Banking Crises, Regulatory Reform and Resolution Charles Calomiris May 11, 2010
Macroeconomics and Banking n n View that banks are sources of shocks and propagators of shocks in the macroeconomy was “rediscovered” in 1980 s, and has received more attention in the past decade, especially after the Asian and Mexican crises. This view has substantial historical precedent, and supporting historical evidence, and is only “new” in the sense that it was ignored by most macroeconomists in 1950 s, 1960 s and 1970 s.
Why the Rediscovery? n n Banking instability became more of an issue in macroeconomics. Key trends Frequency of banking crises n Coinciding of banking crises/capital crunches with macroeconomic declines n Mixing of banking crises with exchange rate or sovereign crises. n
EM Banks Especially Unstable n n n Fiscal costs of banking crises in EMs amounted to about $1 trillion in the 1980 s and 1990 s, which was equal to all foreign assistance transfers from developed countries from 1950 -2001. Many of these collapses also involve twin crises (collapses of both exchange rate and banking systems), with dire macroeconomic consequences. Why is this happening? What can be done?
Central Questions about Bank Risk and Prudential Regulation n n Why are crises so common and so severe now? Are banking crises and their causes the same or different from those of the past? Are crises inherent in the function and structure of banks? Which supervision and regulation rules work? Should government pursue counter-cyclical forbearance policies, or procyclical prudential regulation?
Bank Function and Structure n n Banks control risk via intensive screening, contracting, and monitoring, involving private information production. Bank function and structure n n n Delegated monitoring on asset side, liquidity creation on liability side Maturity and liquidity transformation First-come-first-served rule Essential structure and function of banks has created a special role for debt market discipline of banks, in contrast to other firms. Does this make banks risky? Does that explain EM banking crises? Alternative view: Insider lending, moral hazard, politics of bailouts (Populism meets cronyism)
Crises have different shapes n Currency depreciation only, reflecting an overvaluation of the currency, but without effects on banking system n n Banking collapse only n n Brazil 1999: overvalued currency, lack of fiscal discipline, but banks relatively healthy, no resurrection risk betting Australia 1893: costs of losses in banks absorbed by stockholders and depositors, not taxpayers Twin crises, in which banking collapses and exchange rate collapses happen together. The new phenomenon of twin crises (only a handful were observed in pre-1980 era). But twin crises can also be distinguished according to the dominant direction of causation n n fiscal crisis => banking instability as in Argentina 2001, where government lacked the safety valve of inflationary monetary policy, and thus stole bank capital as last resort means of financing; or banking instability => fiscal crisis, as in Mexico 1994 and East Asia 1997, although in these cases there was also an overvaluation problem of real exchange rate, in Mexico because of boom in demand, and in Asia because of cumulative decline in productivity
Financial system feedback during crises Currency devaluation Rapid rise in interest rates Capital outflow Overextended banks and firms
Risk factors show themselves during crises n n n Law: inability to have orderly workout in financial distress leads to backlog of unresolved debts; reversal of privatization contracts, redenomination of contracts, limits on capital flows, nationalization of assets. Information: markets react dramatically to crises (shut down of orderly information processing, high adverse selection costs) Fiscal policy: lack of political will to reduce expenditures, improve tax collection, avoid inflation tax. Banking: desire to protect bankers, who are often borrowers and political allies, too, leads to lack of credible discipline ex ante, and big bailouts ex post. Quasi privatization can be worse than public banks from the standpoint of the severity of crises. KEY POINT: All these risks can be observed in advance of the crisis!
n Recent crises forecasted in particular countries Mexico: The dog that did not bark in December 1994. n n n East Asia: Diminishing returns / cronyism n n n Weak bank balance sheets, high corporate leverage were known Low or negative return on invested capital due to crony banking Overvaluation related to declining productivity Recessions reflecting declining productivity, overvaluation Brazil: Insufficient fiscal reform n n n Fiscal spending and bank lending, election year Overvaluation (Dornbusch) Bank privatizations, lack of recapitalizations Recession began in 1993 Sterilization, reserve outflows, tesobonos liquidity risk Overvaluation Old story of unsustainable peg given rising inflation Argentina: Insufficient fiscal reform n n n Coparticipation Labor, tax policies, recession (overvaluation-induced deflation) Destruction of banking sector
Causation in Mexico n n n n Spending, weak privatized banks (Haber article), offbalance sheet exposures raise debt and expected monetization. As reserves are drained, central bank sterilizers, thereby increasing current money supply. Rise in money and expected money drive up prices, leading to overvaluation and increasing pressure on exchange rate. Zedillo’s non-reform leads market to realize inevitability of collapse, and run begins. FX exposure is combination of direct bets and defaults linked to dollar debt. Banks double bets on FX by having lots of both (in violation of regs, done with swaps via Wall Street). Uncanny (forecasted) replay of Chile 1982 -83 crisis.
Rising Debt, Sterilization
Sterilization had been the rule
Inflation and base growth linked
Inflation increasingly threatened exchange rate
Mexican Devaluation
Asian Crises n n March and April 1997, the Economist and FT have special reports on declining fortunes of Asian banks, and possible crises there. Alwyn Young writes about declining productivity as threat to sustainability of socalled Asian miracle in 1994 -95. Short-term borrowing in dollars increases as risk rises (largely interbank, “protected”? , and with different weights according to Basel). IMF assistance bails out those debts.
Bank Losses in Asian Crises Thailand Indonesia Korea 1997 NPL/TL 19% 17% 16% 1997 NPL/GDP 30% 10% 22% Cleanup Cost / 1999 GDP 42% 55% 20%
Diminishing Returns => Increasingly Inefficient Capital Investment in East Asia in 1980 s, 1990 s Return on Capital Employed Minus Interest Rate, 1992 Indonesia Korea Malaysia Philippines Thailand -12% - 3% 3% -13% - 9% Source: Pomerleano (1998)
Micro Level Stylized Facts As the 1990 s progressed. . . • Asian corporations experienced a decline in performance. • Asian corporate managers increased the leverage of their firms. • Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars).
How Can You Bet the Country? n n n Government bailouts are anticipated, intermediated by government’s relationship with the IMF, which injects dollars to government, which pays them to crony firms with outstanding short-term debts. Taxpayers pick up the pieces. High leverage of ex ante insolvent banks and firms indicates that both borrowers and US, Japanese, and European bank lenders anticipated this. Note: Capital flows, per se, are not the problem, but rather the allocation of risk by government associated with those flows. There is an argument for waiting to liberalize capital flows until incentives and financial regulation have been fixed. This is a particularly important issue for China, given that it could repeat the Asian crisis pattern, given diminishing returns and lack of market discipline in banking system.
Trends in Corporate Leverage Ratios Country Comparisons Rating Ratio AAA 13. 4 AA 21. 9 A 32. 7 BBB 43. 4 BB 53. 9 B 65. 9
Brazil’s Controlled Devaluation (Healthy banks)
Argentina’s Crisis Anticipated Interest Rates on 30 -Day Time Deposits in Pesos and Dollars Sources: J. P. Morgan Chase & Co. ; Banco Central de la República Argentina, Interest Rates on Deposits ( vailable at http: //www. bcra. gov. ar/). a
Argentina’s Crisis Anticipated Difference Between Interest Rates on 30 -Day Time Deposits in Argentina in Pesos and Dollars vs. EMBI+ Argentina Strip Spread Sources: J. P. Morgan Chase & Co. ; Banco Central de la República Argentina, Interest Rates on Deposits ( available at http: //www. bcra. gov. ar/).
Deposit Outflows Monthly Dollar Deposits in Argentina, 2001 Source: Argentina Ministry of Economy & Production, Macroeconomic Statistics (available at http: //www. mecon. gov. ar/peconomica/basehome/infoeco_ing. html).
International Reserve Outflows, 2001 Note: Because of a change in the BCRA’s definition of international reserves, data after October 31, 2001 includes public bonds involved in reverse repo-operations. Data before October 31 does not include these bonds. Source: Banco Central de la República Argentina, International Reserves and BCRA’s Financial Liabilities ( available at http: //www. bcra. gov. ar/).
Annual Capital Inflows by Type Note: Equity inflow was not available until 1992. I use the following variables from the IMF’s International Financial Statistics as components of capital inflows: 1) FDI: line 78 bed (Direct Investment in the Reporting Economy, n. i. e. ) 2) Equity: line 78 bmd (Equity Securities Liabilities) 3) Debt: line 78 bnd (Debt Securities Liabilities). 4) Other: line 78 bid (Other Investment Liabilities, n. i. e. ) Source: International Monetary Fund, International Financial Statistics, June 2004.
Argentine Devaluation
Role of fixed exchange rates n n n All of the problems discussed would still be problems under flexible exchange rates But fixed exchange rates make things worse by create sudden adjustments, and thus big accumulations of risk. This not only causes sudden problems, it also worsens resurrection risk taking by giving banks and firms something to bet on.
Panics vs. Insolvencies n n Concern that too much, unwarranted, sudden market discipline can create undesirable social costs from contraction of bank deposits during “panics” is the primary justification for bank safety nets in theory and in history (deposit insurance, and lender of last resort). Such systemic panics (as distinct from periods of high bank failure) resulted from a combination of observable shocks and unobservable incidence of shocks, in combination with the structure of banks (liquidity transformation, fcfs rule).
U. S. Experience with Panics n n n 1857, 1873, 1884, 1890, 1893, 1896, 1907 Observable shock was a dual threshold of 9% stock market decline over a quarter, and 50% increase in seasonally adjusted liabilities of failed business (NEWS RELEVANT FOR BANKS) Some shocks originated in NYC and were related to securities markets, use of funds by NYC banks: In 1857, loans to bond dealers, connections to RRs, was the problem. Some shocks may relate more to peripheral areas (perhaps 1893).
Dealing with Panics n n Costly bank panics were almost exclusively a U. S. phenomenon by the mid-19 th century. Market discipline, along with inter-bank cooperation and lending, central banks, and clearing house actions to share risks dealt with threat of panics effectively, except in U. S. where branching limits, pyramiding of reserves created concentrations of risk, and made coordination difficult. Desire to keep unit banking, and risk of panics explains why U. S. originates deposit insurance.
Dealing with Panics (Cont’d) n n Banks assisted each other, sometimes through formal clearing house actions. Market discipline kept risky banks in check, and made other banks see advantage to identifying and punishing risky banks quickly. Suspension was used as a last resort, and market discipline created incentives to restore convertibility quickly. Resumption of convertibility would occur when secondary market discounts on bank paper approached zero.
Historical Banking System Collapses n n Panics in U. S. did not produce banking collapses, because the combination of market discipline, clearing house support, and temporary suspension of convertibility (until asymmetric information was resolved) insulated banks from costs. 1893, worst of U. S. panics, coincided with large exogenous agricultural problems, but bank failures produced negative net worth of failed banks of only 0. 1% of GDP.
Historical Collapses (Cont’d) n n Worldwide, from 1873 to 1913, there were no more than seven episodes of severe bank failure worldwide (defined as collapses that produced banking losses where negative net worth of failed banks in a country exceeded 1% of GDP) Argentina 1890 (~10%), Australia 1893 (~10%), Norway 1900 (~3%), Italy 1893 (~1%), Brazil various (hard to measure, but all much less than 10%). Only 2 -3 of these are “twin crises. ”
Historical Comparison between Today and Pre-WWI Era Appropriate? n n 1870 s-1913 is a time when capital flows to emerging markets were high relative to GDP, limited liability banking was growing rapidly around the world, countries relied on fixed exchange rates, and macroeconomic climate was very volatile. This suggests that according to some explanations of crises (exchange rate fixed, free chartering of banks, multiple equilibria due to foreign capital flows) we should see more then than now. But we do not. h
Historical Collapses (Cont’d) n n n Land booms and busts underlay these collapses, and often bank risk was subsidized by government in one way or another. Argentina, Italy subsidized risky bank lending on land; Norway and Australia promoted land booms in other ways. Banking collapses for some U. S. states also directly traced to safety net policies. Agriculture boom and busts and banking collapses were much more severe in states with deposit insurance (WWI price bets). Twin crises in Italy and Argentina in 1890 s reflected feedback from banking crises to fiscal collapse of government (foreshadowing today’s crises).
State-Level Deposit Insurance in 1920 s 3 Insured 15 Controls Asset Size Equity / Assets Growth during Boom Loans / Assets Negative NW of fails / Survivors NW Source: Calomiris JEH 1990. $320 0. 11 185% 0. 76 $622 0. 13 128% 0. 70 3. 5 0. 5
How the Safety Net Causes Bank Collapses n n Safety net removes market discipline that used to operate, both as a check on conscious risk taking, and on quality of bank management making risk taking decisions. Both effects are important. These two channels do not operate with constant adverse effects, but rather, their effects vary over the cycle. Conscious risk taking increases in wake of losses (resurrection bets on unlikely outcomes with high risk premia, especially in currency markets, which deepens extent of twin crises through feedback effects). Management quality problem can be most hazardous during booms, and becomes visible during busts (WWI grain price bets).
Why Few Twin Crises Historically? n n Other than those exceptions, fiscal discipline coincided with and reinforced benefits of market discipline over banks. Governments adhering to gold standard had access to international capital markets, and could act to protect banks with classical lender of last resort liquidity assistance. Mexico 1907 and Russia 1899 -1900 are prime examples of successful assistance Assistance was limited by credible commitment to stay on gold standard, which in turn ensured access to funds as needed. (Contrast to IMF)
What About the Great Depression? n n n New research (Calomiris and Mason, 1997, 2003) shows that panics were not nationwide phenomenon until very late (early 1933) For the most part, fundamental shocks (deflationary monetary policy, gold standard, agric. distress, other bad economic policies) caused insolvencies by many banks, not panics. And, despite the severe shocks and many failures, losses of failed banks 1930 -1933 only about 3 -4% of GDP.
Banking Collapses Today n n n In contrast, about 150 episodes since 1978 of banking system collapses with costs of more than 1% of GDP, more than 20 with costs in excess of 10% of GDP, and many of those have costs in excess of 20% of GDP. This is unprecedented. Collapses often coincide with currency collapse due to fiscal implications of banking collapse for government. This reflects changes in political economy of banking systems (similar to Eichengreen 1996 argument on inflation process). Like Italy and Argentina pre-WWI, these severe collapses have been directly traced to incentives from government policies protecting banks from market discipline.
How Did / Do Disciplined Systems Behave? n Old-Fashioned Disciplined Banking Equity/Assets and Asset risk managed to target low default risk on debt of bank. During good times, equity capital is cheap (no lemons problems) and lending opportunities are good, so both risk and equity capital rise. n When shock hits, banks face prospect of loss of deposits due to combination of risk aversion and need for liquidity of depositors, and asymmetric information problem about losses within bank. n As banks lose deposits they act to restore confidence by contracting loans, cutting dividends, and expanding cash asset holdings. n
NYC Bank Capital and Risk 1920 -1936
NYC Banks’ Loans/Cash, Equity, Dividends Loans/Cash 1922 2. 1 Equity/Assets 0. 18 1929 3. 3 0. 33 1933 1. 0 0. 15 1940 0. 3 0. 10 Dividends Source: Calomiris-Wilson JB 2004. $392 m $162 m
Discipline Reflected on Liability Side n If discipline exists, it appears in three forms: Interest cost of debt goes up with risk n Rationing effect: deposits decline n Shift to high-cost, “monitored” marginal funds n n n These effects are consistently visible historically, as well as currently, in all types of countries. Bank liability data, and liability interest rate data are the most reliable, consistently reported data on balance sheets, which helps make them especially useful as indicators.
Example: Chicago 1932 Number 1932 Failures 46 1931 RD 1932 Survivors 62 2% 1% 1931 Borr/Debts 12% 2% 1931 Dep growth -45% -33% Source: Calomiris-Mason 1997 AER.
Example: Argentina 1995 Failures 1995 Survivors RD paid in 1993 13% 9. 5%
Example: Mexico 1996 n n Even though there was 100% deposit insurance, the losses were so large, and the political debate so uncertain, that insured deposits were not necessarily protected. Banamex (marginally solvent) paid 17% on its funds, on average, but Bank Serfin (deeply insolvent) paid 29%
Market Discipline Even with Insurance All banks Banamex Serfin 1996 Dep. Int. 25. 2% 17. 4% 28. 9% 1994 branches 1996 branches 5, 051 6, 264 710 912 561 578
Contrast Old (Stable) System with Protected (Unstable) System n n Old, disciplined system reduced bank risk in response to shocks. New system sees banks increasing risks in response to shock (doubling their bets), especially taking on exchange risk. Chile 1982 -1983 n U. S. Savings and Loans in 1980 s n Mexico 1993 -1994 n Japan 1990 -1997 n Korea, Thailand, etc. 1995 -1997 n
Risk-Based Capital Regulation n n Basel and similar systems supposedly target risk-based capital, which is similar to targeting default risk of debt, although measurement of risk and capital are imperfect (to say the least) and ratios are arbitrary. If this is successful, it results in regulatory discipline with effects similar to market discipline: When a bank loses capital, it contracts risk, cuts dividends, in order to comply with standard and in doing so reduces default risk.
Procyclical Effects? n n If effective, this sort of capital regulation necessarily exacerbates the business cycle, since losses of capital (during onset of recession) produce contraction of bank loan supply, which aggravates the recession. Calomiris and Mason (AER 2003) estimate that market discipline during U. S. Great Depression was responsible for income declines roughly one-third as large in percentage terms as the percentage declines in loan supply. These are very large effects.
Procyclical Effects (Cont’d) n n n Two points warrant emphasis: First, any prudent risk-managing bank will have to contract risk in response to loss, so procyclicality is an inevitable feature of a wellmanaged banking system. Second, “forebearance” (the decision by regulators to relax requirements because of a concern about loan supply) tends to produce a larger procyclical effect, because resurrection risk taking leads to systemic collapse, and often unproductive risk taking prior to collapse.
Policy in the Real World n n n Even though policy makers are aware that forbearance is counterproductive, they still do it. Politics tends to produce strong incentives for protection of banks and forbearance, more in some countries than in others (Demirguc-Kunt, Kane and Laeven 2007). Book capital requirements invite discretionary forbearance, as do reliance on supervisory judgments when measuring risk and capital. Also, policymakers may lack timely information, or incentive to put forth effort to collect it, so some forbearance may be inadvertent. S&R fails. Barth-Caprio-Levine find that regulatory and supervisory practices, other than practices that introduce market discipline, make no difference for banking sector growth or stability. Market discipline promotes both greater stability and higher growth.
The Public Corruption Media Politicians corruption Regulators and supervisors corruption Banks The Market: Depositors, creditors, rating agencies Borrowers, counterparties Technology, Information Infrastructure A Framework for Bank Regulation, Barth Caprio and Levine Market Structure Judicial, Legal, Regulatory Environment Institutional Environment Democratic, Political Structure/System
Barth et al Book n n n Study of regulatory practices across 150 countries, asking whether regulations improve bank stability and growth; and also exploring how regulations reflect and alter political economy and corruption. Variation in regulatory practice is enormous (capital regulation, deposit insurance coverage, government ownership of banks, foreign entry permitted, bank powers allowed). Evidence favors the “private interest” (or “grabbing hand”) view over the “public interest” (or “helping hand”) view of bank regulation and supervision in EMs.
Barth et al Findings “Across the different statistical approaches, we find that empowering direct official supervision of banks and strengthening capital standards do not boost bank development, improve bank efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending, and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability. In contrast to these findings…bank supervisory and regulatory policies that facilitate private sector monitoring of banks improve bank operations. ”
Barth et al Details: Univariate Regressions Dependent Var: Bank Credit to Private Sector/GDP (Controls not reported) Entry Req. Index Limits on For. Entry Appl. Denied Activities Restrictions Capital Regulations Prompt Corrective Power Official Supervisory Power Supervisory Independence Government-Owned Banking Private Monitoring Index Negative Insignificant Negative Significant Positive Marginal Negative Insignificant Negative Significant Positive Significant
Barth et al: Multivariate Regression Dependent Var: Bank Credit to Private Sector/GDP (Controls not reported) Entry Req. Index Activities Restrictions Capital Regulations Official Supervisory Power Government-Owned Banking Private Monitoring Index Positive Insignificant Negative Significant Positive Insignificant Negative Insignificant Positive Significant
Barth et al: Multivariate Regression Dependent Var: Bank Crisis Probability (logit) (Controls not reported) Entry Req. Index Activities Restrictions Capital Regulations Official Supervisory Power Government-Owned Banking Moral Hazard Index Political Openness MH x PO Positive Insignificant Positive Significant Negative Insignificant Positive Marginal Positive Significant Positive Insignificant Negative Significant Moral Hazard = Dep Insurance Generosity
Barth et al: Multivariate Regression Dependent Var: Corruption of Banking Officials (Controls not reported) Official Supervisory Power Government-Owned Banking Private Monitoring Positive Significant Negative Significant
Other Evidence on Foreign Bank Entry n n Greater supply of credit (Goldberg, Dages, Kinney 2000), although based more on “hard” information than “soft” information (Mian 2003) Less local presence => greater volatility of credit (Herrero and Peria 2005) Giannetti and Ongena (2005) find that foreign presence reduces connected lending problems, improves access of funds to efficient nonconnected borrowers, and improves efficiency of capital allocation, although effect seems confined to medium and large firms Similarly, Bonin and Imai (2005) show that sale of Korean banks to foreign lenders had large negative effects on stock returns of related borrowers.
% Banking System Foreign-Controlled (IMF 2000) Czech Rep. Hungary Poland Argentina Brazil Chile Colombia Mexico Peru Venezuela Korea Malaysia Thailand 1994 5. 8 19. 8 2. 1 17. 9 8. 4 16. 3 6. 2 1. 0 6. 7 0. 3 0. 8 6. 8 0. 5 1999 49. 3 56. 6 52. 8 48. 6 16. 8 53. 6 17. 8 18. 8 33. 4 41. 9 4. 3 11. 5 5. 6
How can bank regulatory policy help? n n n Repeal the safety net. Perhaps a good idea (a vast body of empirical evidence indicates deposit insurance makes systems more prone to failure, not less), but this is hard to do, and there is often implicit insurance even when explicit insurance is repealed. Narrow banking. This is repeal in disguise. Internal Models. Regulators’ incentives are still to forbear, and thus credibility is lacking. Regulation and supervision become extremely complicated. For developing countries, the cost of implementing complex regulatory apparatus is very high, because banking systems are small (100 countries with banking system deposits under $10 billion).
Combining Safety Nets, S&R, and Elements of Market Discipline n n Once the government is involved in protecting banks, markets have little incentive to take risks, and thus little incentive to monitor, or to act upon information. S&R can incorporate market discipline if it finds a way to (1) require banks to offer some component of risky debt to finance themselves, (2) ensure that the pricing of that instrument is observable to them and the market, and (3) establish rules that force S&R to act upon the information produced by the market.
What Is NOT Market Discipline n n n Disclosure rules, by themselves, are of little use, since market may have little reason to care about disclosure. The presence of uninsured debt is not necessarily indicative of market discipline because the debt may effectively have the option to leave when things go wrong, or because government may use mergers or other protection to bail it out, justified by “least cost resolution policy” Insiders’ holdings of debt (which can be hard to track), or outsiders’ holdings protected via derivatives written by the bank, won’t provide discipline.
Getting Market Discipline to Work: The Integrated Approach of Argentina c. 1999 n n An integrated approach to S&R, in which credible market discipline is required, and produced by a combination of reforms, is the best approach. One of the best examples of this approach was Argentina in the late 1990 s. The collapse of the system in 2001 -2002 was not due to regulatory failure, but rather its success. Cavallo seized bank equity in 2001 to alleviate the government’s fiscal problems because domestic banks were only place to find the money.
Argentina 1992 -2000 n n n n Free foreign entry (competitive pressure, skills) Encouragement of privatization of loss-making provincial banks (pay provinces to privatize and renounce bank chartering). 18 privatized 1992 -99. No explicit deposit insurance (modified in 1995) Book equity capital requirement depends on loan interest rate VAR to set capital requirement for market risk based on market volatility Liquidity requirement can be satisfied with standbys (rewards banks that command market confidence) Aggressive NPL policy
Argentina (Cont’d) n n n BASIC System: Integration of rules for information creation, disclosure, and use. Central de riesgo information pool (crafted to minimize free riding, while allowing banks to avoid bad credits, and avoid double pledging of collateral). Auditing supervised, bonded. Subordinated debt requirement forces banks to issue 2% of deposits in the form of uninsured subordinated debt held at arms length. (Concentration of uninsured claim may be desirable, as more informed, and harder to renege if amount is small…no systemic excuse. ) Banks rated by approved rating agencies (good intentions, bad outcome). n Ratings reform proposals today.
Argentina (Cont’d) n n Subordinated debt is not occurring in a vacuum, but rather alongside other capital and liquidity rules, and other rules, that give market opinions power in the regulatory process. Problems with implementation of sub debt rule. n n Lack of compliance penalized in theory, but not clear whether penalized in practice. No clear regulatory actions (e. g. , closure) required based on high yields or inadequate issuance. No public information on yields, amount, compliance. Not exempted from least-cost resolution. Arms length holding not enforced effectively.
Argentina (Cont’d) n n Still, there is evidence that sub debt helped Low compliance was indicative of bank weakness, and central bank realized this, so it gave them a signal, but not one that the public had access to (so no discipline on regulatory forbearance). Source: Calomiris-Powell 2001. RD NPL Equity ratio 1996 -99 High compliance 7% 14% 0. 157 1996 -99 Low compliance 8% 25% 0. 183
Argentina (Cont’d) n n n More generally, Argentina showed healthy signs of operating with prudent (oldfashioned) risk management. One indication of the effectiveness of the system is the fact that deposit growth rates reflect deposit risk, and that deposit risk is related to book measures of asset risk and equity capital. Another indication of effectiveness is that banks that experienced increases in their interest cost of debt acted quickly to reduce risk, and thus bring interest cost back down.
Argentina (Cont’d) Dependent Variable: Quarterly Deposit Growth Regressor Coefficient Stand. Error Eq Ratio (-1) Loan Int. Rate Loans/Cash 0. 277 -0. 254 -0. 0032 Sample period: 1993: 3 -1999: 1 Number of Observations: 1, 138 Adjusted R-Squared: 0. 31 0. 074 0. 121 0. 0007
Argentina (Cont’d) Deposit Interest Rate Autoregression Dependent Variable: Quarterly Deposit Interest Cost Regressor RD (-1) Coefficient Stand. Error -1. 29 0. 04 Adjusted R-Squared: 0. 58 Number of Observations: 688
Broad Conclusions n n Safety net is major source of risk, market discipline is the ONLY credible mitigator of risk. Market discipline is best introduced with an integrated approach that results in the creation, disclosure and use of credible information in the marketplace. Government regulatory transparency is as important as government mandates for promoting market discipline. Market discipline is a complement, not a substitute for S&R (e. g. , insider holdings).
Specific Recommendations n Good ideas for bringing markets into S&R process: n Free entry, privatization of SOBs, limited safety net n Use of loan interest rate to set capital requirement n Reform of credit ratings: numbers with penalties. n Standbys abroad should substitute for cash reserves n BASIC Argentine system (except use of credit ratings) n Improve on Argentine sub debt to avoid back door bailouts, insider holdings, derivatives; to enforce public disclosure; and to establish prompt corrective action rules to limit forbearance in response to failure to gain market confidence (defined by market yields, flows on debt) n Sub debt’s form can be flexible (e. g. , two year maturity CDs held by banks abroad) depending on environment, and contingent capital certificates are an improvement on sub debt (discussed further below).
Cutting Edge Ideas Co. Cos n n n n Require on top of higher common/assets minimum requirement of 12%, a Co. Co requirement of 10% of quasi market value of firm (face value debt +MVE) Trigger must be credible, predictable, timely, and based on comprehensive view of bank. Goldman proposes book value, but it is not credible or timely. Cumulative market value decline trigger would work (say, 40% from peak). Dilution risk would force voluntary preemptive issues of common stock ahead of triggers. Result would be that banks almost never go under. Design Prompt Corrective Action (PCA) trigger based on similar cumulative value decline basis.
120 Index, Mar-07 = 100 Market Cap for Large American Financial Institutions AIG 80 Bank of America Bear Stearns Citigroup 60 Lehman Brothers Merrill Lynch Benchmark 40 Contingent Capital Trigger Wind-Down Trigger 20 0 Mar-07 Jun-07 Sep-07 Dec-07 Apr-08 Jul-08 Oct-08
140 Market Cap for Large European Financial Institutions 120 Index, Mar-07 = 100 Dexia 80 Fortis ING 60 Lloyds RBS 40 UBS 20 0 Mar-07 Jun-07 Sep-07 Dec-07 Apr-08 Jul-08 Oct-08
Macro Prudential Rules n n Macro prudential regulation that raises capital requirements during normal times in order to lower them during recessions. Additional macro prudential regulatory triggers that increase regulatory requirements for capital, liquidity, or provisioning as a function of credit growth, asset price growth, and possibly other macroeconomic risk measures. (Borio Drehman paper. )
Case Study: Colombia 2006 -2008 n n n n Financial system loans annual growth rose from 10% in December 2005 to 27% by December 2006. Core CPI rose gradually relative to credit (from 3. 5% in April 2006 to 4. 8% in April 2007). Real GDP growth in 2007 was 8%. Current account deficit rose from 1. 8% GDP in second half of 2006 to 3. 6% GDP in first half of 2007. Monetary authority reacted directly to credit growth in real time: Interest rates were increased 400 bps from April 2006 to July 2008. But central bank saw too small a market response to this, so it n increased reserve requirements for banks and n convinced superintendency to raise provisioning for credit, n imposed measures to raise costs of borrowing short-term from abroad (deposit requirement reactivated), and n limited not only currency mismatches of banks and other FX exposure in the system, but also gross currency positions (to avoid counterparty risks). Credit growth is now “only” 13%; risk-weighted capital ratio for banks is 13. 9%, and first half 2008 is 4. 9% above first half of 2007, expected to fall to about 3. 5% for 2008 as a whole.
Fix Too Big To Fail n n Co. Cos for large banks probably will take care of much of the problem. Regulatory surcharge (which takes the form of higher required capital, higher required liquidity, or more aggressive provisioning) on large, complex banks. Detailed regularly updated plans for intervention and resolution of large, complex institutions prepared by them, which specify how control the bank’s operations when transferred to a prepackaged bridge bank if the bank became severely undercapitalized. Hybrid reliance on bankruptcy with special resolution authority triggered by credible determination of real systemic risk. Key problem: how to keep unwarranted resolutions from happening?
Aftermath of crises n Does crisis tend to lay groundwork for more or less liberalization? n n It can go either way, depending on domestic political environment (Mexico, East Asia and Brazil vs. Argentina) How to deal with massive insolvencies? n There are many possible mechanisms n n n n Liquidation via market (but adverse selection problems, legal system and information limits) AMCs a solution? No, since they also must liquidate, and same problems plague them; also corruption plagues them, much more than in U. S. or Scandinavia. Creative solutions that work with market incentives (Punto Final program in Mexico) Assistance to recapitalize banks (RFC vs. Japan) Foreign entry of banks to speed reestablishment of credit. Debt moratorium (cultura de no pago in Mexico) Debt redenomination (Argentina; U. S. precedents)
US Bank Assistance in 1930 s vs. Japan’s in 1990 s (w/ Mason) n US Banking problems Real shocks, not runs (until 1933) (Calomiris. Mason 2003 a) n Market discipline Capital crunch (Calomiris. Wilson 2004) n Depositor preferences (active vs. passive) n Loan supply contracts n Dividends cut n Large adverse macroeconomic consequences of credit contraction (Calomiris-Mason 2003 b) n Asset market illiquidity problems, too, from liquidation of bank assets, which slowed resolution n
US in 1930 s (Cont’d) n Policy Response RFC lending (inadequate) n RFC preferred stock begins in 1933 n Selective: Targeting marginal banks, field office autonomy seems to have limited abuse n Limits behavior: Dividends, capital, voting on management issues; Regression evidence suggests that RFC conditionality mattered n Seems to be effective, reduces failure risk n
Comparison RFC Recipients Non-Recipients Fail Prob ’ 31 Fail Prob ’ 34 0. 147 0. 011 0. 096 0. 004 Div Pay ’ 34 0. 001 0. 008
Japan in the 1990 s n n n Little deposit market discipline Convoy system spreads assistance Dividend payments to common stock remain large (liquidity for Keiretsu firms) Banks do not have to accumulate additional capital to get assistance Assistance seems to have had no effect on failure risk or lending, and NPLs have grown over time
What might have worked better? n Conditional Assistance Dividend limits n Capital plan with matching requirement (note that this is self-selecting) n n Introduce Market Discipline in Regulation Minimum sub debt or other uninsured debts n Interest rate-sensitive capital requirements n High reserve requirements, but allow offshore SLOCs in lieu of reserve requirements n
Debt redenomination: US in 1860 s, US in 1930 s n n In both cases, this was a convenient way of using the change in numeraire of debt to restore net worth of banks and borrowers. Civil War: legal tender acts saved banks after shock of December 1861 by making bank liabilities decline with bank assets (govt. bonds). Great Depression: elimination of gold clauses actually increased values of bonds, implying that effect on default premium outweighed effect on face value. Key advantages: speed, no reliance on institutional quality.
Argentina’s Redenomination 2002 n n Does same logic apply to Argentina 2002? Fiscal crisis leads to arm twisting of banks to buy bonds, then eventual collapse of banks and exchange rate. “Pesification” of debt could provide relief to borrowers, especially high dollar debt firms in non-tradables sector. Asymmetric aspect of pesification hurt banks and had clear political element, but we can conceptually separate it from pesification.
Argentina (Cont’d) n n n Argentina’s peculiar vulnerability to devaluation Investment evidence Stock market reactions Conclusion: There seems to have been a significant positive effect on market and on non-tradable producers with high dollar debt exposures. Net benefit?
Figure 1 C: Reinhart-Rogoff-Savastano Composite Dollarization Index Level vs. Exports-to-GDP Ratio for Reinhart-Rogoff-Savastano’s Fifty Highest Dollarized Countries
Non-Tradable Firms Std. Dev Mean Firms Std. Dev High 0. 0711 Dollar Debt Firms 7 0. 0669 0. 1460 23 0. 1460 Low 0. 1625 Dollar Debt Firms 28 0. 2141 0. 1224 25 0. 0893 Mexico Mean Tradable Firms Dif -0. 0914 0. 0236 T-Stat -1. 9155 0. 6695 Pr(Dif ≥ 0) 0. 0324 0. 7463
Non-Tradable Firms Mean Firms Std. Dev High. Dollar Debt Firms Low. Dollar Debt Firms Dif 0. 0724 6 0. 0959 0. 1817 7 0. 1579 0. 0644 5 0. 0397 0. 2155 7 0. 1537 0. 0080 -0. 0339 T-Stat 0. 1862 -0. 4069 Pr(Dif ≥ 0) 0. 5712 0. 3456 Argentina
DDAt-1 -0. 1449 -1. 79 (0. 0809) 0. 076 0. 2192 1. 63 (0. 1346) 0. 106 0. 1242 1. 21 (0. 1029) 0. 230 TR x DDAt-1 x ARG -0. 2684 -1. 64 (0. 1638) 0. 104 DDAt-1 x ARG TR x DDAt-1
EVENT STUDY Dependent Variable Cumulative Raw Returns Independent Variables Cumulative Abnormal Returns Coefficient (Std. Error) T-Stat P>|t| 0. 1561 3. 82 0. 1249 2. 37 (0. 0409) 0. 001 (0. 0528) 0. 026 0. 2447 2. 33 0. 3473 2. 56 (0. 1051) 0. 028 (0. 1356) 0. 017 Constant -0. 0255 -0. 49 -0. 0959 -1. 42 (0. 0524) 0. 631 (0. 0676) 0. 168 TR DDAt-1 Regression Statistics Observations 29 29 R 2 0. 4070 0. 2912 Adjusted R 2 0. 3613 0. 2367 Root MSE 0. 1009 0. 1301
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