Chapter 24 Commentary on “What’s Wrong with the IMF” and “Containing the Risks”
- International Monetary Fund
- Published Date:
- January 2001
The reasons for the Asian financial crisis clearly are manifold. However, Meltzer pays little attention to the complexities of the recent developments in Asia but rather focuses his presentation excessively on the IMF, its origins and its role in Eastern Europe and in Mexico. As the issues raised by Prof. Meltzer will be the focus of other sessions, they will not be commented upon here, except to state that his analysis seems biased and often misinformed. Nevertheless, one can agree with most his conclusions, except with the proposal for an international lender of last resort with strict collateral rules—the proposal is simply not practical or feasible. A better and proven mechanism for providing countries with liquidity in systemic crisis situations could be facilities such as commercial standby credit lines and remunerated high reserve requirements held abroad, like as those recently used in Argentina.
My commentary will focus on the presentation of de Swaan, who points out the need for strengthening banking supervision to help prevent banking crisis. He also stresses certain preconditions for supervisors to do their work properly, and suggest that the focus has been too much on the Basle Core Principles for Effective Banking Supervision and not enough on their preconditions, which include sound and sustainable macroeconomic policies, a well-developed public infrastructure, effective market discipline, procedures for effective resolution of problem banks, and mechanisms for providing systemic protection.
I could not agree more with de Swaan’s points. In fact, in the IMF we have for some time analyzed the broader setting and the preconditions for effective banking supervision and for stable and efficient banking systems and have come to the same conclusions.1 Our efforts have aimed at increasing the awareness and improving the understanding of financial sector problems and their solutions both among our own staff as well as among national policymakers. Below I will discuss the five areas of preconditions raised by de Swaan, and what efforts are being made in the IMF and elsewhere to deal with them. But before doing so, it is necessary to stress the limitations of regulations and the essential role played by bankers.
Prudential regulations have been under review internationally in recent years and are now being reexamined by the Basle Committee on Banking Supervision (BCBS) and other international bodies in view of the experiences of the recent crises. Such reviews include not only the rules for managing market risks, but also for loan valuation and capital adequacy, disclosure, consolidation, market exit, etc. The focus is not only on rules and practices for borrowers and borrowing banks but also those for lenders and creditor banks in more mature markets. There is a renewed awareness that large short-term capital flows make banking systems more vulnerable, and a search is under way for new policies and institutional arrangements aimed at making banks and banking systems less vulnerable. While all this work to strengthen the regulatory framework is under way, there also is a sobering realization that prudential rules and supervision alone cannot achieve safe banking and banking systems.
Systemic banking problems always have their origin, at least in part, in bad banking. This is typically manifested in a combination of poor corporate governance, lending to related parties, directed credit to uncreditworthy borrowers, excessive risk-taking or concentration, lending without proper credit analysis, excessive reliance on collateral, typically on the assumption that favorable economic conditions and assets price increases will continue forever. The new international emphasis on better risk management by banks and more effective supervision can be expected to help, especially if assisted by market developments. Hopefully, the examples of the massive losses incurred in the ongoing banking crisis cases around the world will lead banks and other market agents to be more cautious in the future. Improved monitoring by shareholders, market analysts, rating agencies, and auditors will also be needed.
Let me now comment on de Swaan’s five areas of preconditions:
- 1. Sound and sustainable macroeconomic policies are crucial for sound banking. At the same time, sound banking is crucial for successful macroeconomic policies and performance. In the IMF, we have for some time been studying and stressing the importance of this dual relationship, the power of which has been amply demonstrated by the recent Asian crises.2 We are still at an early stage of understanding exactly how it works but it is reassuring to see that a lot of research has started on the subject. Banks are highly leveraged and tend to be forcefully affected by major macroeconomic policy shifts or disturbances. The recent crises cases have shown the dangers of excessive short-term foreign borrowing and of maturity and foreign exchange mismatches, not only in the banking sector but also in the nonfinancial sector, as well as the complex links between bank and real/corporate sector restructuring. In order to better foresee and more effectively deal with future financial sector disturbances, the IMF is substantially strengthening the emphasis on financial sector issues in the surveillance of economic policies in the context of its regular consultations with all its member countries.
- 2. A well-developed public infrastructure must include—in addition to competent bankers and macroeconomic policymakers—a proper framework of banking and other laws (including laws on ownership, contracts, collateral and negotiable instruments, foreclosure, and bankruptcy), a reliable judicial system and general respect for the law, proper registries for property and collateral, and payment and settlement systems, proper accounting and auditing practices implemented by competent professionals, as well as foreign exchange, money, and capital markets. Regarding the latter it should be noted that markets often become segmented and can seize up when problems emerge—markets often work the least when they are needed the most. And this applies even to the largest markets—we only need to look at Japan. In addition, and perhaps most importantly for official oversight, it is essential to ensure a supervisory body with autonomy, authority, and professional competence. Such a body must coordinate its work closely with other financial supervisors nationally and internationally. Reforms in these areas already are supported by various international, regional, and bilateral efforts.
The remaining three preconditions have been identified by various international groupings as areas in which standards, principles and best practices are missing. An international effort is to fill these “gaps” to help prevent future problems or deal with them effectively when they occur. These efforts include not only the IMF and the World Bank but also the BCBS which has established several subgroups to deal with the “gaps.”
- 3. The key to effective market discipline is transparency of banking data. The recent crises have shown that banking data often are grossly misleading, and that disclosure of poor data works against effective market discipline. Without reliable data, neither depositors nor creditors, existing or potential shareholder nor official oversight will work as intended. Some improvement could be found through improved loan classification and provisioning rules, more disclosure of qualitative information, and more alert auditors and market analysts. But it is unlikely that changes in banks loan values and accordingly their capital adequacy can be anticipated without analysis of macroeconomic policies and corporate profitability by supervisors as well as by other economic agents involved.
- 4. Early exit of unviable institutions is key to keeping a banking system sound. The development of efficient procedures for dealing with individual problem banks is crucial. This goes beyond the introduction of a prompt corrective action (PCA) framework, which is often undermined due to the problems of loan valuation/capital adequacy mentioned above. There is a need to develop graduated responses to deal with individual problem banks and to strengthen administrative procedures rather than involvement of the courts, in view of the need for speed and efficiency to preserve asset values in banks. There is also a need to study optimal exit arrangements in systemic situations to minimize the disruptive effects of different bank resolution strategies on the real economy; such effects will be different depending on the relative size of the banking system in the economy.3 Bank exit policy also has a cross-border dimension, an area that so far has benefited relatively little from international cooperation and harmonization.
- 5. Systemic protection or official safety nets mainly consist of deposit insurance and lender of last resort (LOLR) facilities. Deposit insurance should be explicitly limited to small depositors to contain moral hazard. But it needs to be recognized that deposit insurance can deal only with individual problem banks, not with systemic problems, and cannot prevent contagion. Also, experience shows that small depositors typically do not run; large institutional investors are the ones that do. The more difficult part of designing a safety net is the design of a proper LOLR facility. While in principle a LOLR should only lend to solvent banks against collateral and at a penal rate, in practice insolvency can seldom be separated from illiquidity and the use of prime collateral in cases of existing insolvency is likely to be contested by other creditors, especially if the LOLR is privy to supervisory information. It should be noted that in cases of systemic banking problems there are typically no private sector solutions; only government intervention can ensure the continued operation of a core banking system so essential for economic activity. Moral hazard is often mentioned as the major cause for excessive risk-taking by banks and major banking problems; however, the power of herd mentality and inflated market expectations should not be disregarded.
Core principles are relatively easy to proclaim but their implementation is a much slower more tedious process. The implementation of the preconditions for a sound banking system and effective banking supervision is an even more complex and longer-term process. While the focus of IMF adjustment programs necessarily is on the short term, it should be stressed that the organization has gone to unprecedented efforts to make sure that fundamental medium-term structural reforms are not being forgotten. Such measures should be in place and tested before crisis occurs. Unfortunately, it is inherently difficult to make any reforms when economic times are good and there are no apparent problems. Also, countries typically consider themselves to be unique and are reluctant to learn from others’ mistakes. Crises provide a window of opportunity to get things done. National authorities and international bodies should take advantage of that window by being prepared to implement necessary reforms as rapidly and thoroughly as possible.
Folkerts-Landau, D., and C-J. Lindgren, 1998, “Toward a Framework for Financial Stability; IMF.
Lindgren, C-J., G. Garcia, and M. Saal, Bank Soundness and Macroeconomic Policy; IMF.
The effect of closing and liquidating a sizable portion of a banking system would be quite different in Russia or Mexico, where banking system assets account for twenty and fifty percent of GDP, respectively, than in Thailand or Japan where they count for 200 or over 300 percent, respectively.