Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Akira Nagashima (Chapter 9) and Miguel Mancera Aguayo (Chapter 10) have presented lucid explanations of the banking problems in their respective countries. Bijan Aghevli and Brian Stuart (see Aghevli in Chapter 9, Stuart in this chapter) have already discussed the key points dealing with the specifics of Japan’s and Mexico’s banking problems. Therefore, I would like to compare the two cases and also bring to bear other familiar experiences from daily work in the IMF.

The two cases of Japan and Mexico have some similarities: depositors were protected fully; fiscal costs were made explicit; and neither country resorted to inflation as a way to deal with banking distress. It is unclear whether existing bank owners were penalized in either of these two situations. There are some differences, though. For instance, the Bank of Japan focused on dealing with the banks’ situation—easing the debt burden of borrowers was left to the new institutions that were set up; in Mexico, debt relief was part of the package to which the Bank of Mexico contributed.

Some broad conclusions can be drawn from the two country experiences discussed in this session. First, banking distress comes from various sources. In Japan’s case, an asset price bubble was a major force in the country’s banking difficulties. In Mexico, a credit expansion fueled by capital inflows and deficient credit analysis by commercial banks, together with shortcomings in bank supervision, have led to banking distress. In other countries, banking problems have surfaced in the wake of successful stabilization programs, since inflation in some situations had been concealing banking distress. Thus, both macro and microeconomic causes generally play a role in bringing about systemic bank distress.

Second, bank illiquidity and insolvency can be clearly distinguished from each other in theory but they are far more difficult to distinguish in specific cases. Quite often, illiquidity is only a manifestation of insolvency.

Third, when a banking crisis occurs, time is of the essence in remedying the emergency, and large resources are needed. In the case of the Mexican peso crisis in 1995, the cost was equivalent to more than 8 percent of GDP; in Japan, nonperforming loans were equivalent to about 6 percent of GDP. In other countries, costs of banking crisis have been also high. At least until recently the Central Bank of Chile had an annual cost equivalent of about 1 percent of GDP, largely due to the cost of having assisted banks back in the early 1980s. Too often it is a country’s central bank that must take on the burden of addressing banking problems. This is because of the central bank’s responsibility and expertise with regard to banking and payment issues, the fact that it can immediately support troubled banks (even if this entails inflation), and the reluctance of other state agencies to act in often unclear situations that can often involve higher costs. Moreover, it is hard to imagine a government budget having large enough uncommitted funds to deal with an unexpected systemic banking crisis.

In these situations, in what way should the central bank act—beyond addressing macroeconomic reasons for the systemic banking problems? Providing liquidity to a solvent bank seems highly appropriate. However, even this may not always be feasible. For instance, Argentina’s currency board arrangement limits its central bank’s ability to assist banks, and thus other mechanisms had to be put in place. For example, the central bank allowed banks in a strong liquidity position to lower their required reserve balances if they lent those funds to banks having liquidity difficulties. Even when a central bank is able to provide liquidity, as noted above, it is often difficult to distinguish whether a commercial bank is just illiquid or also insolvent. Moreover, if a bank is insolvent but has systemic importance, the central bank faces difficult decisions: to close it, to salvage it (which implies a cost); or to seek to transfer its functions to other institutions. However, by intervening, the central bank risks running a quasi-fiscal deficit, and increasing moral hazard.

From our perspective, it is safe to say that systemic banking problems will likely continue to occur. A large part of the IMF’s members have experienced systemic banking problems over the last few years. Measures to reduce the likelihood and minimize the impact of those problems therefore become highly important. The preventive measures adopted by Japan and Mexico to avoid a recurrence of systematic banking problems are good examples of those actions. However, there is also a need to be prepared for inevitable future crises. Making arrangements to provide liquidity support to solvent banks should be part of those preparations. This is particularly important for developing and transition countries-that may have difficulties in accessing capital markets if systemic problems arose. For instance, the experience of 1995 led Argentina to raise liquidity requirements for banks and to obtain a contingent line of credit abroad.

While dealing with liquidity issues can be difficult, as noted earlier it is even more difficult to decide how and to what extent to support insolvent institutions of systemic importance. In any case, it is important to ensure that the central bank does not have ultimate responsibility to pay for assistance provided to such institutions. In this regard, it is encouraging to note that both Japan and Mexico managed to avoid that pitfall.

There are some broad issues that systemic banking problems raise, on which I would welcome the views of both Nagashima and Mancera. First, how can a central bank and appropriate bank regulatory agencies decide on the respective roles of themselves and of the market in preserving banking soundness? Second, how can the banking system deal with moral hazard problems? Measures to deal with immediate banking problems may increase the possibility of moral hazard and negatively affect the longer term development of the system. Moral hazard affects depositors insofar as they lose incentives to consider a bank’s soundness carefully; borrowers insofar as they may expect their loans to be restructured if they encounter difficulties in the future. It also affects bank owners and managers insofar as those who are managing troubled or bankrupt institutions manage to hold on to their equity and maintain their respective managerial positions. Third, how to distribute the costs of banking problems? In particular, what amount should the healthy part of the system contribute? This is especially important, since placing a heavy burden on that sector could lead to financial intermediation being shifted abroad or to the unregulated domestic financial sector. Fourth, where should central bank assistance stop? Even if all agree that the central banks should provide some assistance to troubled institutions, it is unclear at what level such assistance should stop. Economists have sometimes suggested that central banks should focus only on protecting the payments system, and therefore, central banks should worry only about the institutions that are part of that system. However, it is clear that the Bank of Japan felt a need to assist nonbank financial intermediaries that are not part of Japan’s payments system.

Finally, Nagashima’s and Mancera’s presentations suggest that the problems in both countries would have been smaller had the authorities intervened earlier. Similar conclusions have been reached in other banking crises. I wonder whether the speakers have any views as to why these intervention delays are so common. Is it because it is hard to detect whether there is a need to intervene? Is it because the authorities have the expectation that maybe banks will be able to solve their problems on their own? Are there cases in fact where waiting can be appropriate? There remain many unanswered questions to the central bank’s role in banking soundness.

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