Central banks have played an instrumental role in the current financial crisis in mature markets. With the aim of bringing money markets back to normal functioning and stemming financial turmoil, central banks have extended sizable financial assistance to failing banks and other intermediaries – although at the cost of increasing the size of their balance sheets and creating moral hazard and other microeconomic distortions. Today, systemic liquidity has been restored but credit conditions have not been normalised and, hence, economic activity has declined and inflation has started to fall.
While the financial crisis has receded in industrial countries, Latin America is enduring short-term capital outflows and growing liquidity and credit crunches. Central banks are intervening in the foreign exchange market to moderate currency depreciations, albeit at the cost of losing international reserves. In some cases, they are also providing liquidity assistance to troubled banks. However, if liquidity conditions continue to tighten, financial distress may jeopardise the stability of financial systems, and credit risk could be a major threat in 2009.
What should the role of central banks be in this possible scenario? Should they follow the path taken by industrial countries? And, if not, what would be an appropriate response to prevent and manage banking crises? This column addresses these questions based on the performance of central banks in several banking crisis episodes that have occurred in Latin America since the mid-1990s.1
The role of central banks in past banking crises in Latin America
Injecting large amounts of central bank money to cope with banking crises has been a regular practice in Latin America, except in a handful of episodes. The intensive use of central bank money was mainly the result of inappropriate legislation that did not allow governments to address banking problems at an early stage.2 It also aimed at avoiding – or at least postponing in the short-term – the use of taxpayers’ money to finance the cost of resolving the crisis. However, in a small number of cases, governments managed market turmoil effectively without resorting to large amounts of central bank money – provided adequate institutional arrangements were in place or were introduced in a timely manner.
Central bank money was used to provide both limited and extended liquidity assistance, and also to finance bank resolution and the payment of deposit insurance and guarantees. Injecting abundant central bank money was the main policy response to banking crises amid fears of a systemic impact that could lead to the collapse of the payments system (the Dominican Republic in 2003, and Argentina and Uruguay in 2002 are relevant cases). Central banks also pumped in money or issued securities to facilitate bank resolution (Bolivia and El Salvador in 1999), and delivered partial and blanket deposit guarantees (Venezuela in 1994 and Ecuador in 1999). Central banks injected money extensively even to cope with idiosyncratic events (for instance in Guatemala in 2001 and Ecuador in 1996).
In contrast, based on adequate institutional arrangements and strong macroeconomic fundamentals, a few governments tackled banking crises by adopting bank resolution to deal with unviable banks and using central bank money in limited amounts (for example, in Argentina in 1995, Peru and Colombia in 1999, and Guatemala in 2006). In some of these cases, they also strengthened weak but viable banks, implementing capitalisation programs, restructuring assets, and assuming liabilities, among other actions.
When central bank money was intensively used, it constrained central banks’ ability to conduct an orderly monetary policy. As central bank claims on banks mounted, it became increasingly difficult for central banks to mop up liquidity and, hence, monetary aggregates exploded, leaving the economy without a nominal anchor to contain inflation. The crises in Argentina, Mexico, Uruguay, and Venezuela are relevant examples, as well as the banks’ meltdown in the Dominican Republic and Ecuador (Figures 1 and 2).
Figure 1. Outstanding balances, Dominican Republic 2003, millions of pesos
Figure 2. Outstanding balances, Ecuador 1999, billions of sucres
Source: Jácome (2008).
The size of central banks’ balance sheet ballooned and, hence, unlike in industrial countries, domestic currencies depreciated and inflation soared, eventually backfiring on financial systems. A review of 26 episodes of financial distress and crises in Latin America – from the mid-1990s onward – shows that growing financial assistance to impaired banks led market participants to shift portfolios toward foreign currency assets. Central banks tried to smooth exchange rate depreciations by intervening in the foreign currency market. Thus, as the value of central bank claims on banks multiplied by a factor of two or more, international reserves fell by 15% or more. Eventually, as international reserves reached critically low levels, central banks stopped intervening and large devaluations or depreciations materialised (more than 30% in most cases), thereby exacerbating the banking crises – in particular in countries with high financial dollarisation. Because the transmission mechanism from money to prices is generally the exchange rate in these small open economies, currency depreciations fuelled inflation. Thus, when central bank claims on banks increased by a factor of two or more, inflation generally accelerated by more than five percentage points in a one-year period and soared in systemic events.
Banking crises also inflicted lasting effects on monetary policy in a number of countries. In many cases, the recovery of assets pledged as collateral was significantly smaller than the value of the loans (plus interest) provided in the midst of the crises. With interest-bearing liabilities exceeding interest-bearing assets, central bank capital was eventually depleted. Therefore, monetary policy’s room for manoeuvre declined as central banks feared that fully implementing open market operations would further erode their already weak financial positions.3
Following an alternative approach
From the previous analysis, it is clear that developing and emerging countries should not rely on central bank money if they need to tackle financial distress and crises. As opposed to what usually happens in mature markets when dealing with financial turmoil, central banks in emerging and developing countries should also care about internal and external stability as they typically face the risk of not only banking but also currency crises – the so-called twin crises (Kaminsky and Reinhart, 1999). In this environment, monetary policy must find a delicate balance. Central banks should provide financial assistance to troubled banks and simultaneously mop up excess systemic liquidity to maintain monetary control. However, interest rates should be sufficiently low to avoid damaging illiquid banks but high enough to stem possible runs on deposits and capital flights. This is particularly important in countries with financial dollarisation, where large exchange rate depreciations harm bank asset portfolios – as they hit unhedged borrowers – increasing the chances of a full-fledged banking crisis.
Thus, handling banking crises exclusively via monetary policy is restrictive and might not be effective. A broader strategy is required under the umbrella of a financial safety net that should comprise four mutually consistent pillars: (i) early corrective actions; (ii) provisos to conduct bank resolution and restructuring; (iii) deposit insurance; and (iv) central bank lender-of-last-resort provisions. Early corrective actions should have an undisputed legal support to empower regulators to impose timely remedial actions on financial institutions that are not observing prudential regulations, especially solvency requirements. Countries should have the legal foundations and the necessary financial resources to implement bank resolution and restructuring in an orderly fashion. This is critical to enable them to close unviable banks without inducing further financial instability, while minimising the use of inflationary means. A well-designed and funded deposit insurance mechanism allows small depositors to be protected and to have them paid immediately – to prevent contagion – if a financial institution is closed. In turn, central banks should be empowered to provide limited short-term financial assistance to illiquid but solvent banks.
But, the golden rule in emerging and developing countries is to tackle banking crises at an early stage. In particular, it is critical to impose corrective actions before liquidity and capital shortages become chronic and implement bank resolution before the crisis gains momentum. Postponing a lasting response, especially the implementation of cost-effective resolution measures, generally exacerbates macroeconomic instability, risks systemic contagion, and elevates the cost of the crisis. The resulting macroeconomic effects may include a simultaneous currency crisis and even a sovereign debt crisis – in countries where high dollarisation also involves government debt (Ecuador in 1999, and Argentina and Uruguay in 2002). From a microeconomic perspective, a disorderly unravelling of the crisis may lead to the breach of financial contracts – like freezing deposits, reprogramming their maturities, and imposing capital controls – that undermines confidence in the banking system and weakens market discipline for years to come. In any case, governments and not central banks should assume directly the costs of crises. And when central banks initially bear the costs, they should be compensated by governments in order to restore their financial strength, thereby preserving central bank operational autonomy to exercise future monetary policy and credibly commit a to low and stable inflation.
Jácome, L.I, 2008, “Central Bank Involvement in Banking Crises in Latin America” IMF Working Paper 08/135 (Washington: International Monetary Fund).
Kaminsky, G. and C. Reinhart, 1999, “The Twin Crises: The Causes of Banking and Balance of Payments Problems,” American Economic Review, Vol. 89, No. 3, June, pp. 473-500.
Stella, P. and A. Lönnberg, 2008, “Issues in Central Bank Finance and Independence,” IMF Working Paper 08/37 (Washington: International Monetary Fund).
2. While most Latin American countries modernised financial legislation during the 1990s, the reform was aimed at liberalising financial markets with the aim of fostering economic growth and did not provide a suitable framework to cope with major banking problems.