Kane’s concerns, although legitimate, may be exaggerated in the real world—at least in major market economies. Kloefer argues that one of the pillars of a market economy is the fact that entrepreneurs, including owners and managers of banks, are personally responsible for their business activities. However, it is also the case that banks, as financial intermediaries and providers of financial services, play a special role in an economy. But this special role does not mean that bank boards can count on government support in emergencies. Bank supervisors, he argues, must at one and the same time try to prevent bank insolvencies from having serious adverse systemic effects and avoid the moral hazard problems of bailing out banks.

One issue discussed was whether making clear (probably even via legislation) the responsibility of the public sector during financial crises could help bring any incentive-conflicted solution to capital forbearance toward the social optimum. Kane’s view was that increased accountability helps but an approach such as imposing legislative restrictions on the public sector’s role would not really solve the problem and rather would merely be a mitigating factor. Moreover, he argued that accountability resistance existed and hence the likelihood of seeing such an approach adopted was, in any event, small. Nevertheless, in this context and in the discussion of the paper by Hiroshi Nakaso (Chapter 13), some participants expressed the view that having clearly defined responsibilities among the agencies responsible for regulation and supervision was an important component of the institutional framework for promoting financial stability.

Fiscal Support

The complex issues in the area of fiscal support are the subject matter of Timo Välilä’s paper (Chapter 12). He surveys the main analytical issues related to fiscal support in financial sector restructuring and illustrates his analysis by discussing the recent experience of the Republic of Korea and Thailand. He underscores the fact that a restructuring operation similar in magnitude to those in the Republic of Korea and Thailand can have far-reaching implications for fiscal policy. Most notably, the elimination of the debt stock arising from the restructuring operation could necessitate, other things being equal, a significant fiscal adjustment effort for some time to come. For the

Republic of Korea and Thailand, however, the improvement in economic conditions following the resolution of the crises should contribute significantly to a strengthening of the fiscal position, thus lessening the need for active fiscal policy measures to generate primary surpluses. Välilä argues that the main role of fiscal policy in financial sector restructuring is to extend financial support in a cost-effective, efficient, transparent, and equitable way so as to minimize the risk of having to deal with moral hazard problems in the future. Fiscal support could be extended using balance sheet and/or income support instruments, the former being preferable on transparency and efficiency grounds. The use of fiscal instruments should preferably be accompanied by operational and structural reforms aimed at addressing underlying problems.

Jong-Koo Lee, in his comments, elaborates on the financial restructuring process in the Republic of Korea, including the difficulties faced. As in the case of Finland, he argues that the economy has responded well and that the fiscal and other public sector costs are therefore not going to be burdensome. Among other reasons for this success is that the Korean authorities have taken the crisis as an opportunity to push through much needed market reforms.

Early Warning Signals and Prompt Response

Japan was one of the countries that experienced a banking crisis in the 1990s. In Chapter 13, Hiroshi Nakaso outlines some important features of Japan’s financial crisis (which lasted with various degrees of severity for most of the 1990s), the factors behind the crisis, and the conclusions and lessons that he (and some of his colleagues at the Bank of Japan) had drawn for early warning signals of banking crises. He also describes the evolution of the resolution strategy in Japan, with special emphasis on the role of the central bank and the government. A central argument of his presentation is that, in addition to general economic and market indicators, bank behavior can provide early clues to the development of problems in the financial sector. For instance, the deposit-taking institutions’ funding behavior clearly changes as a crisis deepens.

According to Nakaso, the evidence from Japan’s crisis supports the hypothesis that the institutions would tend to go through four stages in a developing crisis. In stage one, market participants and large depositors would charge risk premiums in dealing with troubled institutions. In stage two, as information spreads, troubled deposit-taking institutions would face higher rates and shorter maturities. In addition, providers of funds in the market would avoid making long-term deposits in deposit-taking institutions. In stage three, providers of funds would begin to refuse further credit to troubled deposit-taking institutions and even small depositors would begin to lose confidence such that core deposits become depleted. The deposit-taking institutions then would begin recovering or selling loans and securities and the market would begin to ask for additional collateral. In stage four, the troubled institutions would become unable to obtain negotiable large-lot time deposits and the run on deposits would accelerate. The institutions would then turn to the market even more as selling of assets no longer sufficed. Once an institution could no longer raise funds (especially overnight) in the market, it would face imminent failure.

In her comments, Barbara Baldwin argues that a risk-focused bank supervision framework that is forward-looking can be an important component of an early warning system. Risk-focused supervision requires the supervisor to make qualitative assessments and develop a thorough understanding of a bank’s risk profile and risk management capabilities. Forward-looking and proactive, risk-focused supervision also requires flexibility in supervisory program design. The approach, in brief, involves identifying different categories of banks and then developing supervisory programs tailored to the specific needs of each category. Statutory supervisory requirements must be sufficiently flexible to accommodate such an approach. Nakaso explained that, with their experience in the 1990s, he and his colleagues at the Bank of Japan probably have a greater appreciation of risk-focused supervision now as compared with the 1990s.

Ceyla Pazarbaşloğlu in her comments, and others in the discussion, noted the common thread of the Japanese financial crisis with the Nordic ones although the Japanese crisis had been more protracted and costly. Apparently this was due to a slow response of the authorities to the emerging crisis. Nakaso, in his paper, outlines four reasons why the authorities were so slow to respond in a concerted way, namely: (1) no one expected that land and stock prices would fall so sharply and continuously but rather there was a vague expectation that the drop in asset prices would soon stop once the economy picked up; (2) there was inadequate public disclosure of the gravity of the situation because of a fear of social unrest, given that the Japanese public was not used to financial disruption; (3) there was fear that if a deposit-taking institution failed it could have led to contagion in a situation in which the resolution framework was insufficient and the human resources for crisis management limited; and (4) due to insufficient infrastructure with respect to accounting, public disclosure, and corporate governance, market discipline did not function effectively.

Capital Mobility and Financial System Stability

An area of public policy that has become increasingly important with so-called globalization is that of international capital mobility and financial system stability. The paper by V. Sundararajan, Akira Ariyoshi and İnci Ötker-Robe surveys a number of issues related to this subject matter. The basic message is that capital mobility has major implications for financial system stability. Capital mobility has a positive impact on financial market development: among other things, it improves the menu of investment outlets available to suppliers of funds while users of funds have access to cheaper and more sophisticated financing, and it expands the opportunities for portfolio diversification. At the same time, capital mobility complicates risk management for individual financial firms, makes macroeconomic management more challenging, and fosters financial integration, which increases the risk of cross-border contagion. The authors explain that, in order to address the complications, two fundamental policy responses have been found useful. First, the macroeconomic policy framework (most notably monetary and exchange policies) must be appropriately designed and tailored to meet the circumstances. This framework must be supported by appropriate institutional measures and reforms in other areas. Second, a strong prudential framework should be developed to help ensure a sound financial sector and a high standard of risk management.

On the question of capital controls to supplement the above two fundamental responses, the authors argue, first, that country experiences show that for those countries with substantially liberalized capital transactions, the ability of selective capital controls to provide monetary independence was limited. Second, reimposition of capital controls also appears ineffective in preventing large-scale outflows that precipitate financial crises, especially when the reversals reflect unsustainable macroeconomic policies. When comprehensively applied, it might be possible for outflow controls to provide a temporary breathing space during which to address weaknesses and to stabilize expectations. This assumes that the breathing space provided is used effectively; but if this is not the case, the result instead would become a delay in the implementation of corrective policies, increasing the costs associated with the crises. The imposition of controls, among other things, could also have a chilling effect on investor confidence.

As regards the use of capital controls to discourage inflows and reduce the probability of excessive risk-taking, the authors argue, first, that as far as external borrowing by banks is concerned, effective prudential supervision should be able to contain risks and capital controls may not be necessary. Second, they argue that when capital controls are used experience indicates that controls need to be broad-based and adjusted continuously to prevent circumvention.

While agreeing with much of the substance of the paper by Sundararajan and others, the commentators and others felt that something more detailed than a mere survey of issues was required for policymakers. As Felipe Morandé puts it, it is not enough to say that countries need a consistent macroeconomic policy mix (or that strong bank supervision should be in place). Policymakers need good research and advice on the subtleties and details of policy implementation. He illustrates this point with a discussion of issues related to the question of the extent to which inflation targeting is consistent or can be made consistent with reducing vulnerabilities in a context of open capital accounts.

In the same vein, Latifah Cheong argues that the value of the paper by Sundararajan and others as a survey of issues would have been greater if it had included an assessment of prevailing conditions when policy responses had been more effective. Such an assessment would have provided more insight into the efficacy of measures on management of capital mobility. In short, she would have preferred to have seen a paper on a survey of “lessons” to policymakers, instead of one that, in her view, merely enumerates the various policy options that are available to governments. In her comments, she illustrates some of her concerns using the recent experience of Malaysia. She concludes, in particular, that in implementing capital controls, the Malaysian authorities had to trade off efficiency gains against stability of the economy. From this perspective, once the economy has stabilized and recovery has occurred, a step-by-step approach to liberalization can be pursued, to reinstill dynamism and risk-taking in the economy.

International Cooperation

The seminar discussants underscored the value of cooperation in the assessment of financial sector soundness and vulnerabilities. At the same time, many of the basic issues provoke intense debate, especially in the case of standards—for instance, who sets the international standards, what happens when a country disagrees, and whether the standards do not sometimes get set at levels hard to attain by some emerging countries. Also, there is some concern that standards may be proliferating, that they may often be too costly to implement, and that they may not, in fact, even when applied faithfully, guarantee financial system stability. There is, however, also an appreciation that standards, in recent years at any rate, emerge out of a process of consensus and that they are typically intended and recommended to be applied flexibly, even where they are minimum standards—especially when they are of a quantitative nature. All these sentiments and viewpoints were reflected in the comments and discussions engendered by the four papers included here as Chapters 15-18.

International Initiatives and the Role of the IMF and World Bank

The paper by Ydahlia Metzgen, Marco Rossi, and Przemyslaw Gajdeczka (Chapter 15) summarizes the various initiatives being pursued at the national and international level to improve the functioning of national and international financial markets, takes stock of progress so far, and offers a view of the challenges ahead. Apart from the IMF, international bodies whose work and cooperation are mentioned include the Financial Stability Forum, the Bank for International Settlements, the International Organization for Securities Commissions, the International Association of Insurance Supervisors, the International Accounting Standards Committee, the International Federation of Accountants, the United Nations Commission of International Trade Law, and the World Bank. Important initiatives in which the IMF has been active, mentioned by the authors, include the Financial Sector Assessment Program (FSAP), the Basel Committee on Banking Supervision, and the Financial Stability Forum and its working groups on offshore financial centers capital flows, and highly leveraged institutions. Apart from the FSAP and related work, the IMF is also working to develop standards. In that context, it has produced two codes on transparency (concerning fiscal policies, on the one hand, and monetary and financial policies, on the other) and the two-tiered data standards (the Special Data Dissemination Standard and the General Data Dissemination Standard). The IMF is also producing, jointly with the World Bank, Reports on Standards and Codes for individual countries. The IMF’s multilateral surveillance of international economic and financial market developments has expanded and is playing an important role in focusing the international community’s attention on the key financial market issues. The IMF is also devoting increasing attention to regional surveillance and technical assistance. The authors of the paper in Chapter 15 note the resource-intensive nature and the complexity of the above processes and underscore the need for coordination to prevent duplication and waste of resources.

André Icard, in Chapter 16, engages in a very useful and informative discussion of international cooperative efforts and the work of various organizations on standards and codes. He welcomes the role that the IMF and the World Bank are playing in assessing and strengthening financial system soundness. But he would like to see improvements made in the procedures followed in this work, basically to give greater attention to crisis prevention and ownership of country authorities in policy formulation.

Carl-Johan Lindgren, in Chapter 17, provides additional details on the changing role of the IMF in promoting financial system soundness and the attempts to further strengthen cooperation between the IMF and the World Bank. He notes that an important lesson of the Asian crises is that the financial sector does matter very much for macro-economic performance, especially in cases of highly leveraged systems. Hence, now, every IMF mission is reminded to look into the financial sector and explore its two-way linkages with the macro-economy. Lindgren underscores that, with some 64 different standards, assessments have to be very selective. In the necessary prioritizing, the mission team leaders under the FSAP have been allowed to make the judgment. They are instructed to cover only those areas that are truly important and relevant for identifying financial sector vulnerabilities and development needs. Criteria for setting priorities should be whether or not compliance with standards matters in terms of macro vulnerabilities, and whether the assessment will help in identifying major inefficiencies and reform needs. He agrees with the view that the IMF should not be in the standard-setting business, even though the organization has developed some of the transparency and data standards. But he argues that, at a minimum, the IMF needs to be consulted by other parties involved in the standard-setting process, because of the wide experience of the organization gained from its country work. This experience can be very valuable in the standard-setting process; in brief, the IMF can provide feedback when standards are being assessed and implemented.

In the open discussion, participants at the seminar agreed that, in light of their universal membership and the nature of their core functions, the two Bretton Woods institutions had a comparative advantage in assessing financial systems and promoting their stability worldwide. Participants underscored the need for cooperation between the two international financial organizations and with other international organizations working in the financial area. In addition, seminar participants agreed that standards should not be allowed to proliferate unnecessarily and the costs of implementation should be taken into account when promoting standards.

IMF-World Bank Financial Sector Assessment

In Chapter 18, Stefan Ingves, Alfredo Leone, Paul Hilbers, and Mark O’Brien discuss the Financial Sector Assessment Program: its purpose, process, and the technical nature of its content. They also discuss the Financial System Stability Assessment (FSSA), which is the paper prepared by the IMF staff for its Executive Board following the IMF-World Bank FSAP mission and report for the country authorities. The Financial Sector Assessment Program (FSAP) is designed to identify and assess financial system strengths and vulnerabilities from the perspective of best practice. The FSAP looks at the macroeconomic environment, financial institutions’ structure and soundness, and financial market structure and market liquidity. To this end, the FSAP reviews and assesses systemic risks in payment systems, including the risk management processes and procedures in place. It also examines the legal framework and the system of official oversight and prudential regulations and supervision. The FSAP, in addition, looks into the institutional (including legal) arrangements in place for crisis management, the financial safety nets, and the mechanisms for financial and corporate intervention as well as workouts. Based on these assessments, FSAP missions can formulate action plans for financial system reforms and propose a sequencing of specific measures to be implemented in the short to medium run. Missions also seek to identify sector development and technical assistance needs to support reforms. The authors discuss some of the analytical approaches, including stress testing, used by FSAP missions.

Linked to FSAP, there is substantial financial sector analytical work under way in the IMF, particularly to develop macroprudential indicators. The authors note that, because of resource constraints, it would not be possible to undertake assessments of every member country on an annual basis. This would raise the question of whether coverage should be universal or confined to only a subgroup of countries. If the logic of IMF surveillance and equal treatment favors universal coverage, then the relative infrequency of assessments for any given country would pose a challenge as to how to keep the assessments up to date.

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