The nature of a crisis

The logic of cost-benefit analysis is straightforward: the government will maximize the net benefit, appropriately discounted, of its actions. Formally,

• Net benefits = Benefits (Intervention actions) – Costs (Intervention actions),

where the amount of both benefits and costs depends on the kinds and degrees of intervention actions taken.

The first necessary step in giving this formal rule content is to define the features of a crisis. Characterizing a crisis will specify the nature of the benefits and costs involved and the kinds of intervention actions that can be taken. A crisis represents a pathological condition of the banking system. In one dimension, the crisis state entails a greater degree of the kind of distress that may affect a banking system without posing a critical problem. Distress consists of accumulated losses that have generated capital deficiencies (relative to regulatory requirements) and insolvencies. The problem of distress is more severe if the accumulated losses are accompanied by chronic unprofitability rather than being the consequence of a onetime loss of asset value. Limited distress, affecting single institutions or narrow classes of banks, may prompt official actions, but on a small scale that does not require the commitment of extraordinary resources.

A distress grows, it becomes at some point systemic in scope and produces a qualitatively distinct feature characteristic of the crisis state—the threat of a banking panic. Panic concerns the liquidity state of the system. Liquidity problems, like distress caused by asset losses, can develop by varying degrees short of a systemic problem. In the mildest form of a liquidity problem, an individual institution may have to pay a premium but can still maintain deposit levels. In a more severe problem, a bank starts to lose deposits but is able to replace these with funds from the interbank market. If the interbank market dries up, the bank may seek lender-of-last-resort (LOLR) assistance.

An individual bank may find itself with a liquidity problem for reasons that are independent of its distress level. In principle, a systemic liquidity problem could emerge for a relatively distress-free system, for example, if a contagious depositor panic feeds off the failure of the banking system in a neighboring country with a structurally similar economy While such a scenario exists as a logical possibility, it seems to be an extremely rare historical occurrence. The emergence of a systemic liquidity problem in a banking crisis is typically the consequence of deepening and widening distress. Therefore, the prototype of a banking crisis examined in this paper is characterized by two essential elements: a high degree of systemic distress and the imminent prospect of panic.

Intervening in a crisis

These characteristics of a banking crisis define the broad outlines of intervention actions. Intervention will occur in a two-step process The threat of panic is the immediate problem and the government must first decide whether it is worthwhile to pay the costs to avert it. This step will entail some form of liquidity support, typically the guarantee of bank deposits by the government. If the guarantee successfully averts the spread of panic, the government is then exposed to costs arising from the distorted incentives produced by deep and widespread distress. These costs will include the potential fiscal costs of the deposit guarantee on banks that continue to fail and the economic costs of distorted bank behavior, including credit crunch effects and financial market uncertainties.

The government makes a choice about how aggressively to intervene according to the criterion of maximizing benefits, chiefly economic in nature, less costs, both fiscal and economic. It is possible that, following this criterion, the government will choose not to intervene. This outcome is more likely the greater is the initial damage to the banking system. A very large initial shock has two consequences. First, it leaves little value in the banking system to be defended from further loss. Second, it exposes the government to a relatively large payment on any guarantee of deposits to avert a panic because many banks will already be put in a position of deep insolvency. Both of these factors work against the government providing liquidity support and toward allowing a panic to run its course. In other words, if there is relatively little to be saved from averting a panic, the government may prefer to let depositors rather than taxpayers bear the cost of the crisis.

Another factor is the size of the banking system relative to the economy. If bank loans are not a large source of credit to the enterprise sector, the collapse of the banking system will have a less disruptive effect on investment and employment. In this case, the government will be less likely to stem a panic since the economic benefits of that intervention are relatively small. Even in this case, however, banking system collapse will disrupt the payment system. The economic costs of that disruption can be large. The case of Russia, for example, suggests that the collapse of a relatively small banking system can have serious economic costs through payments disruption. The reversion of large transactions to barter arrangements in the wake of the Russian banking system collapse greatly impeded economic efficiency and government tax collections.

If the government does intervene to avert panic, it must then determine how aggressively it will act to resolve distress within the banking system. The existence of distress produces distorted incentives that generate new economic losses and further banking system distress. The government can choose to eliminate distress and the economic costs that it produces. Actions to resolve banking system distress will involve closing or restructuring failed and weakened banks. In some cases, restorations can be carried out by private restructuring, but these efforts may involve some kinds of official assistance. In other cases, the direct use of government funds through payment under deposit guarantees or public recapitalization will be needed.

In general, the government’s decision will balance the economic and fiscal costs of using public sector resources against the benefits of forestalling further economic deterioration through prompt action. In a case where the premium attached to the use of public sector resources is large, for example, because of a high current or prospective government debt burden, the government may pursue a very deliberative and slow intervention strategy in order to economize on the outlay of public monies, even at the expense of higher economic costs. An aggressive resolution strategy, on the other hand, will limit deterioration costs by cutting short the intervention period but may require a greater use of public funds by relying more on nationalization or liquidation of banks with payments to depositors and less on private recapitalization and merger, which are time-intensive resolution options.

Nature of benefits

The benefits of official intervention in a banking crisis can be organized into broad classes that reflect benefits of intervention both to stabilize the banking system and avert a panic and to restore the banking system to a healthy state, free from distress-related distortions. These benefits, which can also be interpreted as the avoided costs of failing to act, can be characterized as:

• (1) Maintain the integrity of the credit mechanism. A dysfunctional banking system is subject to many kinds of distorted behavior that disrupt normal credit relationships. Different banks may simultaneously take uneconomic risks; restrict credit to viable borrowers; force acceleration of loans and, thereby, disrupt productive activities; force liquidation of assets, depressing prices below fundamental valuations; and so forth.

• (2) Maintain the integrity of the payments system. The collapse of a banking system will disrupt the payments system in ways that will go beyond interruption to the clearing and settlement mechanism. Bank deposits will be destroyed and economic participants will be forced to hold the medium of exchange in the form of currency. The absence of bank deposits will inefficiently restrict transactions to currency and barter.

• (3) Maintain general financial stability. The general financial uncertainty produced by a banking crisis increases the country’s risk premium, which raises borrowing costs to all classes of borrowers and depresses asset prices, and spreads contagion effects to balance sheets outside the banking system.

• (4) Maintain economic stability. The negative financial consequences of a banking crisis—a credit crunch, high borrowing costs, weak asset prices, liquidity squeezes—breed losses in wealth and recessionary contractions of output.

• (5) Promote an efficiently structured banking system. A final benefit of intervention in a banking crisis is the opportunity it provides for a microeconomic reorganization of the banking system through an efficiently managed exit of unprofitable institutions.

Nature of costs

The costs of intervening in a banking crisis fall into two broad classes: fiscal costs and economic costs. Fiscal costs reflect actions that generate an actual outlay of public funds. Economic costs reflect the distortionary consequences of intervention actions on the incentives facing economic participants.

Liquidity support

Typically, liquidity support from the central bank to troubled financial institutions starts long before the systemic nature of a banking crisis has been recognized. When a bank, or several banks, start experiencing withdrawals from depositors and creditors (both domestic and foreign), and they cannot borrow directly, or only at high rates, from the interbank market, the central bank becomes their “last resort.” Very often this is the first clear sign of distress in a bank.

To address the problem, central banks may in the initial stages be more prepared to ensure funding for the distressed bank(s) by channeling interbank funds to them. This approach would not commit the central bank’s own resources and emphasizes the reliance on markets to solve the problem. This approach, however, might be unsuccessful because other banks could become unwilling to lend to troubled institutions, once the latter are known to be in such a state. In that case, recourse to the central bank is the only alternative for the troubled bank.

In principle, central banks should only support illiquid but still solvent banks. However, during the early stages of an unfolding crisis, it is often very difficult to distinguish illiquidity from insolvency. Very often, it turns out that banks resorting to the central bank for liquidity support have been insolvent for a while, without this being known.

In theory, central bank loans should always be fully collateralized to avoid losses for the central bank. This is even more the case when a bank is suspected to be in a state of distress, even though in such a situation it may become increasingly difficult to identify good collateral. When a state of distress is discovered in a borrowing bank, the bank should be inspected and monitored closely and further borrowing from the central bank (under an emergency facility) should be subject to specific conditions, decided upon in consultation with the supervisors. Such conditions are needed to avoid the central bank lending to a “lost case” and, thus, incurring more and more losses.

Depending on the origin and type of the unfolding crisis, a central bank may be forced to provide support other than under its traditional mechanisms, such as overdraft loans to support the payments system, broad discounting of eligible paper, reduction of required reserves or foreign exchange loans to banks (Dziobek, 1998). To keep the system afloat, the central bank may also be forced to reschedule short-term loans into medium- or long-term obligations.

Deposit insurance and blanket guarantee

Once the true nature of the crisis has been identified and bank insolvency has been revealed as widespread, other instruments are needed to stabilize the system. Quite often, countries have established limited deposit insurance funds, but experience has proven that, when faced with a systemic crisis, limited deposit insurance schemes become inadequate to restore confidence. On the contrary, as was clearly indicated in the Indonesian case, they may aggravate the crisis.

What is needed in such cases is the announcement of full protection for depositors and (most) creditors. Such a blanket guarantee aims to stabilize the banks’ funding and prevent, or stop, bank runs. As such, it is mainly a confidence booster. In addition, announcing a blanket guarantee buys the government time while the restructuring work is being organized and carried out. A blanket guarantee entails a firm commitment by the government to depositors and most creditors of financial institutions that their claims will be honored.⁴

By announcing a blanket guarantee the government acquires a very sizeable contingent liability against assets of uncertain value. These assets are very often insufficient to pay for the contingent liability that the government may be called to honor. Finally, a blanket guarantee is only able to stabilize the banking system’s domestic funding. Other measures—some of them already listed above under liquidity support—may be needed to stop a flight from the currency, if that is also an issue.

Bank resolution

Once some initial stabilization of the banking system has been achieved through a combination of liquidity support, announcing the blanket guarantee and, perhaps, the closing of some nonviable financial institutions (to stop the drain on government resources), governments need to devise a bank-restructuring plan. While private sector involvement should be sought from the start—in particular if the private banking sector is significant—the nature of the crisis itself may make government intervention a necessity.

Government intervention broadly takes three forms: closure and liquidation of nonviable banks and recapitalization through capital injections or through rehabilitating the assets. Both recapitalization approaches can be used separately, depending on the particular condition a bank is in, but more often they are combined when rehabilitating an insolvent bank. Because the cost involved in closure and liquidation boils down to paying out the depositors and other creditors under the blanket guarantee, as discussed under the previous section, this intervention will not be further discussed in this section.

Other intervention tools

Governments may resort to some other intervention tools to expedite the restructuring process and enhance its efficiency. Such tools are used in conjunction with other tools, described above. While some of these tools have no impact on the fiscal cost to be borne by the government, their advantage is often that they limit the need to activate the blanket guarantee if the weaker bank(s) would fail in the absence of the operation.

Mergers can be assisted or unassisted. In the unassisted merger, a weaker partner is merged with a stronger one and the involvement of the authorities is limited to bringing the parties together and overseeing the merger process. An assisted merger involves some type of financial assistance to the acquirer (or tax incentives) by the government. As such, there is a fiscal cost involved, similar to the one involved in recapitalizations, but at a smaller scale. The benefit of mergers (both types) is in avoiding potential failures of the weaker partner(s) involved in the deal and, therefore, potentially limiting the resort to the blanket deposit guarantee. However, if mergers are not implemented properly, and the resulting new institution turns out to be weak, more costs might be involved in the future.

Transfers of deposits. To assist troubled banks, the authorities may decide to transfer government deposits from sound banks to troubled banks. In principle, such operation should be neutral in fiscal terms, unless the troubled bank offers a lower interest rate on those deposits, or, even worse, the weaker bank fails at a later stage.

Tax incentives are sometimes given temporarily to weaker banks or to acquiring banks (either under P&As, bridge banks or mergers) to facilitate the operation and the return to profitability. They result in foregone revenue for the government.

Forbearance. To assist troubled but viable banks in the rehabilitation process, authorities may give these banks time to meet new loan loss provisioning rules or new capital adequacy requirements. There is an ongoing debate about benefits and drawbacks of forbearance. The benefits attached to such policies—as long as they are conducted transparently—are that they allow the banks to operate temporarily under less stringent conditions and therefore allow a continuous flow of credit to the economy. In addition, forbearance may avoid bank failures and thus, indirectly reduce the cost that would otherwise fall on the deposit insurance scheme. However, some studies point out that forbearance results in higher long-run resolution costs. FDIC (1998) states, referring to the 1980s experience with the savings and loan industry, that forbearance without proper oversight can create the opportunity for further deterioration of financial institutions and result in increased resolution costs as operating costs accumulate, thus leading to higher intervention costs in the medium and long run.

State guarantees are often attached to specific operations of troubled banks to facilitate their “return to normal” and to avoid interruptions in the flows of credit to the economy. For instance in the Asian crisis countries, governments provided guarantees on credit to the export sector or to the small and medium-sized enterprise sector. While no direct fiscal cost is attached to such operations, these guarantees create a contingent liability to the government.

Ex ante versus ex post issues

When taking the decision to intervene in a banking system hit by a crisis, it is very hard for the government to form a reasonable ex ante estimate of the benefits and the costs. The nature of the identification process of costs and benefits is very different. At the onset of the crisis, the gross costs are a given factor (deposits are being withdrawn and assets are losing value). However, their amounts are unknown (and still growing). During the crisis, governments can try to minimize the net cost by using the most appropriate intervention techniques (the difference between gross and net can be considered a measurable benefit from the intervention). Some of these cost are quantifiable as they enter the fiscal accounts. Other costs are harder to quantify (disruption of payments system and of credit flows, loss of confidence in the banking system, deteriorating macroeconomic conditions), as discussed in Sections VI and VII. Benefits of intervention are of a different nature. Some are of an immediate nature, while others will only become apparent in the medium and long run Immediate benefits of the intervention are very often of a counterfactual nature: preventing the system for deteriorating further, i.e., keep credit flows going, keep the payment system going, restore depositor confidence. Medium and long-term benefits are mainly the emergence of a more efficient banking system.

Establishing ex ante estimates of costs and benefits is rendered difficult by the following factors:

• Experience has proven that it takes time for the government to recognize that there is a crisis and that this crisis is of a systemic nature.

• Once the systemic nature is recognized, it takes time to make an inventory of the problems, while at the same time the situation is most likely still deteriorating.

• The initial estimate of the size of the problem will, in the course of the restructuring process change (sometimes dramatically) as a result of factors that are under the government’s control, but more importantly by factors that are not under the government’s control.

Under the government’s control are:

• The speed at which initial measures are taken (blanket guarantee, liquidation of nonviable banks).

• The speed at which a restructuring strategy is worked out.

• The types of resolution procedures use (recapitalization, impaired asset management).

• The measures taken to address the crisis in the corporate sector.

• Factors that are not, or only marginally, under the government’s control include:

• The impact of the macroeconomic environment. Will it further deteriorate or stabilize?

• The size of the corporate sector crisis. This factor, taken together with the first one, will determine if restructuring will go through cycles, i.e., that following any initial clean-up period, more nonperforming loans will show up on the books of the banks, further increasing the cost of the crisis.

• The market’s reaction to the government’s measures (blanket guarantee, bank liquidations).

• The market’s willingness to participate in the restructuring process, i.e., the willingness of the private sector to assist in the recapitalization process and willingness of the foreign sector to participate. Availability of capital in the private domestic and foreign economy will determine to what extent the government may have to provide incentives to attract these sources of capital. This will also add to the cost for the government.

Taken together, these factors make it very difficult to get a reliable ex ante idea of costs and benefits from intervening in a systemic crisis. To underline this point, Table 1 provides a comparison for selected countries between the fiscal costs estimated at the beginning of the crisis and the most recent estimate. Such a comparison clearly indicates the shaky nature of any ex ante estimates. It should be noted that this comparison only covers measurable fiscal costs. Other costs and benefits are even harder to forecast and compare.

Table 1.

Comparisons of Initial and Final Fiscal Costs of Bank Restructuring

Note: Estimates refer to gross fiscal costs as a percentage of GDP.

^1/IMF Staff estimates of November 30, 1998, WEO.

^2/Authorities’ estimates for the gross cost of financial sector restructuring. OccP No. 188.

^3/Merrill Lynch, “Asia-Pacific Banks: Progress and Issues in Restructuring,” February 23, 1999.

^4/“Financial Sector Crisis and Restructuring: Lessons from Asia,” OccP No. 188, 1999.

^5/GAO “Actions Taken to reform Financial Sectors in Asian Emerging Markets,” September 1999.

^6/Fernando Montes-Negret, World Bank, Second WB/IMF Financial Sector Liaison Committee Seminar, January 11, 2000.

^7/Bulletin of Bank of Finland, August 1994.

^8/In Sweden the majority of bank support has been recovered in proceeds through the sales of Nordbanken/Gota Bank, Securum and Retriva. As estimated by Ingves and Lind (1997), SKr 48 billion or 73.8 percent of original support were recovered. Note: since almost all support has been recovered, this may not be the best example to illustrate that costs are being underestimated at the onset of the crisis. Instead, we have included as a case of underestimation the U.S. thrift crisis.

^9/Congressional Budget Office, “Resolving the Thrift Crisis,” April 1993.

Table 1.

Comparisons of Initial and Final Fiscal Costs of Bank Restructuring

Country	Initial Estimate	Latest Estimate (chronologically)
Indonesia (1997-99)	29 (11/98)1/	45 (authort.) 2/
		42 (2/99) 3/
		51 (mid-99) 4/
		45-80 (9/99) 5/
Korea (1997-99)	17.5 (11/98)1	15 (authort.) 2/
		10 (2/99) 3/
		13 (mid-99) 4/
		15-40 (9/99)5/
Mexico (1994-97)	8.4 (1996)6	14
		12-15 (10/96) 5/
		21.3 (1999)6/
Malaysia (1997-99)	18 (11/98)1	12 (authort.)2/
		11(2/99) 3/
		5 (3/99)4
Sweden (1991-93)	4.7 (1994)1	1.2 (1997)8
		4-5
Thailand (1997-99)	32 (11/98)1	25 (end-98)4
		26 (2/99)3
		35-45 (9/99)5
Chile (1981-85)		19-41
Finland (1991-93)	14.7 (1994)7	8-10
Colombia (1982-87)		5-6
USA (1980-92)	0.07 (1984)9	2.4 (1992)9

Note: Estimates refer to gross fiscal costs as a percentage of GDP.

^1/IMF Staff estimates of November 30, 1998, WEO.

^2/Authorities’ estimates for the gross cost of financial sector restructuring. OccP No. 188.

^3/Merrill Lynch, “Asia-Pacific Banks: Progress and Issues in Restructuring,” February 23, 1999.

^4/“Financial Sector Crisis and Restructuring: Lessons from Asia,” OccP No. 188, 1999.

^5/GAO “Actions Taken to reform Financial Sectors in Asian Emerging Markets,” September 1999.

^6/Fernando Montes-Negret, World Bank, Second WB/IMF Financial Sector Liaison Committee Seminar, January 11, 2000.

^7/Bulletin of Bank of Finland, August 1994.

^8/In Sweden the majority of bank support has been recovered in proceeds through the sales of Nordbanken/Gota Bank, Securum and Retriva. As estimated by Ingves and Lind (1997), SKr 48 billion or 73.8 percent of original support were recovered. Note: since almost all support has been recovered, this may not be the best example to illustrate that costs are being underestimated at the onset of the crisis. Instead, we have included as a case of underestimation the U.S. thrift crisis.

^9/Congressional Budget Office, “Resolving the Thrift Crisis,” April 1993.

View Table

Table 1.

Comparisons of Initial and Final Fiscal Costs of Bank Restructuring

Country	Initial Estimate	Latest Estimate (chronologically)
Indonesia (1997-99)	29 (11/98)1/	45 (authort.) 2/
		42 (2/99) 3/
		51 (mid-99) 4/
		45-80 (9/99) 5/
Korea (1997-99)	17.5 (11/98)1	15 (authort.) 2/
		10 (2/99) 3/
		13 (mid-99) 4/
		15-40 (9/99)5/
Mexico (1994-97)	8.4 (1996)6	14
		12-15 (10/96) 5/
		21.3 (1999)6/
Malaysia (1997-99)	18 (11/98)1	12 (authort.)2/
		11(2/99) 3/
		5 (3/99)4
Sweden (1991-93)	4.7 (1994)1	1.2 (1997)8
		4-5
Thailand (1997-99)	32 (11/98)1	25 (end-98)4
		26 (2/99)3
		35-45 (9/99)5
Chile (1981-85)		19-41
Finland (1991-93)	14.7 (1994)7	8-10
Colombia (1982-87)		5-6
USA (1980-92)	0.07 (1984)9	2.4 (1992)9

Note: Estimates refer to gross fiscal costs as a percentage of GDP.

^1/IMF Staff estimates of November 30, 1998, WEO.

^2/Authorities’ estimates for the gross cost of financial sector restructuring. OccP No. 188.

^3/Merrill Lynch, “Asia-Pacific Banks: Progress and Issues in Restructuring,” February 23, 1999.

^4/“Financial Sector Crisis and Restructuring: Lessons from Asia,” OccP No. 188, 1999.

^5/GAO “Actions Taken to reform Financial Sectors in Asian Emerging Markets,” September 1999.

^6/Fernando Montes-Negret, World Bank, Second WB/IMF Financial Sector Liaison Committee Seminar, January 11, 2000.

^7/Bulletin of Bank of Finland, August 1994.

^8/In Sweden the majority of bank support has been recovered in proceeds through the sales of Nordbanken/Gota Bank, Securum and Retriva. As estimated by Ingves and Lind (1997), SKr 48 billion or 73.8 percent of original support were recovered. Note: since almost all support has been recovered, this may not be the best example to illustrate that costs are being underestimated at the onset of the crisis. Instead, we have included as a case of underestimation the U.S. thrift crisis.

^9/Congressional Budget Office, “Resolving the Thrift Crisis,” April 1993.

In the same vein, it is difficult to base the decision to intervene or not on any specific ex post observation. There is a general belief and understanding that government intervention in a systemic crisis in the end yields more benefits than costs, but the specific nature thereof varies greatly from country to country.

The very factors that were listed above appear in different intensities in crisis countries and, therefore, lead to different costs to the government. The table above also compares across countries the estimated fiscal cost of some major banking crises in the 1980s and 1990s and clearly points out how difficult it is to infer any reasonable estimate from previous crises.

Furthermore, benefits and costs will also depend on the type of intervention. For example, interventions can be proactive or not, broad-based versus specific, aggressive or deliberate, and can rely heavily on nationalization or not. In most of these scenarios, the decisive factor is the difference in cost needed to achieve the same nature of benefits.

Proactive interventions (interventions before a real crisis breaks) seem to have been rare so far. However, if intervention is planned when the first signs of distress are discovered, the cost of intervention could be reduced significantly, while the intervention strategy could yield the same benefits as when the intervention takes place in a full-blown crisis. Lower costs would come from lower fiscal costs (less liquidity support, no resort to blanket guarantee, lower recapitalization because erosion of the capital base is interrupted earlier in the process) and lower costs associated with no (or smaller) disruption of the payments system and of credit flows.

Broad-based interventions are often more costly than specific ones, but may reap more benefits because they aim at more thoroughly cleaning the banking system, allowing a more efficient system to operate after the crisis. Specific interventions may lead to situations where inefficient or loss-making institutions can continue to operate in the system, leading to new problems at a later stage. Aggressive or quick strategies may be more costly in the short term, but again, they may lead to reaping the benefits of the intervention more quickly because a well-operating core banking system may be put in place more quickly than in the case of an intervention that allows banks time to restructure. Finally, depending on the size and nature of the crisis, widespread nationalizations early in the crisis could be beneficial in that they help stop runs and, therefore, lead to a faster restoration of confidence in the system. However, the ultimate cost of interventions that rely heavily on nationalization depends on how well these nationalized institutions are managed and sold, once intervened.

Budgetary accounting

This section discusses issues in budgetary accounting for the intervention techniques, building on the previous chapter. Depending on their nature, some costs are fiscal, others are quasi-fiscal. Table 2 presents an overview of their nature and the way they should be accounted.

Table 2.

Government Intervention Techniques and Their Fiscal Implications

Table 2.

Government Intervention Techniques and Their Fiscal Implications

Intervention technique	Fiscal Cost	Fiscal Revenue	Fiscal Treatment
Liquidity Support
Lender-of-Last Resort (different types)	As long as cost stays with the central bank (CB), it is a quasi-fiscal cost. As explained in text, most types of LOLR that do not meet market criteria result in CB lower income, thus lower profit remittances to the budget		Lower profit remittances are foregone revenue. If central bank lending is converted into government bonds: interest payments annually and repayment of bonds at maturity.
Deposit Insurance
Limited Deposit Insurance	N/A in systemic crisis		Depends on arrangement. If privately funded, no fiscal contribution. Government contribution can be in cash or bonds.
Blanket guarantee	Is a contingent liability initially. When called upon, will be direct fiscal cost (when financed from budget) or quasi-fiscal cost (when financed through the CB). Ultimately always budget.		Depends on arrangement. Cash, directly from the budget or bonds, If bonds arc used, interest payments enter annual budget, repayments of bonds at maturity.
Recapitalization through capital injections
Capital Injections (nationalization, bridge bank, P&A) bonds versus shares	Cash outlays from budget For bonds: interest and amortization	Dividends Proceeds from (re)privatization at a later stage	Cash payments: directly from budget. Bonds: see above. Dividends: nontax revenue.
Intervention technique	Fiscal Cost	Fiscal Revenue	Fiscal Treatment
Recapitalization through rehabilitation of assets
Rehabilitation of bank assets through private AMCs	If incentives are given to establish private AMC, this is a cost, depending on the type of incentive.	none	Depends on type of incentive (most often forgone revenue or subsidy).
Rehabilitation of bank assets through public AMCs	If bonds are issued: interest and amortization costs	Sales of impaired assets	Bonds and interests: see above. Sales of impaired assets: capital revenue for government.
Other techniques
Merger (assisted and unassisted)	Assisted merger may involve tax advantages.	May avoid resort to blanket guarantee if weaker institution had failed.	Forgone revenue in case of tax advantages.
Transfer of government deposits	If new bank offers lower interest rates, there is forgone revenue for the government.	Same	Forgone revenue in some cases
Tax incentives			Forgone tax revenue
Forbearance		May avoid resort to blanket guarantee if weaker institution had failed. Or lower recapitalization costs for government.
State guarantee	Is contingent liability
Operational costs (operation of institutions such as BRA, AMC, asset valuation, experts) Others costs (macrocost from credit crunch, greater interest spreads)			Current government expenditures (operations and maintenance).

View Table

Table 2.

Government Intervention Techniques and Their Fiscal Implications

Intervention technique	Fiscal Cost	Fiscal Revenue	Fiscal Treatment
Liquidity Support
Lender-of-Last Resort (different types)	As long as cost stays with the central bank (CB), it is a quasi-fiscal cost. As explained in text, most types of LOLR that do not meet market criteria result in CB lower income, thus lower profit remittances to the budget		Lower profit remittances are foregone revenue. If central bank lending is converted into government bonds: interest payments annually and repayment of bonds at maturity.
Deposit Insurance
Limited Deposit Insurance	N/A in systemic crisis		Depends on arrangement. If privately funded, no fiscal contribution. Government contribution can be in cash or bonds.
Blanket guarantee	Is a contingent liability initially. When called upon, will be direct fiscal cost (when financed from budget) or quasi-fiscal cost (when financed through the CB). Ultimately always budget.		Depends on arrangement. Cash, directly from the budget or bonds, If bonds arc used, interest payments enter annual budget, repayments of bonds at maturity.
Recapitalization through capital injections
Capital Injections (nationalization, bridge bank, P&A) bonds versus shares	Cash outlays from budget For bonds: interest and amortization	Dividends Proceeds from (re)privatization at a later stage	Cash payments: directly from budget. Bonds: see above. Dividends: nontax revenue.
Intervention technique	Fiscal Cost	Fiscal Revenue	Fiscal Treatment
Recapitalization through rehabilitation of assets
Rehabilitation of bank assets through private AMCs	If incentives are given to establish private AMC, this is a cost, depending on the type of incentive.	none	Depends on type of incentive (most often forgone revenue or subsidy).
Rehabilitation of bank assets through public AMCs	If bonds are issued: interest and amortization costs	Sales of impaired assets	Bonds and interests: see above. Sales of impaired assets: capital revenue for government.
Other techniques
Merger (assisted and unassisted)	Assisted merger may involve tax advantages.	May avoid resort to blanket guarantee if weaker institution had failed.	Forgone revenue in case of tax advantages.
Transfer of government deposits	If new bank offers lower interest rates, there is forgone revenue for the government.	Same	Forgone revenue in some cases
Tax incentives			Forgone tax revenue
Forbearance		May avoid resort to blanket guarantee if weaker institution had failed. Or lower recapitalization costs for government.
State guarantee	Is contingent liability
Operational costs (operation of institutions such as BRA, AMC, asset valuation, experts) Others costs (macrocost from credit crunch, greater interest spreads)			Current government expenditures (operations and maintenance).

Liquidity support is typically provided by the central bank. This, and the fact that it comes early in the unfolding crisis, often leads to situations wherein the quasi-fiscal costs attached to the support are not taken into account in the final calculation of the cost of the restructuring. It is only when this liquidity support is actually recognized by the government as part of the restructuring bill that it draws attention as a fiscal item. Sometimes the government issues bonds to compensate the central bank for its support (Indonesia, Thailand), or the support is converted into equity or subordinated debt.

The budgetary implications of central bank instruments used to support banks differ, depending on the type of instrument used (Dziobek and Pazarbaşioğlu, 1997). Normal central bank lending (i.e., at market conditions) has no fiscal impact in principle. However, if lending takes place at below market rates or if the central bank applies broader than normal principles of discounting, there will be an impact on central bank income, and profit remittances to the government budget will be smaller. In the same vein, if other measures are taken, such as a reduction of reserve requirements to assist commercial banks, profit remittances will be lower through the impact on central bank income. In the worst case, such measures might lead to central bank losses. If central banks provide foreign currency loans to commercial banks, central bank international reserves fall and so will the bank’s income from capital.

Very often, faced with a systemic crisis, governments and central banks have no time to organize themselves properly to tackle the crisis. In such cases—as was seen in the Asian crisis—central bank liquidity is the main source of funds to the system in the initial stages. In Indonesia and Thailand, formal arrangements were worked out later, whereby the government compensated the central bank for any losses it had incurred while providing liquidity support to the system. As such, the issuance of government bonds to the central bank replaces the quasi-fiscal cost by an explicit fiscal cost. When central bank lending is converted into equity or subordinated debt, central bank income also falls and so do profit remittances to the budget.

Blanket guarantees. It is possible that blanket guarantees, mainly being confidence boosters, are not called upon. In other words, it is possible that the mere announcement of such guarantees suffices to stop bank runs and restore confidence in the banking system. However, if called upon, the affected banks’ assets will most likely not be sufficient to pay for the contingent liability that the government may need to honor. So, the fiscal implications of the blanket guarantee may be significant. The guarantee can either be financed directly from the budget or through the central bank. In the latter case, the central bank would give a long-term loan to the agency in charge of the restructuring, and the government would guarantee this loan and pay the interest and amortization through the budget. While the direct fiscal cost of giving a blanket guarantee might be considerable, this cost might in the end be lower than the potential economic and social cost of a complete collapse of the banking system.⁸

Recapitalization. Capital injections and rehabilitation through purchases of impaired assets. The fiscal impact of straight capital injections depends on the methods and means of payment used. If government bonds are used, the fiscal accounts will reflect interest payments and, later on upon maturity, amortization. If payment in cash is used, the ways the recapitalization enters the fiscal accounts depends on the origin of the cash. Japan, for instance, has issued government bonds to fund the cash injections; Malaysia has used the proceeds from the sale of impaired assets as cash injection. Thailand converted LOLR support into equity in intervened banks; in Chile, the central bank issued central bank bills to replace nonperforming assets in the banks’ balance sheets; and in still other countries, the government borrowed from the central bank.

The net fiscal cost of recapitalization will most likely be lower because, in the case of equity holding by the government, the payment of dividends to the government provides a flow of income. However, this flow comes later in the process when banks start to become profitable again. In addition, privatization of the nationalized banks will reduce the net cost of the operation significantly, and may even yield a profit to the government.

Government support through the purchase of impaired assets mainly takes place through the issuance of government bonds, or government-guaranteed bonds to replace the nonperforming assets in the books of the banks. Impaired assets can either be bought at book value or at market value. When buying impaired assets at book value, the operation amounts to a back-door recapitalization of the problem bank. Buying at market prices gives an incentive to the problem bank to continue the recovery efforts of its assets and to the AMC to sell the acquired assets at a better price, thus realizing a profit. The net cost/benefit of the operation depends in the end on the government’s ability to sell the impaired assets (through the AMC).

In some countries (Chile, for example) assistance to banks took place through the issuance of central bank bills (long-term paper) in exchange for nonperforming loans. The impact on the budget of such operations comes through a fall in the asset quality and in the earnings of the central bank, leading to lower profit remittances to the government.

State guarantees on bank credits, like deposit guarantees represent a contingent liability for the budget. Tax incentives represent forgone revenue for the government. Forbearance, finally, should have no direct fiscal impact, but could have a medium-or long-term impact in the form of higher resolution costs later. Such costs of a prolonged or recurring crisis would be accounted for under one of the categories listed here.

Other costs that need to be taken into account and that have an impact on the budget include the salaries of experts hired to assist the government in addressing the crisis, the hiring of accounting firms to audit the troubled banks and to value bank assets, the hiring of experts (firms) to manage impaired assets and to prepare banks for sale. If central banks are involved in the restructuring process, their administrative costs will increase, since they will need experts to handle parts of the process.

Shock and distress

Banking system distress can be characterized by varying degrees of severity. Systemic distress is not a simple concept but has several interrelated features, the most important of which are the extent of asset value loss, the extent of insolvency, and the risk of a liquidity panic. A stylized version of the structure and evolution of banking system distress that integrates these features and sheds some light on intervention strategy is presented in Figure 1.

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Structure and Evolution of a Banking Crisis

Citation: IMF Working Papers 2000, 147; 10.5089/9781451856729.001.A001

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The axes represent two key characteristics of banking system distress, loss of asset value and the degree of systemic insolvency. The fall in assets, α, is measured by the ratio decline in the value of pre-shock assets

where A is the current book value of banking system assets and A(0) is the pre-shock level, valued at point 0. The maximum loss reached when all system assets must be liquidated is

where A(b) is the liquidation value.

The degree of systemic insolvency, β, is measured by the share of the booked value of banking system assets held by insolvent banks

where A_I is the volume of assets held by insolvent institutions.

A loss in asset value of a given size can be associated with varying degrees of systemic insolvency, depending on how that loss is distributed across the banking system. The line Oa represents the maximum degree of insolvency for each level of loss in aggregate banking system assets. Similarly, the line α^κb represents the minimum degree of systemic insolvency corresponding to any loss of asset value. When the asset loss exceeds α^κ, the aggregate pre-crisis capital of the banking system, some institutions must be insolvent. Minimum levels of systemic insolvency increase with asset loss along the line α^κb, until the maximum degree of asset loss, α^max, is reached. The area Oabα^κ, then, gives the set of feasible outcomes (α, β) that characterize conditions of banking system distress.⁹

Starting from a given point in the feasible set, systemic distress will increase along any path that moves upward and to the right. As systemic distress increases, it is reasonable to think that liquidity problems among banks will become generally more widespread. At some point, the combination of banking system distress and emergent liquidity problems becomes so pervasive that the system reaches a state characterized by the prospect of qualitatively different behavior that can be categorized as a crisis rather than just general distress. A crisis, then, represents an advanced state of systemic distress combined with the prospect of systemic illiquidity.

When all banks in the system are insolvent, represented by outcomes on the line ab, risk-neutral depositors will have an incentive to panic. In that case, each depositor will realize that every bank lacks sufficient funds to meet all of its potential deposit withdrawals. Since banks meet deposit withdrawals on a first-come-first-serve basis, each depositor has an incentive to withdraw funds immediately, creating panic.

Risk-averse depositors, however, can panic even when β < 1. Some banks may not be insolvent but asset losses may be so great that depositors view the risk of systemic insolvency as unacceptably high. At any given level of systemic insolvency, higher levels of asset loss will raise the risk of additional insolvencies. Therefore, if depositors are risk-averse, there will be a larger set of points (α, β) that will induce panic than those lying on line ab. This set is labeled “Panic zone” in Figure 1. In this zone, every bank in the system can experience a run regardless of its capital condition, unless there is some guarantee on deposit values.

The beginning of an episode of banking system distress can be viewed as drawing an initial point (α, β) from the feasible set, which represents the initial shock. This initial shock may arise in two broad ways. First, there may be relatively abrupt changes in economic or financial conditions that negatively impact bank asset values, such as the onset of recession or a collapse in real estate values. This type of shock emerges from an actual change in the state of the world.¹⁰ Second, there may be a relatively sudden realization of changes in the condition of the banking system that have built up gradually over time. Typically, this kind of shock represents an accounting event, such as the discovery of hidden fraud or of “evergreening”, throwing good money after bad by propping up nonperforming loans through new credits. Also, a change in accounting rules that causes previously hidden shortfalls, such as losses on a securities portfolio or accumulated losses on subsidized lending to state-owned enterprises, to be marked to market or otherwise shown more transparently in the accounting information set can be the trigger for a crisis.

The initial shock that generates systemic distress will affect banks differently. How the banking system will evolve depends on the specific conditions created by the initial shock. Of particular importance is how asset losses are distributed across banks. The distribution of initial losses will determine the capital conditions of banks in the system. The capital condition of banks, in turn, will have a large effect on their liquidity condition and their risk behavior. These conditions together will affect the evolution of the system in the absence of official intervention. A detailed discussion of how conditions of distress generate distortions in bank behavior is presented is Appendix I.

Factors causing increased distress

A distressed banking system is in a pathological condition. Banks that are knocked out of a healthy condition of capital adequacy and normal liquidity (classified as Class 1 banks in Appendix I) by an initial shock face distorted incentives that lead to further expected deterioration in the state of the banking system unless the authorities intervene to resolve the problem. This further deterioration arises for several reasons:

• (1) Distortions that produce inefficient lending. Banking system distress can produce inefficiencies in bank lending. These inefficiencies can be manifested in two broad ways: through excessive risk-taking, which will threaten to worsen bank asset losses, or through a “credit crunch,” which will aggravate the economic costs of the crisis for business borrowers and further weaken bank loan quality.

• (a) Risk taking. Low net worth and insolvent banks have an incentive to “gamble for resurrection”, that is, to take risky positions with low probabilities of large payoffs but negative expected returns, in order to try to recover from insolvency before being forced into closure. The illiquid condition of these banks will, of course, limit the extent of risk-taking in which they can engage, but will not prevent it. This risk-taking will manifest itself in many different ways, e.g., through taking off-balance sheet positions, mismatching maturities and currencies, or extending risky loans. It is likely that risk-taking banks will direct new loans to borrowers who were excluded in pre-crisis conditions, because they will offer the largest (but riskiest) potential payoffs, rather than to less risky borrowers that have been shut out by risk-averse banks after the initial shock, even if the latter offer a positive expected return.

• (b) Credit rationing. Relatively strong banks that have experienced some asset loss but are not near insolvency will become risk-averse. If they have slipped below regulatory minimum capital ratios, they will be reluctant to add to risk assets, even as they obtain inflows of funds, until they have rebuilt their capital ratios. In this regard, even if they are receiving inflows of funds as the counterparts to illiquid banks that are experiencing deposit withdrawals, they will not necessarily provide sufficient demand for assets or extend sufficient new loans to offset the negative effects of asset sales and loan liquidations by illiquid banks. If the initial shock is severe and pervasive enough that there are no Class 1 banks, no liquid institutions will be inclined to extend credit to borrowers who were squeezed by risk-averse banks. A consequence of this restriction of the supply of credit is that some previously creditworthy borrowers will be rationed out of the market—a credit crunch. So, a banking crisis can exhibit both credit crunch conditions and excessive risk taking simultaneously.

• (2) Illiquidity. Low net worth and insolvent banks will experience liquidity pressures that drive them to sell assets and liquidate loans, resulting in depressed asset prices and economic activity.

• (3) Rise in risk premium. A banking crisis can produce a loss of confidence among investors in the ability of the country to conduct a suitable macroeconomic policy. This loss of confidence, together with a general uncertainty about the full dimensions of the crisis that will exist until it is more clearly resolved, will work to raise the country risk premium. This increase in the risk premium is likely to be embedded in the borrowing costs for all classes of borrowers—banks, businesses, and government—not just in bank loans but in international and other domestic financial markets as well. Furthermore, this rise in the risk premium can spread credit crunch behavior even to healthy banks.

  A credit crunch provoked by a banking crisis, then, develops along two dimensions. First, it is driven by the interaction of capital deficiency, distorted incentives and illiquidity. Second, even healthy banks may ration credit if the increased risk premium drives interest rate levels up to so high a level that the risk concerns of adverse selection—only impetuous or untrustworthy borrowers are willing to pay the prevailing rates—dominate the higher returns.

• (4) Contagion. The increases in uncertainty and risk premiums, the assets sales by illiquid banks, and the credit rationing by risk-averse and other banks associated with a banking crisis can disrupt the liquidity of financial markets, weaken the economy, and spread a broader contagion affecting other financial institutions. Public debt markets and the cost of issuing domestic public debt may be adversely affected. Failures may result among other highly leveraged institutions, and derivatives transactions can extend the losses more broadly through the financial sector.

For these reasons, banking system distress will be expected to worsen after the initial shock if no intervention actions are taken to mitigate the problem. For example, in Figure 1, if point d represents the condition of the banking system after the initial shock, the system will experience over time an expected deterioration along the path de in the absence of intervention actions. Of course, all participants—the authorities, banks, customers, depositors—will have only uncertain expectations about the magnitude and direction of the path de and about how fast conditions will deteriorate.¹¹

States of the system

Keeping that point in mind, we can make certain useful distinctions about different states of banking system distress. All of the initial starting points (α, β) that will eventually deteriorate into the panic zone if no intervention steps are taken are labeled “Crisis zone” in Figure 1. Starting from an initial point, f, in the crisis zone, the banking system would deteriorate without intervention along the expected path fh. The evolution of the system would not reach point h, however. At point g where it crosses into the panic zone, the system would shift to path gb, characterized by very rapid deterioration because of panic withdrawals of deposits and culminating in total liquidation of the banking system.

All other initial points that do not deteriorate into the panic zone are labeled “Distress zone.”¹² Starting from point d in the distress zone, the system will, without intervention, cross into the crisis zone and reach the end point e. It will not deteriorate further, however, because the factors driving the deterioration will have burned out. For example, although risk-taking banks initially tend to go deeper into insolvency, they will eventually become bankrupt and be liquidated, ending their capacity to do further damage. Low levels of asset loss and insolvency, then, may produce conditions of distress that generate further deterioration, but not to levels sufficient to provoke systemic disintegration. Crisis distress and non-crisis distress evolve in much the same way, but crisis distress reaches a state advanced enough to trigger panic.

Depositor behavior and attendant bank liquidity problems differ in degree among the three zones and will be managed in different ways. In the distress zone, liquidity problems are most likely to be sporadic and limited to name problems for individual institutions. They can usually be managed through the normal functioning of an interbank market or through the extension of LOLR credit to individual banks in need.

In the crisis zone, liquidity problems are likely to be more extensive and may affect entire classes of banking institutions that are viewed as being especially impacted by the nature of the initial crisis shocks. Depositors will exhibit widespread “flight to quality” behavior and severe tiering may occur in the interbank market, with the classes of banks having problems being shut out from access to funds. These conditions will require interventions that go beyond ordinary LOLR actions. The central bank may have to inject general liquidity into the market and may have to organize “lifeboat”–style concerted lending to compensate for the seizing up in the interbank market.

Deposit guarantees to stop panic

Liquidity conditions in the panic zone are qualitatively worse. In the crisis zone, even though conditions are characterized by a pervasive flight to quality, funds still remain in the banking system and there is no damage to the payments system. Not so in the panic zone, where depositors are withdrawing funds from all banks, threatening an implosion of the stock of deposits and a collapse of the payments system.¹³ These conditions cannot be easily managed by LOLR interventions. Central banks are generally heavily constrained from making direct loans to insolvent banks and insolvencies are widespread in the panic zone. While general liquidity support through massive open market operations (if the central bank has such capability) can mitigate the monetary contraction arising from depositor panic, it cannot readily restore confidence in the banking system and stanch the outflow of deposits and the resulting losses from forced asset liquidations and payments system disruption. The authorities are most likely in this situation to resort to granting emergency universal deposit guarantees to stabilize deposits.¹⁴ Such guarantees are typically temporary but the conditions under which they will be removed are left unspecified at the time that they are granted.

In the context of Figure 1, a universal deposit guarantee means that the banking system will not shift onto path gb as it passes into the panic zone but will, rather, follow along the path fh. In other words, the guarantee neutralizes the system against the effects of passing into the panic zone.

Such neutralization comes at a cost, however. Guarantees enhance the level of moral hazard in the system. Low net worth and insolvent banks that have an incentive to take on more uneconomic risk will be less constrained by liquidity problems and will take on risk faster. The system will move more rapidly along the path fh once guarantees have been issued.¹⁵ This development represents a problem of short-term moral hazard. It creates an incentive for the authorities to take quick action to resolve the crisis and prevent deterioration. On balance, deposit guarantees buy time for the authorities to take appropriate and value-conserving interventions to deal with the damage to the banking system by forestalling the threat of complete meltdown in a panic. However, deposit guarantees will tend to accelerate the actual rate of deterioration in the banking system by worsening the problem of short-term moral hazard before interventions are undertaken to relieve distress.

Another aspect of risk related to granting deposit guarantees can arise. The authorities may have information regarding the initial shock that allows them to form an expectation of α, the size of the asset loss, before they have information on β, the degree of systemic insolvency, or other conditions of banks in the system. Take the expected loss of asset value to be αⁱ in Figure 1. If α₀ < αⁱ < α₁, there is a probability, but not a certainty, that an asset loss of that size will lead to panic.¹⁶ The authorities must decide on incomplete information whether to grant a guarantee. Suppose they do and conditions turn out to place the system in the distress zone at αⁱ. This action would increase the short-term and long-term moral hazard of dealing with the system’s distress. On the other hand, not granting the guarantee could result in panic.

Resolving distress

After dealing with the threat of an incipient panic, the authorities must resolve the conditions of distress that generate short-term moral hazard, that is, they must take steps to stop the system’s deterioration along path fh. This deterioration stems from (1) credit crunch effects arising from risk aversion created by capital deficiencies and general uncertainty, (2) the risk taking of insolvent and low net worth banks, and (3) the economic burden of a higher risk premium, which is itself generated by systemic insolvency and capital inadequacy.

A direct approach to overcoming credit crunch effects is to quickly restore the capital position of risk-averse banks. Encouragement for recapitalization through directions and incentives to retain earnings and issue new equity is one option. Temporary relaxation of capital requirements is another route, but this could have further negative effects on the country’s risk premium and thereby produce additional self-defeating credit crunch effects. Finally, the authorities may use monetary or fiscal policy to try to offset the economic consequences of the credit crunch.

Shutting down the risk taking of insolvent and low net worth banks will require action to put the institutions under some form of conservatorship that will be charged with protecting asset values. The capacity for this kind of intervention will typically not exist and will have to be developed, which will be costly. The more quickly this step can be taken, however, the sooner deterioration can be slowed.

Restoration of a normal risk premium will usually depend on resolution of systemic distress. Achieving this outcome will involve a sequence of actions. The following steps make up a prototypical sequence. First, the bank restructuring authorities must pay a monitoring cost to determine which institutions have a positive franchise value. Those without a positive franchise value will be liquidated, which will generate costs for paying out on guaranteed deposits in excess of liquidated assets. Then, the authorities will seek to arrange private restructurings or mergers for banks with positive franchise values. This stage may entail search costs, as well as tax incentives or other implicit or explicit subsidies, such as temporary relaxation of various banking regulations. The impaired assets of such banks will often be transferred to a public AMC, which will also require a payout. Last, banks with positive franchise value that cannot be privately recapitalized or merged will be recapitalized with public funds with the aim of future reprivatization. In the long run, the authorities may realize cost offsets through recoveries on impaired assets or profits on reprivatizations.

Long-term consequences

There are also long-run consequences of intervention actions that will have their effect beyond the time horizon in which the bank crisis is resolved. Two types of these consequences are worth noting: long-term moral hazard and the efficient structure of the banking system.

• (1) Long-term moral hazard. Interventions that contain some element of subsidy, notably granting deposit guarantees, will change the future direction of bank risk taking even after the episode of crisis is concluded and the emergency guarantees are removed. Under limited liability, bank equity holders, who typically control the decision on bank asset risk profiles in normal times, have an incentive to take on more risk than depositors prefer. Depositors can limit this risk taking by incorporating a risk premium into the return on deposits, if they have information on the risks that banks are assuming. However, if the government is willing to provide guarantees on deposits in certain states of the world, such as during a banking crisis, depositors will require a somewhat lower risk premium, since any risks that banks assume that result in those states being realized will not harm depositors.

  Emergency guarantees, in contrast to a permanent system of universal deposit insurance, provide protection only in some states of the world when there is a state of systemic crisis. Therefore, an individual bank will still face the prospect of a rising risk premium on its deposits if it increases its idiosyncratic risk. This condition creates an incentive for different banks to take on risk in ways that are positively correlated, since such action increases the conditional probability that if a bad outcome occurs for an individual bank, it will be perceived by the government as part of a systemic problem. Granting emergency universal guarantees creates an incentive for the banking system to take on higher risk in the form of risks that are positively correlated across banks—for example, all banks increasing their lending to the real estate sector. Positively correlated risk taking, however, increases the risk of another systemic crisis, since it eliminates diversification benefits in the total banking system portfolio in the case of a negative exogenous shock. In this sense, granting emergency universal guarantees creates a perverse moral hazard incentive.

• (2) Efficient structure. Intervention to stabilize the banking system in a crisis and conduct orderly resolution of problem banks can have the additional benefit of producing an efficiently restructured banking system at lower cost than will a disorderly liquidation. Both liquidation through panic and a more orderly resolution will remove badly mismanaged and truly insolvent banks and replace them, in the long run, with investments in new banks that have an efficient structure. However, a disorderly liquidation will require a more expensive investment to restore an efficient banking system structure, since it will also eliminate all well-managed banks with a positive franchise value. Orderly resolution procedures allow restructuring plans for these institutions and, hence, keep them intact.

Benefits of a deposit guarantee

The economic benefits of intervening can be defined in terms of economic costs that are avoided from letting a crisis run its course. These benefits can be divided into those arising from granting the deposit guarantee and those stemming from resolution actions. The benefits of granting the guarantee are the avoided costs of panic. We take these costs to be given by the condition of moving from point g to point b in Figure 1. The costs of panic are valued at point b and at t = T₀, because no intervention actions apart from a deposit guarantee can forestall these costs once point g is reached and because they proceed rapidly. These benefits are summarized in Table 3.

Table 3.

Economic Benefits of Intervening in a Banking Crisis

Table 3.

Economic Benefits of Intervening in a Banking Crisis

	Immediate (t=T0)	Short run(T0 < t ≤ TE)	Long run (t > TE)
Benefits
Deposit guarantee
(1) Avoided liquidation of  banking system assets
(a) marketable assets	ϕ(M(g) − M(b))		δ(t>TE)ϕ(M(g) − M(b))
(b) nonmarketable assets	AC(g) - AC(b)	δ(T0 < t < RE)λ [(AC(g) - AC(b))−(L(g) −L(b))]
(2) Avoided disruption  to payments system	[μ(D(g) − A(b)) + vA(b)]		δ(t > TE)[μ(D(g) − A(b)) + vA(b)]
Resolution actions
(1) Profit on asset disposition			δ(t > TE)IIA(ρ(g))
(2) Profit on reprivatization			δ(t > TE)IIE(ρ(g))
(3) Efficient restructuring			γδ(t > TE)(A(0) − AI-(0))

View Table

Table 3.

Economic Benefits of Intervening in a Banking Crisis

	Immediate (t=T0)	Short run(T0 < t ≤ TE)	Long run (t > TE)
Benefits
Deposit guarantee
(1) Avoided liquidation of  banking system assets
(a) marketable assets	ϕ(M(g) − M(b))		δ(t>TE)ϕ(M(g) − M(b))
(b) nonmarketable assets	AC(g) - AC(b)	δ(T0 < t < RE)λ [(AC(g) - AC(b))−(L(g) −L(b))]
(2) Avoided disruption  to payments system	[μ(D(g) − A(b)) + vA(b)]		δ(t > TE)[μ(D(g) − A(b)) + vA(b)]
Resolution actions
(1) Profit on asset disposition			δ(t > TE)IIA(ρ(g))
(2) Profit on reprivatization			δ(t > TE)IIE(ρ(g))
(3) Efficient restructuring			γδ(t > TE)(A(0) − AI-(0))

Table 4.

Economic Costs of Intervening in a Banking Crisis

Table 4.

Economic Costs of Intervening in a Banking Crisis

		Immediate(t=T0)	Short run(T0 < t ≤ TE)	Long run(t > TE)
Costs
Deposit guarantee
(I) Fiscal-related			${\theta }{\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \sum _{{{C}}_{{I}-}}({D}(\mathbf{g})-{A}[\mathbf{g},\mathbf{x}({T})])}$
(2) Long-term moral hazard				${\delta }({t}>{{T}}_{{E}}){\displaystyle \underset{{T}}{\overset{{\infty }}{\int }}[{y}({{r}}_1,{\omega }({{p}}_1),{t})-{y}({{r}}_0,{\omega }({{p}}_0),{t})]{d}{t}}$
Resolution Actions
(1) Fiscal-related
	(a) monitoring costs	mCI
	(b) search costs		δ(T0 < t ≤ TE)s(σ,(C4 + C5+),T)
	(c) support for private restructuring		${\delta }({{T}}_0<{t}\le {{T}}_{{E}})({\psi }(\mathbf{g}){\displaystyle \sum _{{{C}}_{{P}}}{A}[\mathbf{g},}{ }\mathbf{x}({T})]+{\theta }{\displaystyle \sum _{{{C}}_{{P}}\cap {{C}}_{{I}+}}({D}(\mathbf{g})-{A}[{g},{ }\mathbf{x}({T})]))}$
	(d) temporary public recapitalization		${\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \sum _{{{C}}_{{N}}}({A}(\mathbf{0})-{A}[\mathbf{g},\mathbf{x}({T})])}$
(2) Short-term moral hazard			${\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \underset{0}{\overset{{T}}{\int }}{\displaystyle \underset{{f}({z})=0}{\int }{Y}\prime ({Z}){dZ}{dt}}}$

View Table

Table 4.

Economic Costs of Intervening in a Banking Crisis

		Immediate(t=T0)	Short run(T0 < t ≤ TE)	Long run(t > TE)
Costs
Deposit guarantee
(I) Fiscal-related			${\theta }{\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \sum _{{{C}}_{{I}-}}({D}(\mathbf{g})-{A}[\mathbf{g},\mathbf{x}({T})])}$
(2) Long-term moral hazard				${\delta }({t}>{{T}}_{{E}}){\displaystyle \underset{{T}}{\overset{{\infty }}{\int }}[{y}({{r}}_1,{\omega }({{p}}_1),{t})-{y}({{r}}_0,{\omega }({{p}}_0),{t})]{d}{t}}$
Resolution Actions
(1) Fiscal-related
	(a) monitoring costs	mCI
	(b) search costs		δ(T0 < t ≤ TE)s(σ,(C4 + C5+),T)
	(c) support for private restructuring		${\delta }({{T}}_0<{t}\le {{T}}_{{E}})({\psi }(\mathbf{g}){\displaystyle \sum _{{{C}}_{{P}}}{A}[\mathbf{g},}{ }\mathbf{x}({T})]+{\theta }{\displaystyle \sum _{{{C}}_{{P}}\cap {{C}}_{{I}+}}({D}(\mathbf{g})-{A}[{g},{ }\mathbf{x}({T})]))}$
	(d) temporary public recapitalization		${\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \sum _{{{C}}_{{N}}}({A}(\mathbf{0})-{A}[\mathbf{g},\mathbf{x}({T})])}$
(2) Short-term moral hazard			${\delta }({{T}}_0<{t}\le {{T}}_{{E}}){\displaystyle \underset{0}{\overset{{T}}{\int }}{\displaystyle \underset{{f}({z})=0}{\int }{Y}\prime ({Z}){dZ}{dt}}}$

Long-term benefits from efficient restructuring

In the absence of intervention, all banks are driven to insolvency and forced into liquidation. In the long run, the banking system will be reconstituted. Assume that it is reconstituted at its pre-crisis capacity. Similarly, after intervention is completed, the banking system will be reconstituted at pre-crisis capacity. However, the costs differ in the two cases.

Assume that the organizational set-up costs for de novo banks in the reconstituted system are proportional to the pre-crisis level of assets (the measure of capacity) held by banks liquidated during the crisis.¹⁸ Without intervention, all banks wind up liquidated and set-up costs are proportional to systemic pre-crisis assets, A(0). Under intervention, however, only the class of insolvent banks without a positive franchise value, designated C_I, is liquidated. Set-up costs in this case are proportional to the pre-crisis assets of that smaller set of liquidated banks, A_I-(0). The benefits of efficient restructuring, then, are given by:

Fiscal-related costs

Fiscal cost versus economic cost

The economic cost of the deposit guarantee is different from the fiscal cost. The loss represented by the payments on deposit guarantees has already occurred before any payments are made and must be borne by some group, either depositors or taxpayers through the government. If the government were indifferent between these two groups, there would be no economic cost to the payout on the guarantee. But the government is not indifferent. The economic cost to the government, then, is given by the term θ. This term is positive since payouts, which effectively transfer the burden to taxpayers, are assumed to be more costly than losses borne by depositors because the government gives priority to the protection of taxpayer interests.¹⁹ Governments grant depositor guarantees, therefore, not because they value depositor gains more highly than taxpayer gains, but in order to avoid the economic costs of depositor panic.

A similar premium does not apply to other disbursements of government money in interventions. Monitoring and search costs are not realized if the government does not take intervention actions. Public funds used to purchase and segregate impaired assets or to recapitalize banks represent new investment choices. The net return (or loss) on the face value of these investments is an accurate measure of the economic benefit (or cost).

Short-term moral hazard

Another kind of cost associated with crisis intervention has already been alluded to and can be characterized as short-term moral hazard. Essentially, it represents the deterioration in income that results from the persistence of banking system distress. Even if banking system distress does not increase, economic costs will increase from the initial level of distress as time passes until resolution is completed. So this cost must be aggregated over both time and conditions in the banking system. This moral hazard cost (MHC) is given by

where Z = (α, β, ρ(α, β)) is a vector of the factors arising from the conditions of distress in the banking system that generate economic costs: as in Figure 1, α is the aggregate loss in banking system asset value; β = (β₁, . . . .β_n) is a vector of the distress conditions in the banking system, with each β_i equal to the share of banking system assets held by banks in distress class i²⁰; and ρ(α, β) is the risk premium induced by banking system distress.

The relation f(Z) = 0 implicitly defines the path of evolution of banking system conditions through the crisis and its resolution. Starting from point g in Figure 1, conditions will deteriorate to a point of maximum distress, x(T), and then follow some path back to normality, represented by point 0, when the banking system is reconstituted at the end of the resolution period. The authorities can minimize this cost, and search costs as well, by being very aggressive in their intervention strategy and setting T close at a low value. But that choice will maximize liquidations of banks and payouts to depositors, which may not be the efficient choice.

Long-term moral hazard

As discussed earlier, granting a guarantee can change incentives for future actions on the part of banks and depositors. More precisely, the degree of future risk taking that banks undertake depends on their expectation of government intervention in future crises. If the outcome of the government’s decision whether to grant the guarantee or not is expected, no new moral hazard effects are generated. If the outcome is unexpected, future risk taking changes. In either case, the government will have to take account of what future risk taking will be in light of its decision.

The natural assumption is that market participants expect the authorities to issue a guarantee to forestall a panic; this action has typically been the actual choice of governments that have found their banking systems in extreme jeopardy. The discussion in this paper, however, has used the case of no intervention as the baseline for discussing benefits and costs. By making no intervention the baseline expectation, the paper will refer to the moral hazard costs of intervention rather than the moral hazard benefits of no intervention.

The essential element of long-term moral hazard is this: emergency deposit guarantees shift banks toward increased risk taking because the guarantees protect depositors in certain conditions, namely, a systemic crisis, and thereby lessen any discipline depositors may exert on bank decisions. It is unclear, however, whether this shift toward increased risk taking will have an economic cost.

To see this point, consider a simple comparison. Assume that the baseline case of no deposit guarantees is associated with a particular future path of economic growth. This outcome would occur if the availability of banking finance is actually a binding constraint on the development of some economic assets. Assume also that the shift to increased risk taking produced by the moral hazard of granting a deposit guarantee is manifested as recurrent episodes of temporary shortfalls from baseline growth – recessions caused by recurrent banking crises. The greater the degree of moral hazard, the greater is the frequency of these recurrent crises.

If the growth path that incorporates the moral hazard effects is no higher than the baseline path, then the riskier path clearly has a lower present value in terms of current income and moral hazard is costly. If, however, the higher risk assets that banks finance under moral hazard also generate a higher expected return, then the present value outcome of the change in future growth paths is unclear. In light of this ignorance, the government can reasonably take the expected value of the economic cost of long-term moral hazard to be zero and can neglect it as a factor in its decision regarding the granting of a deposit guarantee.

Formally, the cost (benefit) of long-term moral hazard can be represented as

which is the discounted value of the difference in the growth paths with (subscript 1) and without (subscript 0) the deposit guarantee. The path of y depends on time; on r, the growth rate of potential output; and on ω, a process that generates recurrent crisis episodes of shortfall from the potential output growth path. The process ω, depends on ρ, the probability of a banking crisis, with a higher probability producing more frequent and, possibly, larger crises. The moral hazard of granting a deposit guarantee implies that p₁ > p₀. But if r₁ > r₀, the value of the moral hazard term may be a positive net benefit.

When will r₁ > r₀? If the banking system in its pre-crisis risk-normal²¹ condition was truly risk-neutral, it financed assets in priority of their expected returns only, regardless of their riskiness. In order to take on more risk, then, in light of the moral hazard of the deposit guarantee, the banking system in the future would have to adopt a risk-taking bias. To achieve this state, the banking system would have to switch into some lower yield but higher risk assets, which would actually reduce the potential growth path that it finances.

If, however, the banking system in its pre-crisis risk-normal condition was risk-averse, it could shift into riskier assets that also produce a higher yield, since not all high yield assets would have already been incorporated into the baseline growth path. As a consequence, r₁ could exceed r₀ and the net economic effect of moral hazard would be uncertain. It is not unreasonable to think that some degree of risk aversion, rather than strict risk neutrality, characterizes the risk-normal condition of the banking system. If so, the government would be justified in ignoring long-term moral hazard effects, since it could not form a clear expectation of the direction of these effects in terms of economic costs.

The government’s decision process

The government’s problem in intervening in a banking crisis is to maximize net benefits by choosing values of the policy variables that it controls. A crisis is defined so that intervention requires issuing a deposit guarantee followed by actions to resolve distress among capital-deficient and insolvent banks. Not intervening entails not issuing a deposit guarantee and allowing a panic to run its course.

A “quick and dirty” method

A short-cut procedure for assessing the benefits and costs of actions to deal with a banking crisis can be developed along the lines of the framework presented above. This approach focuses on a general relation between an aggregate measure of the severity of the banking crisis and some measure of the overall macroeconomic costs that are avoided through intervention actions.

As noted earlier, resolution costs, as they appear in the fiscal accounts of the government, are not typically an accurate representation of the underlying economic costs of intervening in a banking crisis. A “rational” government, which would seek to minimize total economic costs, would recognize losses that had already occurred. A deposit guarantee transfers these losses from depositors to taxpayers but does not increase their size.²⁴

The economic cost of redistribution under a deposit guarantee will be some proportion, θ, of the face value of the fiscal costs of the guarantee. This proportion will depend on a complex of factors, including the tax burden on taxpayers, the debt-servicing burden on the government, the share of guaranteed deposits held by individuals, etc. However, it is reasonable to assume that, other things equal, the government will place a premium on the use of public funds in order to protect taxpayer interests. As a consequence, we assume θ > 0.

A first approximation of additional economic costs is to add to fiscal costs an estimate of the economic growth shortfall that arises from the distressed condition of the banking system—essentially, short-term moral hazard costs. These costs, as a fraction of GDP, grow with delay in taking intervention actions and, therefore, depend on the length of the intervention period, T:²⁵

where Y is the level of GDP at the start of the crisis and k is the annual economic shortfall represented as a fraction of GDP.

Total costs of intervening in a banking crisis (C), then, are the sum of the economic burden generated by fiscal costs and short-term moral hazard costs:

A simple specification of the benefits of intervening is given by the expected avoided costs of a banking panic, represented by the probability of panic at the start of the crisis multiplied by an overall measure of panic costs. The avoided costs of panic are a measure of a counterfactual outcome and are, therefore, unobservable except in the case where panic is actually allowed to happen. Such cases are sporadic and it is even arguable that there are no clear examples at all of a full-scale panic allowed to run its course without some kind of intervention, at least in recent history. A simple rough estimate of panic costs can be made by extrapolating to the whole banking system the experience of asset loss for individual banks that suffered runs.²⁶ An estimate of the panic loss as a percentage of assets, represented by α, an observed loss in asset value for individual banks experiencing forced liquidations, which we set at .33. Expected panic costs, C^P, then, are given by .33A, where A is the value of banking system assets, measured by loans to businesses at the start of the crisis.

The net benefits of intervention are:

Drawing on an estimate of the average economic costs of delaying resolution action based on a cross-section of banking crises,²⁷ we set k = .007. Ex ante fiscal costs are measured by their realized outcome taken at face value (θ = 1).

To make this simple rule-of-thumb formula applicable to our case study, we insert variable values that correspond to the Swedish banking crisis. We date the Swedish crisis at 1991-Q1 to 1993-Q4; so T = 2.25. The value of A is given by the 1991-Q3 amount of banking system loans to business, SEK484 billion. This estimate underestimates the base of banking system assets subject to liquidation in a panic since it ignores the fire-sale liquidation of marketable assets. Fiscal costs are taken as the undiscounted sum of funds expended over the crisis period, SEK64 billion, which exaggerates net fiscal costs by ignoring discounting and not taking account of offsets, such as gains from reprivatization Base year (1991) GDP, Y, is SEK1447 billion. At these values net benefits are given by

This calculation (which should be viewed as a high-end estimate of the break-even probability of panic) implies that the net benefits of intervention in the Swedish case were positive if p > .54, or if the odds of panic were roughly even.

Benefits of intervention

Avoided costs of liquidation of marketable assets

Under panic conditions, the banking system is forced to dump its holdings of marketable assets. Assume that this fire sale immediately depresses asset prices to a new equilibrium.

Figure 2 illustrates the case. Forced liquidation by banks during a panic depresses the demand curve for marketable assets from DD to D′D′. Demand for marketable assets falls by Q₀ – Q₁ = M(g), the level of the banking system’s holdings at the start of the crisis. This decline depresses the equilibrium price level immediately to P₁ so that asset holders experience a wealth loss equal to (P₀ – P₁)Q₀. Since the percentage change in quantity demanded is fixed at the banking system’s share of the market, the percentage change in asset prices and the wealth loss can be calculated if the price elasticity of demand is known.

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Fire Sale of Marketable Assets by Banks

Citation: IMF Working Papers 2000, 147; 10.5089/9781451856729.001.A001

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Costs of intervention