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STARTING OVER SAFELY: REBUILDING BANKING SYSTEMS Gerard Caprio and Patrick Honohan Prepared for the Conference “The Financial Sector PostCrisis: Challenges and Vulnerabilities” Brookings Institution, Washington, DC, April 26-27, 2005 Outline • Features of recent crises • Post-containment resolution policy (short term) • Infrastructure-building (medium term) Varied sources of crises • Unstable macro conditions – positive feedback loop – but banking often not causal – unhedged positions a special feature • Unraveling of government impositions – China, Vietnam, Zambia, etc. • Management failures – “diverted deposits” fraud Four distinctive features of recent resolutions • Skewed distribution of losses – not all banks fail: the fittest survive • State-owned as well as private bank losses – Even in macro-related collapses, • Turkey=50%, Indonesia=46% • Information emerges slowly – One-shot resolution is rare: it’s not over ’til it’s over • Currency depreciation has often been central – Sometimes a trigger, sometimes a resolution tool Post-crisis systemic performance (1) There is no universal pattern • GDP growth tends to be adversely affected – But could be misleading to interpret as causal • Inflation more often slows than accelerates • Nominal interest rates more often fall than increase GDP growth before and after 10 China 8 Vietnam 6 Lithuania Ukraine Cameroon Latvia 4 After Costa Rica Swaziland Malaysia Thailand Bulgaria CAR 2 Yemen Korea Paraguay Argentina Ecuador Jamaica Venezuela Burundi Zimbabwe 0 -2 Congo DR -4 -20 -15 -10 -5 0 Before 5 10 15 Inflation before and after 1.8 1.6 1.4 1.2 After 1.0 0.8 0.6 0.4 Zimbabwe 0.2 Congo DR Russia 0.0 0.0 0.2 0.4 0.6 0.8 Bulgaria 1.0 -0.2 Before 1.2 Brazil 1.4 1.6 1.8 Post-crisis systemic performance (2) • Bank lending does tend to be compressed after crises, even when financial depth increases. • Long-lived macrodoubts, sometimes fuelled by the crisis, can cause dollarization to jump. • Shrinking intermediation spreads have been correlated with falling concentration rates. Bank credit to pvt sector before & after (% GDP) 1.6 1.4 China 1.2 Korea 1.0 After Malaysia Thailand 0.8 0.6 Croatia Vietnam 0.4 Ukraine 0.2 0.0 0.0 Philippines Bulgaria Indonesia Ecuador Mexico Venezuela 0.2 0.4 0.6 Before 0.8 1.0 1.2 1.4 Deposit dollarization before and after 100 Bolivia 90 80 70 Paraguay 60 After Ecuador Bulgaria 50 Zambia 40 Vietnam 30 20 10 0 0 20 40 60 Before 80 100 Spreads (loan-deposit rates) before and after 70 Zimbabwe 60 50 After 40 Paraguay 30 20 Zambia Croatia Jamaica Ecuador Lithuania 10 Argentina 0 0 10 Ukraine Bolivia Bulgaria Latvia 20 30 Before 40 50 Post-containment resolution issues: Common ground (1) • Transparent resolution policy; speed of action; deal also with corporate distress. • Merits of an all-private resolution; avoid full socialization of losses – shareholders & subordinated claimholders should pay – Recaps should be with tradable/bankable instruments, not vague IOUs Post-containment resolution issues: Common ground (2) • Actual practice follows the consensus -- with implementation deficiencies: – Insiders allowed to loot – Unsuitable new shareholders – Too optimistic on asset recoverability (mistaken attempt to protect the budget) Post-containment resolution issues: Points of contention • Capital and ownership – Also: when to recapitalize state-owned banks • No monopoly for AMCs? • Real value of deposits/exchange rate policy Capital and ownership: options • Relying on existing shareholders – But risk of self-dealing and looting – Leaves State in poor bargaining position – Preserves existing power structures (cf Rajan-Zingales) • Seeking domestic merger partner – 2 weak banks = 1 strong one? • Finding other local owners (where?) • Nationalization (only temporary solution) • Foreign buyers Recapitalizing state-owned banks • Fox and chickens • Wait until governance is right • This surprisingly is not yet part of the conventional wisdom AMCs • Can assets find a ready market? • Loss of information capital may be important • Recovery experience not great Real value of deposits • Depositor confidence is important, but also need to set system on sustainable path • Nominal losses for local currency deposits (Argentina), FX deposits (Argentina, Russia); real losses from deval (Turkey, Indonesia) -- impact on financial depth surprisingly low • Devaluation and dollarization: endogenous and official Monetary depth, selected countries 1990-2003 0.7 0.6 share of GDP 0.5 Argentina 0.4 Indonesia Russia 0.3 Turkey 0.2 0.1 0 1990 1992 1994 1996 1998 2000 2002 Reshaping the sector for the medium term • Stability through development • Global finance and small financial systems • Excessive reliance on banks and poorly structured debt finance • Bank regulation and supervision • Financial sector standards, growth, and crisis prevention Stability through development • Financial systems that do not provide broad access to financial services are not stable – Preferred credit schemes can erode “credit culture” – Diversified portfolio of loans is more stable – Why can’t developing country banks make loans at a marginal cost of pennies? Global finance and small systems • Insufficient diversification a leading cause of crises – Requires more foreign entry, regional banking, and/or investment abroad – Should the World Bank become a global bond fund? – Can credit default swaps help (soon)? Reducing reliance on banks/debt • Underdeveloped financial infrastructure creates a bias for a bank debt finance • Underpriced deposit insurance further skews the playing field • Tax policy often reinforces the bias in favor of debt relative to equity. Rethinking regulation • Technical view of regulation has produced Basel II, reliance on complex approach backed by supervisory discretion • Neither speaks to elements of developing countries. Better risk management is desirable but… – Where are the data? – Where are the skills? – Do developing countries want their best and brightest in bank supervision? Institutional Environment Democratic, Political Structure/System Media Market Structure Judicial, Legal, Regulatory Environment The Public Politicians Regulators and supervisors Corruption Banks Corruption The Market: Depositors,creditors, rating agencies Borrowers, counterparties Technology, Information Infrastructure Financial Regulation: an institutional view Better than Basel • Emphasize market monitoring • Put supervision in a supporting role – Verifying the information that is disclosed – Penalizing those disclosing inaccurate or misleading information • Building solid infrastructure in the financial sector needs to be a priority Beyond financial sector standards • Standards virtually a tautology – If you had them, you would be developed; if not developed, you must be missing some. – Standards give no priorities; no country could really change their compliance overnight with all standards – Their impact on the ground depends on the institutional environment in which they are planted – Rich got rich without them!