Front Matter Page

Monetary and Capital Markets Department and Research Department

Authorized for distribution by José Viñals

Contents

• Executive Summary

• I. Introduction

• II. What Was Different This Time?

  • A. Initial Macroeconomic and Financial Conditions

  • B. The Policy Responses

• III. Policy Choices And Preliminary Lessons

  • A. The Costs of Crises

  • B. The Policy Choices and Preliminary Lessons

• IV. Conclusions

• References

• Tables

  • 1. Pre-Crisis Indicators

  • 2. Selected Asset Relief Measures during Recent and Past Crises

• Figures

  • 1. Timing of Interventions and Amount of Liquidity Support

  • 2. Containment and Resolution Policies

  • 3. Monetary and Fiscal Policies during the Crises

  • 4. Nonperforming Loans

  • 5. Cost of Recent and Past Crises

• Box

  • 1. Bank Restructuring and Asset Management: Sweden versus Japan

• Appendix

  • 1. Definitions, Data Sample, and Fiscal Costs of Crises

  • 2. Timeline of Events and Policy Responses

  • 3. The “ABCs” of Crisis Resolution and Experience in the Recent Crisis

  • 4. Resolution Approaches, Restructuring and Moral Hazard

Executive Summary

This paper compares the policy choices in recent and past crises, explains why those choices varied, and assesses the current state of financial and operational restructuring and institutional reform. While acknowledging the unique and global nature of the recent crisis and varying country circumstances, analysis suggests that the diagnosis and repair of financial institutions and overall asset restructuring are much less advanced than they should be at this stage and that moral hazard has increased. Consequently, vulnerabilities in the global financial system remain considerable and continue to threaten the sustainability of the recovery. These conclusions point to a number of steps to finish the business of financial sector repair and reform.

Establishing the long-term viability of the financial system requires recognizing nonperforming assets at financial institutions and a deeper operational restructuring of debts of enterprises and households. Regarding the persistent weaknesses in bank balance sheets, in-depth diagnoses still need to be conducted, including through strict and transparent stress tests. When the diagnoses call for credible recapitalization plans or restructuring of liabilities, they should be carried out swiftly in ways that do not worsen sovereign debt burdens. Conditions in some countries require government interventions, including targeted programs to alleviate debt overhangs in the household and commercial real estate sectors. More broadly, asset restructuring needs to be driven by market forces, supported by tighter regulations—including in the areas of loan-loss classification, provisioning, and disclosure—and enhanced supervision.

In most countries, more-effective resolution tools are required to preserve financial stability in an increasingly complex and interconnected global system. Progress is being made at national levels, but many challenges remain, also at the international level. These include the design of infrastructures to wind down nonbank financial institutions that are of systemic importance and banking organizations that operate across borders and the design of mechanisms to ensure that the losses are borne by the creditors of the institutions rather than by taxpayers. Enhanced supervision of cross-border exposures and related systemic risks is also needed. Moving expeditiously on this reform agenda, including adopting rules for cross-border burden sharing, requires more political commitment.

Confidence in financial systems is still highly dependent on explicit and implicit central bank and government support. Moral hazard has increased, in part as sectors have become more concentrated, while financial systems are still prone to stress and turmoil. Measures are needed to restore proper incentives and market discipline. Governments need to rethink how to reduce the threat that large financial institutions pose to systemic stability, including through reduced complexity, better capital structures, and, possibly, restrictions on their scope and activities.

Past crises shed light on the sequencing and mix of policies best suited for the management and resolution of crises. The quick deployment of containment measures during the recent global financial crisis, including accommodative monetary and fiscal policies, helped establish confidence and restore economic stability. But compared with earlier episodes, the response featured less attention to in-depth diagnosis of financial institutions and fewer incentives for an early restructuring of assets. Moreover, the conditions imposed on institutions that received public support were less-stringent than in past crises. The policy mix applied in the recent crisis has come at a high overall cost and has intensified moral hazard. The mix is unlikely to be repeated in response to a future crisis because it would be too costly economically and too controversial politically. In preparing for a future crisis, therefore, we must consider how to apply the constructive aspects of the recent response—early stabilization through accommodative policies—and improve the areas in which it was weakest—the limited conditionality of public support and the gradual restructuring of assets.