1 49514 NUMBER NOTE PUBLIC POLICY FOR THE PRIVATE SECTOR 2009 Dealing with the Crisis JUNE Constantinos Stephanou Taking Stock of the Global Policy Response PRESIDENCY Constantinos Stephanou The immediate financial sector policy responses to the financial crisis-- (cstephanou@worldbank including emergency liquidity support, expansion of financial safety nets, VICE .org) is a senior financial economist in the Financial and interventions in financial institutions--have succeeded in stemming and Private Sector Devel- widespread panic. But the effort has generally been insufficient and ad opment Vice Presidency of the World Bank Group. hoc. Issues that remain include the resolution of problem assets, the re- structuring of troubled, systemically important financial institutions, and DEVELOPMENT This is the first in a the development of credible exit strategies. Only a handful of countries series of policy briefs on the crisis--assessing the have attempted to tackle these issues head-on. As past experience has SECTOR policy responses, shedding shown, that may well have negative repercussions for the duration and light on financial reforms currently under debate, strength of a subsequent recovery. PRIVATE and providing insights for emerging-market policy The financial crisis is upon us, and its duration asset prices, and increased financial innovation AND makers. is still unknown. We are well past what might and globalization. These factors bred compla- be considered the first two stages (the U.S.- cency and led to underpricing of risks by market subprime-mortgage-cum-structured-finance participants and regulators, resulting in increas- debacle and the post-Lehman global financial inglyriskierstrategiesandthebuildupofsystemic FINANCIAL market turmoil) and have moved to the third vulnerabilities.2 and final stage (worldwide economic reces- Unlikerecentepisodes,thiscrisisoriginatedin sion). Compared with previous crises, this one developedcountriesandhasspreadtoemerging- is deeper and wider, reflecting the growth in market economies through a range of financial GROUP financialpenetrationandglobalizationinrecent and real sector channels. While the crisis first decades.1 emerged in the U.S. subprime mortgage market, While observers disagree about the relative poorpolicyresponseshaveprobablycontributed BANK importance of different contributing factors, it is to its propagation--with a widely cited example generally accepted that the crisis stemmed from beingthedecisionbytheU.S.authoritiestoallow a combination of unsustainable global macro- the failure of Lehman Brothers in September WORLD economic imbalances and structural financial 2008. The worldwide economic recession has system weaknesses in the context of excessively added even more--especially nonfinancial-- THE loose monetary policy, abundant liquidity, rising channels of transmission. D E A L I N G W I T H T H E C R I S I S T A K I N G S T O C K O F T H E G L O B A L P O L I C Y R E S P O N S E Policy responses in developed countries would be extended for 18­36 months, they are As recent events have shown, important weak- likely to be maintained until financial stability nesses remain in crisis preparedness and contin- is consolidated and credit flows resume on a gency planning arrangements both within and sustained basis, which may take longer. across borders. Key needs include assessing risks The design and scope of such guarantees to the financial system (including through stress vary widely across countries. Two essential con- testing and crisis simulation exercises), identify- ditions--their proper pricing and the parallel ing key counterparties (both within and across introductionofcrediblepolicymeasurestoclean countries) and developing coordination proto- up the banking system--have not always been 2 cols, reviewing the authorities' legal powers and met, leading to such distortions as the implicit resources,andadoptinganappropriatecrisisand subsidization of weaker banks and the crowding communication plan. Although these needs are out of nonguaranteed forms of debt issuance. not new, they have once again come to the fore. In addition, the crisis has shown the need for Thespeedwithwhichthecrisishasspreadmeans much greater international policy coordination that the development of such arrangements has in adopting and suspending such guarantees to come too late for several countries, leading to ad avoid inefficient beggar-thy-neighbor outcomes. hoc and inconsistent policy responses. Whilesuchcoordinationgenerallywasnotcritical As with previous crises, the immediate finan- in earlier crises, today's global interconnected- cial sector policy responses have sought to stem ness makes it imperative. panic among market participants and the wider Someoftheannouncedchangestothedesign public and to restore financial stability.3 Five of deposit insurance schemes may become per- types of measures have been undertaken, often manent. In addition, the size of such schemes, sequentially: especiallytheirinabilitytocoverthecostsoflarge Provisionofemergencyliquiditysupport(not failing banks, is likely to be reviewed. But the cen- discussed here), typically by easing access to tral question is whether safety nets will be cred- central bank "lender of last resort" facilities, ibleafterthenewguaranteesaresuspended.The establishing foreign exchange swap facilities, potential lack of credibility and the associated and lowering reserve requirements moral hazard are likely to impose a heavier bur- Expansion of financial safety nets den on financial regulation and supervision. Interventions and capital injections in finan- cial institutions Recapitalizing financial institutions Financial institution restructuring and prob- Spurred by increases in write-downs and credit lem asset resolution losses, the United States and several European Measures to kick-start lending countries have pursued bank intervention strat- egies that have included arranged takeovers Expanding financial safety nets of weaker entities by stronger partners (Bear Prompted by systemic stability and, in a few Stearns, HBOS, Wachovia), conservatorship cases, competitive concerns, most high-income (Fannie Mae, Freddie Mac), closures (Lehman countries have provided extensive assurances Brothers, Washington Mutual), and nationaliza- to depositors and creditors of banks and, in a tions(NorthernRock,Bradford&Bingley).These few cases, to those of nonbank financial insti- countries have also provided significant capital tutions. Some of these arrangements include injectionstootherprivatefinancialinstitutionsto blanket guarantees on deposits and guarantees prevent breach of minimum prudential require- on (mostly new) bank debt issues in order to ments. These were initially ad hoc responses to maintain funding, restore investor confidence, rescuespecificinstitutions--perceivedbymarket and buy time for other policy measures to take participants to be at imminent risk of failure-- effect. The guarantees are unprecedented in in the belief that the overall financial system scale and reflect a paradigm shift from the tra- remainedfundamentallysolvent.Later,however, ditional role of preventing bank runs by small, especially from late 2008 on, such interventions uninformed depositors. Although some coun- took the form of industry-wide support packages. tries initially announced that the guarantees In some cases they have led to the government becoming the main shareholder of still-private support as an "investor of last resort." In taking financialinstitutions(AIG,Citigroup,RoyalBank such a step, policy makers need to develop an of Scotland). institutional framework for governing banks in Thepreferencehasbeenforinjectionsthrough the transitional period, ranging from an autono- the issuance of preferred shares, although these mous agency to bank restructuring units within will be converted to common shares carrying full theministryoffinanceorcentralbank.Adhering votingrightsifcontinuedlosseswipeoutfinancial togoodcorporategovernancepracticesandcom- institutions' equity positions. Some of the injec- mercial principles would help the government tionshavebeencriticizedforlackoftransparency maximize the value of its investments and bring 3 and accountability, for inconsistency across insti- forward the time of exit. tutions and countries, and for lack of a rigorous assessment of the financial institutions' viability Dealing with problem assets and true capital needs. Equally important, they Several countries have announced programs raise fundamental issues of fairness because they to deal with exposures on bank balance sheets. expose taxpayers before creditors to mounting Most of them target higher-quality assets and financial institution losses, allegedly to prevent thus do not specifically attempt to clean banks anyadversesystemicknock-oneffects.Asaresult, of their problem exposures. These programs there is a danger that governments will prefer to involve either a government guarantee on cer- keep "zombie banks" operating and profitable so tain types of loans while keeping those loans on astominimize(short-run)lossestotaxpayersand bank balance sheets or the purchase of a broad avoid the negative externalities associated with rangeofstructuredsecuritiesandloanportfolios. the banks' closure. Approaches differ widely and result in different Government exit plans are defined in only a ex ante allocations of losses between bank share- handful of programs and are conditional on the holders and taxpayers, although their effects can recoveryprocess.Participationintheseprograms be fully assessed only when the crisis has been increasingly involves conditions on board repre- contained. sentation, executive compensation, and profit Only a few countries have attempted to distribution. Some countries (such as the United tackle problem assets head-on. The United Kingdom) have introduced particularly strict States recently announced the Public-Private conditions that include significant shareholder Investment Program through which the govern- dilution and changes to board composition; ment will provide cofinancing and guarantees others (such as the United States) have mostly for private investors to purchase troubled assets avoided such measures so far. The programs (bothloansandsecurities)frombanks.Germany also differ in objectives, with some explicitly set- announced a plan to segregate toxic assets in ting loan growth targets to prevent a potential separate vehicles within each bank using public credit crunch while attempting to avoid political guarantees. Ireland intends to establish a single, interference in bank operations--a difficult if industry-wide "bad bank" to take over the prob- not impossible balancing act. For EU member lem loans of Irish banks. A few other countries states, the European Commission has attempted have moved such assets into separate vehicles as to limit potential competitive distortions arising part of an attempt to clean up domestic banks from such programs by introducing a set of rules (as with UBS in Switzerland). togovernthem(seeEuropeanCommission2008 While these types of financial engineering for details). may improve banks' liquidity and creditworthi- The deepening recession may force some ness, they do not necessarily promote efficient countriestonationalize(dejureordefacto)even resolution of problem assets. Different workout more of their domestic banking system. While approaches, centralized or decentralized, can unthinkable until a few months ago, such a step be pursued regardless of which measures are mayultimatelybetheonlywaytolimitrisingbank adopted to restore bank solvency and liquidity. losses, resolve the asset valuation problems (see Manyemergingandafewhigh-incomeeconomies below), protect taxpayers, and convince market are familiar with the issues, having faced large- participants of the government's unconditional scale restructurings and workouts in the 1990s. D E A L I N G W I T H T H E C R I S I S T A K I N G S T O C K O F T H E G L O B A L P O L I C Y R E S P O N S E But in the current crisis, unlike in previous ones, releasing foreign exchange reserves to kick-start mostofthedistressedassetshavebeenstructured financingincreditmarkets.Theirunconventional, securities (rather than corporate debt) and thus quasi-fiscal tactics, sometimes forced on them as difficult to unbundle and restructure. policy rates drop to zero and political deadlock If unbundling proves to be impossible, the andfiscalinflexibilityconstraingovernments,will alternative may be to separate the pools of be closely scrutinized for their effectiveness and problem assets into distinct vehicles (legally or their impact on inflation objectives. throughguarantees)andallowtheassetstoessen- The crisis has led some countries to abandon tially run off. The problem with this is twofold: orthodoxy and adopt whatever policy levers are 4 valuation of the assets at the time of transfer and at their disposal to ease the credit crunch. These theimplicationsforbanks'capitaladequacy.The have included additional lending by state-owned customization and extreme market illiquidity financialinstitutions,theprovisionofcreditguar- of such assets make valuations difficult with- antees and lines of credit, and even direct gov- out detailed--and time-consuming--audits of ernment support for troubled borrowers (such the characteristics of the underlying pool. The as the car industry). All this is rekindling old debates on fair-value accounting and on estab- debates about the desirability and usefulness of lishing auction mechanisms for such assets stem state intervention in the financial system. largely from this problem, which will help deter- mine the size and allocation of losses from their Policy responses in emerging economies transfer. Since valuations are likely to result in The risk aversion and deleveraging that followed greater losses for banks at the time of transfer, the collapse of Lehman Brothers in September substantial additional capital injections may be 2008 led to a global reversal in capital flows and needed--one reason this method has not been hit emerging-market economies particularly widely used in the crisis thus far. The governance hard. The outflows led to significant--and some- structure and risk sharing profile (that is, the times indiscriminate--financial market sell-offs, sharing of the upside between government and higher interest rates and spreads, and pressures private participants) of any "bad bank" vehicles on exchange rates. These created negative feed- will also be contentious. back loops and raised fears (not yet realized) of "sudden stops"--the abrupt reversals in the Unfreezing lending availabilityofforeigncreditcharacterizingrecent Evidence of a credit crunch remains mostly anec- financial crises in emerging economies. dotal, although credit growth rates have plunged The channels of contagion differ widely around the world. While research on past crises across countries. The crisis has revealed preex- showsthatoutputtendstorecoverbeforecredit,4 isting homegrown problems ranging from large a healthy financial system is needed to promote external deficits and overvalued currencies to a sustainable economic recovery. Capital injec- lax credit underwriting standards and maturity tions may partly restore banks' financial health, and currency mismatches on bank and corpo- buttheworseningoutlookunderstandablymakes rate balance sheets. Adopting a "one size fits all" banks cautious about new lending. At the same explanation of the propagators of the crisis--or, time, demand for bank financing has increased by implication, of the different policy responses in some countries as a result of the implosion of adopted in these countries--would therefore be the "shadow financial system" and the drying up inappropriate. of liquidity and risk appetite in capital markets. Several of the crisis management measures These pressures are beginning to lead to the discussed have not (yet?) been necessary for crowding out of smaller and riskier borrowers most emerging economies. Review of a sample in countries where governments and large cor- of emerging economies shows that emergency porationsthatwerefundedincapitalmarketsare liquidity support to the domestic banking sys- reverting to banks for their financing needs. tem has been the main policy response, followed Central banks have stepped into the void by, by the expansion of safety nets and measures for example, adopting credit easing policies or to kick-start lending (table 1). Those that were Table Crisis-related policy measures announced by selected emerging economies by April 2009 1 Increased Measures Emergency deposit Troubled asset to liquidity insurance Guarantees on purchases or kick-start support coverage bank debt Capital support guarantees lending East Asia China Indonesia Korea, Rep. of Malaysia Philippines Thailand Vietnam Emerging Europe and Central Asia Bulgaria Croatia Czech Republic Estonia Hungary Kazakhstan Latvia Lithuania Poland Romania Russian Federation Serbia Slovak Republic Slovenia Turkey Ukraine Latin America Argentina Brazil Chile Colombia Mexico Peru Middle East Jordan Kuwait Qatar Saudi Arabia United Arab Emirates South Asia India Sub-Saharan Africa Nigeria South Africa Source: World Bank; International Monetary Fund; Fitch Ratings; BNP Paribas. D E A L I N G W I T H T H E C R I S I S T A K I N G S T O C K O F T H E G L O B A L P O L I C Y R E S P O N S E less financially integrated (such as Sub-Saharan ing.Governmentsupportprogramsindeveloped African countries) or that had stronger macro- countries that set domestic lending targets have economic and financial system fundamentals had the unintended consequence of reducing (such as Latin American ones) have generally cross-border lending (such as trade finance) and been less affected. acceleratingdomesticbanks'retrenchmentfrom A few emerging economies--particularly in foreign activities. emerging Europe and parts of the Middle East Finally, in emerging economies, as in devel- and East Asia--have attempted to match devel- oped ones, deleveraging is leading to the crowd- oped countries by increasing deposit insurance ingoutofriskierborrowers,particularlysmalland 6 coverage and introducing blanket guarantees medium-size enterprises. Thus it is no surprise so as to prevent capital outflows or destabilizing that emerging economies have adopted a range bank runs. But the state guarantee is unlikely to of measures to avoid a credit crunch. The dura- becredibleincountrieswithsizablepublicsector tion of this external shock will largely determine debt, a large banking system, and an open capital whether such measures are more appropriate account. A few countries have also introduced than adjustments in the economic structure. selective controls on capital outflows, and more may do so as they try to prevent "leakages" of Conclusion domestic liquidity injections or find themselves The immediate financial sector policy responses unable to cover external financing needs. As by developed countries--including emergency past experience has shown, such tools may have liquidity support, expansion of financial safety short-term success in stemming outflows but nets,andinterventionsinfinancialinstitutions-- long-lasting adverse effects on domestic deposit have succeeded in stemming widespread panic. mobilization. Few emerging economies outside of emerging Capitalsupporthasfocusedmostlyonexpand- Europehaveneededtoadoptmostsuchresponses ing the equity base of state-owned banks as a way so far, although policy makers around the world to increase lending (China, India), as a preemp- havetakenmeasures--includingunconventional tivemeasure(Qatar,SaudiArabia),orasameans ones--to ease the perceived credit crunch and toaddresstroubledfinancialinstitutions(Russian kick-start lending. Federation, United Arab Emirates). There have Westillhavenotexitedfromthecrisis,soafull been relatively few instances of banking-system- assessmentofthepolicyresponsesremainstenta- wide problems due to a significant accumula- tive. As with previous crises, however, the depth tion of nonperforming loans. But the continuing of this one has been consistently underestimated sharp declines in economic activity and the large and initial policy measures have been ad hoc refinancingneedsofcorporations(financialand andinsufficientgiventhemagnitudeoftheprob- nonfinancial) in some emerging economies are lems. Issues that remain unsolved--the "known likely to create bank funding and solvency prob- unknowns"--include the resolution of problem lemsandgeneratecorporaterestructuringneeds assets, the restructuring of troubled, systemically that will ultimately require support from govern- importantfinancialinstitutions,andthedevelop- ments and the international community. ment of credible exit strategies. Only a handful In many emerging economies the crisis has of countries have attempted to tackle these issues manifested itself mainly through terms-of-trade head-on. As past experience has shown, that may and investment (rather than financial) links, wellhavenegativerepercussionsfortheduration including drops in commodity prices, remit- and strength of a subsequent recovery. tances, and foreign direct investment. Its global Equally important, some measures, such as naturewillmakeitdifficultforeconomiestogrow those that have shielded troubled financial insti- their way out through higher exports as in the tutions from the full brunt of market forces, are past. The pressures are particularly severe for at odds with the policy advice promulgated by countries that have relied on capital inflows to developedcountriesinthepast.Thatraiseslegiti- expand economic activity and domestic financ- mate questions among emerging-market policy makers about double standards. Whether this Note prepared by IMF staff for the March 13­14 perception will change by the time the crisis is meeting of the G-20 ministers and central bank fully contained remains to be seen. governors. Reinhart, C. M., and K. S. Rogoff. 2008. This Time Is Dif- ferent: A Panoramic View of Eight Centuries of Financial Crises. NBER Working Paper 13882. Cambridge, MA: Notes National Bureau of Economic Research. The author would like to thank Roberto Rocha for his considerable input on an earlier version, Haocong Ren 7 for valuable research assistance, and Erik Feyen, John Pollner, Simeon Djankov, and Neil Gregory for helpful comments and suggestions. 1. Banking crises are quite common and tend to follow periods of high international capital mobility; see Rein- hart and Rogoff (2008) for a historical overview. 2. For analysis of the causes of the crisis, see Acharya and Richardson (2009); Brunnermeier (2009); FSA (2009); and Hellwig (2008). 3. See IMF (2009) for a summary of crisis response measures in G-20 countries. 4. See Calvo, Izquierdo, and Talvi (2006) for a descrip- tion of the "Phoenix miracle" for emerging economies. References Acharya, V. V., and M. Richardson, eds. 2009. Restoring Financial Stability: How to Repair a Failed System. Hobo- ken, NJ: Wiley Finance. Brunnermeier, M. K. 2009. "Deciphering the Liquidity and Credit Crunch 2007­2008." Journal of Economic Perspectives 23 (1): 77­100. Calvo, G. A., A. Izquierdo, and E. Talvi. 2006. "Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises." BIS Work- ing Paper 221, Bank for International Settlements, Basel. European Commission. 2008. "The Recapitalization of Financial Institutions in the Current Financial Crisis: Limitation of Aid to the Minimum Necessary and Safeguards against Undue Distortions of Competi- tion." Communication document, December 5. FSA (U.K. Financial Services Authority). 2009. The Turner Review: A Regulatory Response to the Global Bank- ing Crisis. London. Hellwig, M. 2008. "Systemic Risk in the Financial Sec- tor: An Analysis of the Subprime-Mortgage Financial Crisis." Report 2008/43, Max Planck Institute for Research on Collective Goods, Bonn. IMF (International Monetary Fund). 2009. "Stocktaking of the G-20 Responses to the Global Banking Crisis." P R I V A T I Z A T I O N T R E N D S A R E C O R D Y E A R I N 2 0 0 6 crisisresponse The views published here are those of the authors and should not be attributed to the World Bank Group. Nor do any of the conclusions represent official policy of the World Bank Group or of its Executive Directors or the countries they represent. To order additional copies contact Suzanne Smith, managing editor, The World Bank, 1818 H Street, NW, Washington, DC 20433. Telephone: 001 202 458 7281 Fax: 001 202 522 3480 Email: ssmith7@worldbank.org Produced by Grammarians, Inc. 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