12 Macroeconomic Policy Design

Matthew Saal, Carl-Johan Lindgren, and G. Garcia
Published Date:
September 1996
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The fact that weaknesses in the banking system can constrain the effectiveness of macroeconomic measures and damage economic performance suggests that promotion of a sound banking system represents a legitimate policy objective—as well as a constraint—in the design of macroeconomic policies. Thus, strategies for dealing with macroeconomic imbalances will need to consider the degree of soundness of the banking system, and in many cases an understanding of banking system problems is a prerequisite for analysis of macroeconomic policies. The need for appropriate structural policies to underpin the soundness of the banking system has been discussed in the preceding chapters. Most structural policy initiatives have their full impact only over an extended period of time. In the meantime, the severity of any banking problems must be assessed in order to adapt the objectives and instruments of macroeconomic policies so as to prevent the system from deteriorating further and facilitate its strengthening. This chapter further explores four key areas in which the linkages between macroeconomic policies and banking system soundness may require adaptation of objectives or instruments: overall macroeconomic policy formulation in the context of stabilization policies, the choice of monetary instruments, the fiscal balance, and dealing with foreign capital flows.

Stabilization Policies

While stabilization generally has a positive impact on the economy as a whole, as well as on the banking system, it can also pose transitional problems. Concern for the soundness of the banking system can bring to the surface trade-offs in the choice of policy objectives and program targets and influence the pace with which such objectives can be pursued. Typically, inflation and balance of payments targets are pursued with monetary, exchange rate, and fiscal policies. In choosing the mix of these policies, their implications for the soundness of the banking system should be considered along with the influence of the banking system on policy flexibility.

It is clear that the effect of banking system soundness on policy flexibility would vary depending upon the specific structure of banks’ balance sheets and other initial conditions. Restrictive monetary policy measures that cause high interest rates or large exchange rate adjustments may result in major distress for banks and bank customers exposed to market risks, and this could trigger systemic problems. Thus, the soundness of the banking system could constrain the use of monetary and exchange rate policies to achieve program objectives.

The most extreme case is when a banking system has already deteriorated to the point where a financial crisis is imminent or in process. The experience in most countries is that when this situation is faced, short-term stabilization objectives give way to efforts related to preventing or dealing with the crisis. The prospect of a crisis—which could take the form of a run on banks or a general collapse of financial institutions—tends to subordinate most other policy considerations, including those in the monetary and fiscal domains. Avoiding this undesirable outcome argues for realistic precrisis assessments of weak banking systems, of the trade-offs in each individual situation, and of the probability of crisis. This should lead to an orderly bank-restructuring program that is well integrated with macroeconomic and prudential policies.

The constraint of an unsound banking system must be considered when formulating the targets and phasing of any macroeconomic program; otherwise, early policy gains could be eroded through bank losses or swept away in a banking crisis. There may, therefore, be a need to adjust the objectives or the phasing of a macroeconomic program to support other structural reforms to restore soundness to the banking system and flexibility to policymaking. This may require an allocation of resources, including human resources, to facilitate the structural reforms. Needless to say, concern with banking system unsoundness cannot be seen as an excuse for postponing adjustment, but rather should lead to a sustainable pace of adjustment, and to an appropriately designed adjustment program that combines macroeconomic and structural policies.

For example, a sharp decline in inflation, while beneficial over the medium term, may have negative effects for the banking system in the short term. Banks earning their income from inflation-driven activities need time to refocus their business toward traditional banking in a low-inflation environment. Bank clients could be exposed to large relative price adjustments and rising real interest rates. An inflation target, therefore, may need to be tempered by concerns that a faster reduction in inflation might have an adverse impact on the banking system in the short term, as was the case recently in Mexico. Programs of sharp disinflation would therefore require particular attention to banking soundness issues.

At all times, monetary policy will be constrained by what the banking system can be counted on to accomplish, which is largely dependent on how sensitive banks are to interest rate signals and the extent to which the banking system and the central bank itself are able to control their own balance sheets. For example, attainment of a targeted accumulation of international reserves may be sought through restraint in domestic credit expansion or through a combination of credit policy and an exchange rate adjustment. An unsound banking system saddled with a large share of nonperforming loans may not be able to reduce aggregate credit flows to the extent required by the first course of action. Alternatively, a devaluation can bring a different set of problems, if banks or their customers have significant foreign exchange exposures.

Major changes in the exchange rate can seriously damage a banking system, as can prolonged over- or undervaluation of an exchange rate—although in these situations there are always gainers as well as losers. A shift in the exchange rate will similarly have mixed effects. An exchange appreciation, for example, in response to capital inflows, might hurt some borrowers as well as banks with net external asset positions, but could result in lower interest rates and strengthen banks to the extent that they have net external liabilities (which is often the case after a period of capital inflows). At the same time, the limitations imposed by a weak banking system on the use of interest rate policy will limit the scope for exchange rate management through domestic interest rates—regardless of exchange rate regime. In particular, an unsound banking system may limit the scope for sustaining a currency board arrangement.118

While in the long run the scope for substituting fiscal and monetary policies may be limited, insofar as monetary and exchange rate policies are constrained in their short-run effects by weaknesses in the banking sector, an additional fiscal effort may become necessary to reduce resource pressures in the economy. There may be very limited room for such compensatory tightening, however, when public finances are weak and the government already is being called upon to honor various deposit and loan guarantees. This situation would typically call for a well-considered phasing of the necessary fiscal adjustment to support bank restructuring, in parallel with other structural policies.

Monetary Instruments

When a banking system is fragile, there is not only a need to carefully evaluate the feasibility and implications of the overall macroeconomic targets and policy mix, but also of the instruments with which these policies will be pursued. This is particularly important in the monetary area.

Use of Indirect Instruments

As explained in Chapter 5, the effectiveness of indirect instruments of monetary control is constrained when weaknesses in banks’ loan portfolios or management make banks unresponsive to price signals and lead to interbank market segmentation. If unsound banks’ responsiveness to interest rates is in question, safeguards may be required in the operation of central bank credit facilities. For example, participation of weak banks in central bank credit auctions might be limited.119 Market segmentation is typically reflected in sound banks receiving more deposits than they can lend, and in their quest for safe and liquid assets cutting their interbank exposures and becoming the principal holders of safe instruments like treasury bills, the yields of which tend to decline. At the same time, because unsound banks may not have access to the interbank market, there may be frequent shortfalls in their required reserves, overdrafts in their clearing accounts at the central bank, and distress borrowing. This situation would distort interest rates and complicate the use of market-based instruments.

Under circumstances of extreme market segmentation, indirect instruments may lose their effectiveness altogether and direct instruments of monetary policy may be required for short-term control. This would be true, for example, when interbank markets are not functioning and the central bank has to redistribute bank liquidity. Under such circumstances, bank-by-bank credit ceilings could be useful for credit management on a temporary basis, as could interest rate ceilings to limit distress borrowing. Using such instruments, however, could well weaken banks’ profitability and constrain their liquidity management and thus further deepen their financial difficulties. In cases of management intransigence or other extreme circumstances, the only way to establish monetary control over weak banks might be through supervisory intervention, which would imply official administration of problem banks.

Many developing and transition countries are seeking to develop their money markets and shift monetary intervention to market-based instruments. Problems in the banking system may influence the pace of these reforms, as was observed in a number of countries in the 1980s; for example, Argentina, Chile, and the Philippines temporarily reintroduced interest rate controls to alleviate the burden of high real interest rates on borrowers and banks.120 The appropriate instrument mix and the phasing of any new instruments will depend on the general state of development of a country’s banking system and broader financial markets, the degree of unsoundness in the system, and the scope for fiscal, prudential, and other structural measures to strengthen bank soundness.

Lender-of-Last-Resort Facilities

Considerations of bank solvency become highly relevant in managing central bank LOLR facilities and related payment system policies. Most central banks provide some form of credit facility, such as a Lombard facility or discount window, which can be used to provide liquidity and facilitate payments settlement for banks in distress. Central bank last-resort lending will generally take the form of liquidity injections directed to a particular bank or set of banks and may need to be sterilized by reducing liquidity elsewhere, for example, through open market operations or other instruments.

The intent of central bank LOLR facilities is not to provide resources to insolvent institutions, but to provide temporary liquidity to sound institutions, typically at a penalty rate. To manage its LOLR facility, the central bank must know (on the basis of information from supervisors) which banks are approaching insolvency or are insolvent. In practice, however, both central banks and supervisors often have difficulty distinguishing illiquid but solvent banks from insolvent ones.121 This is even more difficult when most banks or the entire system is in distress. Experience shows that banks that have major or protracted liquidity problems invariably also are insolvent.

In exceptional cases, the central bank may be called upon to lend to insolvent banks, for example, to buy time for the design of restructuring strategies when banks are viewed as “too big to fail” or when the lending is part of a systemic restructuring strategy. In all such cases, central bank credit (which essentially provides insolvent banks with equity as well as liquidity) must be fully guaranteed by the government. In the case of central bank lending to insolvent banks, the use of collateral is largely illusory from the public sector’s point of view, in the sense that central bank claims crowd out other creditors in the final liquidation of a bank and saddle them with the bank’s growing negative net worth, which the government often ends up absorbing in part or in full.122 These considerations suggest that LOLR facilities must be managed with utmost caution, relying on careful monitoring of banking soundness.

Fiscal Balance

The fact that resolving banking system unsoundness often involves substantial government expenditure means that the fiscal balance becomes a constraint on the type of corrective action that can be taken. Banking system problems are often known but neglected, and supervisors often are prevented from intervening in banks because this would bring the problems out in the open and “cause” government expenditure. Typical justifications for inaction are that there is “no room in the budget” or that the fiscal situation is “too weak” to allow for any consideration of banking problems.

The reasons for a lack of early action are often political, and the opacity of banking problems makes it relatively easy to delay them for a subsequent government to deal with. But from an economic point of view such delays are costly; experience has shown that the longer a solution is delayed, the more difficult the ultimate resolution becomes, as banks may spiral deeper into insolvency. Furthermore, the longer insolvent banks are allowed to continue operations, the more implicated and obligated the authorities become, which makes it more likely that the ultimate resolution will involve fiscal expenditure on a substantial scale. For example, the U.S. General Accounting Office (1987) tracked the condition of U.S. banks whose resolution was delayed and found that in most instances their condition deteriorated further during the delay.

It is essential for efficient resource allocation that banking system problems not be “swept under the rug” in fiscal policy formulation. The government’s full costs, including estimated contingency costs, need to be taken into consideration in a transparent way. All government current obligations to banks, including the servicing of any securities for bank capitalization or restructuring, should be brought into the budget. Contingent liabilities (such as loan and deposit guarantees, and any negative net worth of the central bank or state-owned banks) should be estimated as well as possible. The extent and form in which such contingencies should be included in the budget needs to be considered in each case. Excluding such contingencies from the budget does not make the expenditure avoidable; ultimately, the cost of bank unsoundness must be paid.

However, if such contingencies were transparent to the public, it would be readily recognized that the fiscal liabilities had already been incurred. This recognition could in turn contribute to pressure for timely action to deal with the problem, ultimately reducing fiscal costs.

On the revenue side, tax policies can also be used to provide transparency and keep banks sound. To prevent tax payments on fictitious profits that would cause gradual decapitalization of banks, it is desirable that loan-loss provisions be fully tax deductible and that interest accrued on nonperforming loans not be recognized as income, until it is actually received.

The impact of a weak banking sector on fiscal balance should be evaluated after projecting the actual and contingency costs of supporting the banking system both for the short and medium term. In addition, current and prospective expenditures resulting from bank-restructuring strategies and loan-recovery arrangements should be considered. Special tax breaks for banks to allow their rehabilitation should be discouraged; it is better to show such transfers openly. Similarly, any support for weak banks through loans or deposits from state-controlled entities should be part of a comprehensive bank-restructuring strategy and not be used merely to keep banks liquid, which would only serve to increase ultimate government resolution costs.

Foreign Capital Flows

Banks facilitate international capital movements and contribute to the integration of international financial markets. Given the central role of the banking system in all countries, the perceived soundness of a banking system will affect capital flows. A sound banking system has greater access to foreign interbank and capital markets and could induce repatriation of capital. If the system is allowed to fall into distress, capital flight can be triggered and bank access to interbank and other foreign capital markets can be constrained; such a loss of access could in turn trigger a systemic crisis.

In recent years, as a result of freer capital movements and increased financial market integration internationally, the management of large capital flows, and especially of swings in such flows, has become a challenge for macroeconomic policymakers and bank supervisors in many countries. The dual relationship between macroeconomic policies and banking system weaknesses has become more transparent with the internationalization of the financial system. In particular, banks now face greater exposure to credit and market risk—including off-balance-sheet risks—on account of their participation in international financial markets. The objective of a sound banking system therefore should be added to the well-known policy dilemma of how to balance monetary, exchange rate, and fiscal policy objectives in the context of an open capital account.123

The impact of capital flows and their reversals on a banking system are in some ways similar to the impact of cyclical movements in the domestic economy. A rapid credit expansion and asset-price inflation can be of domestic or external origin. In the case of capital inflows and the resulting rapid growth of liquidity in the banking system—unless the liquidity is appropriately sterilized—there is pressure for bank credit to grow rapidly. Experience has shown that the quality of credit tends to suffer when credit grows too quickly. This becomes particularly worrisome when there are known weaknesses in the banking system, including problems in banks’ credit appraisal and internal control procedures, poor compliance with prudential rules, poor loan-valuation practices, or weak capitalization. In the case of capital outflows, banking system liquidity would tighten and—unless expanded by monetary (re)injection of liquidity—banks would be forced to call in credits. This process would expose underlying weaknesses in bank-loan portfolios, which if widespread could also result in a systemic crisis.

The design of prudential as well as macroeconomic policies, therefore, should consider the banking system’s capacity to effectively intermediate capital flows. This will be particularly important in the context of capital account liberalization, which may radically change banks’ operating environment. Prudential measures should seek to foster a strengthening of credit and other risk-management capabilities in banks, supported by strictly enforced capital adequacy and other prudential regulations. Banks not in compliance with prudential regulations should be barred from entering into new activities, accepting new liabilities, or extending certain credits. A tightening of prudential policies also could have a direct effecton the capital flows, by leading banks to reduce deposit rates insofar as banks become restrained in accepting new liabilities and granting new credits.

If it is known that a banking system is weak and that prudential policies are ineffective or seriously deficient in controlling banks’ risk exposures, there is an argument in favor of including in the management of monetary policy the aim of preventing excessive credit expansion or contraction to contain the possible adverse effects on asset quality and banking system soundness of swings in capital flows. These soundness considerations could influence the mix of exchange rate and interest rate adjustments in response to capital flows, and thereby affect the choice of specific operating targets and policy instruments.

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