Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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Professor Kane has written a stimulating paper. The paper provides a clear and comprehensive framework and addresses in an elegant way several important problems that bear directly on the resolution of troubled financial institutions: how and when to intervene in such institutions has been a major issue for the financial system and its clients and also for policymakers. Moreover, the debate has international dimensions. In several recent crises (for instance, those in East Asia in 1997), not only national authorities but also international financial institutions had to spend a lot of time dealing with bank resolution problems. These issues also are key to many of the ongoing discussions on the reform of the international financial architecture. Moreover, the wave of bank consolidations that are taking place across the world is raising legitimate concerns about leading to “too-big-to-fail” banks, a topic dealt with in the paper.

I broadly agree with the paper’s methodology and the conclusions, and therefore I will just focus on a few points. A strong point of the paper is its clear taxonomy of costs and benefits, which is very helpful when thinking through the issues that real-life situations present. It forces the reader to focus on the different components that determine the costs and benefits of different solutions to the problem of dealing with troubled banks.

Professor Kane indicates (and I agree) that large banks usually have intangible assets (such as a well known name) that make a takeover without closure a better solution than closure. However, we see in many cases that authorities justify a government takeover and the provision of public funds with the argument that otherwise a large bank would be closed, and that such a closure would have large social costs. They probably ask themselves: do we see many cases of creditors agreeing to take over and restructure a troubled bank? And I am afraid the answer is no. One questions why the private creditors do not find it to their advantage to rescue the bank and the government does. Are transaction costs prohibitively high for the private sector? Is it because the government adds social benefits that the private creditors ignore? Is it because the government has superior information regarding the bank’s true prospects? Is it because of different risk preferences or different rates of discount? Or is it because of an incentive-conflicted maximization process? In fact, there are quite a few possibilities and choosing among them requires a case-by-case analysis.

Also, in today’s world in some cases a bank’s situation may deteriorate very rapidly (e.g., poor internal controls and risky off-balance transactions can drive a bank into failure overnight). In those cases, it may be very difficult for the creditors to carry out the negotiations to take over the bank in a timely manner. Could it be that in such cases the regulator, less risk-averse and perhaps with better information than the creditors, can act more rapidly and increase social welfare? Also, the paper ignores the fact that it is hard to estimate when a crisis will blow up. Thus, a complacent regulator may well find out that the problem blows up in his face during his watch. This is particularly the case in banking crises. I would suggest that a key issue in banking distress is the high degree of uncertainty pervading the system. Part of this relates to disclosure, accounting rules, and other things about which some improvements can be made. But uncertainty and risk are intrinsic features of banking business and have important implications for the issues at hand. These features can change, for instance in a crisis, and also account for the different behavioral characteristics of the private sector and regulators (e.g., their different risk preferences). And these features make it difficult to estimate the value of assets. This can be even harder for a large number of small creditors.

Another question that naturally emerges is, what can be done to reduce the problems of time costs inconsistency and incentive-conflicted decisions? One proposal by Professor Kane would offer government regulators improved performance measurement and deferred compensation employment contracts. I would welcome some further elaboration on the specifics of these arrangements. Also, I would argue that there is already some element of deferred compensation in current arrangements, insofar as the value of the human capital of these agents would suffer (i.e., it would be harder for them to get consultant jobs or higher-level positions) if problems emerge in banks that were under their supervision, even if that happens after they have left public service. Thus, incentives also run the other way: bureaucrats do not like to be accused of missing signs of an impending crisis since their reputations and lifetime career prospects would suffer.

Finally, over the last few years, there has been a strong movement in favor of increased transparency and improved data being made available to the public. This would refer not only to banks’ true condition but also to the government’s hidden liabilities discussed in the paper. Thus, more transparency and disclosure probably would help in alleviating the problems that Professor Kane has addressed in his paper. Such disclosure would likely put pressure on regulators to act in cases where, otherwise, they would have chosen forbearance. It also would help in dealing with the time inconsistency problem, to the extent that public exposure of the intention to leave the problem to future regulators (or future generations) would produce pressure for that behavior to change.

In sum, Professor Kane has given us abundant food for thought in this paper.

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