Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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I appreciate the opportunity to participate in this seminar. The subject is of great interest to the Institute of International Finance (IIF) and its member firms. My handicap is that I am not an expert on financial sector soundness, or banking supervision, or credit risk assessment, or other topics addressed during this seminar, and I have never worked in a financial firm. So I feel a bit awkward in speaking for the financial industry. I spent most of my career in the U.S. Treasury Department working on debt problems and the transition economies. At the IIF for the past six years, my work has focused on the broad topic of crisis prevention and resolution and public-private sector cooperation in this area.

I would like to begin my remarks by relating the topic of financial systems under stress to the recent work of the IIF. Then, I will say a few words about Mr. Mahoney’s paper and conclude with a reflection about the IMF.

Recent Work of the IIF

Some of you may know that, following the Mexican crisis, the IIF formed a Working Group of experts from member firms that produced a report on resolving sovereign financial crises, mirroring a report from the G-10 Deputies. A prominent recommendation in both reports was to increase transparency, especially in the release of key data needed to assess the vulnerability of emerging market economies to financial crises.

Even before the IMF launched its Special Data Dissemination Standards (SDDS), the IIF formulated data release standards for emerging market economies and evaluated the performance of about 25 major borrowing countries against these standards. Following the Asian crises, the IIF undertook a much more ambitious policy review guided by a high-level Steering Committee on Emerging Markets Finance composed of senior executives from leading member firms. In the process, five separate Working Groups were formed. One of these focused on transparency issues, and its report was published in March 1999.

Among other recommendations, the Working Group on Transparency called for specific improvements in the IIF’s data release standards and in the IMF’s SDDS. The report also advocated the development by the financial industry of indicators of financial sector soundness to fill an important gap in transparency.

A second group, the Working Group on Loan Quality, focused on the lack of a globally accepted definition of nonperforming bank loans. As you can appreciate, it will be hard to establish meaningful standards for financial sector soundness without some common definitions. The report of this Working Group was issued in July 1999 and included a set of definitions for loan quality and proposals for disclosing portfolio quality acceptable to the global banking industry. Considering the differences that currently exist among bank regulations in the major industrial countries, this was a remarkable but little noticed achievement. You may also be interested in knowing that the Basel Committee on Banking Supervision has recently approached the IIF to propose some collaboration in this area.

Perhaps I should also mention the report published a year ago by a third group, the Working Group on Risk Assessment. It describes weaknesses in risk management in member firms that may have contributed to the recent crises and outlines steps that can be taken to overcome these weaknesses. Now, let me turn to Mr. Mahoney’s paper.

The Mahoney Paper

Mr. Mahoney focuses on four factors that relate closely to the vulnerability of financial systems to stress. I agree that these are important factors, but I would be inclined to add two more: management style and the macro environment.

In most crises, we have seen failed banks and nonbank financial intermediaries that were operated by managers for their personal benefit at the expense of other parties. We have seen other failed firms where managers were well intentioned but incompetent. Solid financial firms tend to have managers who strike a reasonable balance between the pursuit of their own personal wealth and power and the long-term interests of their shareholders and depositors. Part of assessing system soundness should be determining where the managers in a particular country tend to cluster along the spectrum of styles, with special attention to banks that play a dominant role in the economy. A shorthand term for this is bank governance.

I would also argue that the macro environment is as important a factor as any of the four put forward by Mr. Mahoney. Price stability is especially critical. I do not know the empirical evidence, but I imagine that the incidence of systemic failure associated with periods of low inflation is relatively small. I also believe it is much harder for managers of financial intermediaries to invest funds prudently in a high-inflation environment.

One of the most interesting points stressed by Mr. Mahoney is that weak banks do not fail “unless some external element intervenes.” I agree with that observation and with his reference to China as an illustration. This is an aspect worth discussing fully at this seminar because we are all interested in avoiding system failures—or crises—and therefore need to continuously scan the horizon for external elements that may precipitate a crisis.

Mr. Mahoney goes on to argue that there are only two elements that are sufficient to cause a banking crisis: the injudicious introduction of market discipline and an external payments crisis. Here, I am less comfortable with Mr. Mahoney’s approach.

My work with debt problems—country defaults—has helped me understand that financial systems are basically built on air. They are all to some extent Ponzi schemes. They depend on confidence. The pyramid schemes in Albania a few years ago are fascinating as an extreme example of this phenomenon.

A well-managed and well-capitalized financial intermediary will fail if it loses the confidence of its sources of funding. And, it is important to understand that the reasons for losing confidence may relate more to gut feelings than objective facts. It is hard to lose a little confidence just as it is hard to be a little pregnant. When confidence starts to slip, it can develop a momentum that is hard to stop. In a competitive market environment, there will be a tendency toward overshooting. Heroic measures may be required to stem a loss of confidence before it reaches its natural turning point.

From this perspective, I would argue that there are many more than two things that are sufficient to cause a loss of confidence that produces a financial crisis. More of them may be political factors than economic factors, including a change in government or a war. In the pathology of financial crises, you can turn the familiar phrase around and say “it’s the politics.” A crisis starts when someone “pulls the plug.” It may be the government that decides not to tolerate loose lending practices. It may be foreign creditors who decide that a boom is coming to an end. It may be residents who decide that they will lose their money if they don’t move it out—through inflation, expropriation, or some other means.

In short, I would advise officials against feeling they will be immune from crises as long as they introduce market discipline gradually and avoid an external payments crisis. For countries that rely substantially on flows of private capital to finance their growth, the IIF advocates the adoption of proactive investor relations programs explicitly designed to detect signs of anxiety among investors and lenders and to deliver information that will help to maintain their confidence through good times and bad.

Two minor points may be worth mentioning. First, the title and text of Mr. Mahoney’s paper refer to “financial systems,” but the template put forward for assessing vulnerability seems to focus exclusively on banks. It is very important not to overlook nonbank financial intermediaries, which have been a prominent part of the problem in some recent cases such as Thailand. It also may be the case that as capital markets develop and fund managers assume responsibility for a larger share of the world’s investable assets than banks, banking systems will tend to become less vulnerable. But we may also start to see more capital market crises.

Second, Mr. Mahoney’s paper concludes with a plea for systems that provide a safety net for the banks’ creditors that is “strong, credible, and unquestioned.” This goes too far. It sounds like a system that would “bail out” banks’ creditors in a crisis. Even the IIF is on record as opposing bailouts. I believe the best systems are ones that let banks fail from time to time. This is necessary to keep bank managers on their toes and to force depositors and creditors to monitor closely and continuously the performance of banks and the quality of bank management.

Conclusion

I would like to conclude my remarks with a somewhat philosophical digression about the role of the IMF. I have been deeply concerned by the extent to which public support for the IMF appears to have eroded over the past decade. I am not so concerned about the ritual attacks that break out locally whenever a country embarks on an IMF-supported adjustment program. My concern is with a change in attitude among people who understand the post-war “architecture” and its contributions to rising standards of living globally. They seem less sure that the IMF is doing what it should be doing.

I think part of the problem may be that the IMF has become less visibly linked to its core concern: money. It is conceivable to me that over the past fifty years the ordinary citizens of the world have suffered as much from governments that debased or misused money as they have from wars. Ordinary people need the IMF to help ensure that the currencies they use to consume and save and invest maintain their value. By more visibly warning ordinary citizens when their money is being threatened by government action or inaction, I believe the IMF could develop a deeper and stronger global constituency. This task arguably begins with the IMF becoming more active as a “whistle blower” when the value of money is being threatened by loose monetary policy or undisciplined fiscal policy. But helping to ensure that peoples’ money is not lost in mismanaged or poorly supervised bank and nonbank financial intermediaries is another key part of the task.

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