The cost of resolving financial crises

Luc Laeven

31 October 2008

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The crisis is evolving with breakneck speed. The debate about why it happened and how it will unfold is still very much ongoing, as Felton and Reinhart (2008) show.

While it may be too early to write about the lessons learned, authorities do not have the luxury to wait for these, and have already embarked on large-scale interventions in the financial sector and beyond.

US moves: $700 billion only a third of the average cost

Earlier this month, after a first round of hesitation, the US House of Representatives voted in favour of the Stabilization Act to bail out the US financial sector in the amount of $700 billion. Though the Act was initially sold as a government program to purchase distressed financial assets, it has since been recast as a program to recapitalise financial institutions by directly injecting capital.

$700 billion is of course a large number by any measure if taken at face value. But let’s put this number in perspective. It amounts to 4.9% of US GDP. This is not an outlier when compared to fiscal costs associated with government action to resolve financial crises of the past.

An IMF study of 40 financial crisis episodes puts the fiscal costs associated with resolving financial crises in the average country at 16% of GDP (Laeven and Valencia 2008). Although this average includes some small and emerging economies, the fiscal cost is equally high among industrialised economies - at 15% of GDP on average.

  • About half (or 8% of GDP) of these fiscal outlays relate to costs associated with government-assisted recapitalisation of banks.
  • The remainder relate mainly to costs associated with government asset purchase and debtor relief programs.

Variation in the fiscal cost of resolving financial crises

There is much variation in this number, though, as the severity and management of crises have varied a great deal. The crisis management packages in countries as diverse as Finland, Japan, Korea, Mexico, and Turkey all cost the taxpayer a multiple of the current US bailout plan, ranging from 13% of GDP in Finland to as high as 32% in Turkey. Countries like Norway and Sweden fared much better with costs to the taxpayer of 3% and 4% of GDP, respectively.

Of course, the current US financial crisis is still ongoing and the ultimate fiscal costs could be much higher. Recent bailouts of individual financial institutions and extensions of government guarantees for deposits and money market funds have already added significant contingent fiscal liabilities. Other countries, particularly in Europe, have followed suit, varying from the announcement of a blanket guarantee on bank liabilities in Ireland to a comprehensive bailout package for major financial institutions in the UK.

Speed saves

A key driver of this variation in ultimate fiscal costs is the speed with which governments act to resolve the crisis. Speed is of the essence and is often accomplished through a comprehensive package of simple assistance measures to borrowers and banks that is politically acceptable.

Also, while the upfront cost of interventions is high, if done right, the government will not be left empty handed. If the government purchases bad assets, these assets may recover in value, and if the government takes equity stakes in banks, the value of these stakes may increase in the years to come. The ultimate cost to the taxpayer is likely to be smaller.

Necessary but politically sensitive wealth transfer

Surely, any bailout plan involves a transfer of wealth from creditors to debtors, from those that behaved prudently to those that took excessive risks. However, the consequence of no action is likely to be worse. What starts as a crisis of confidence in the financial system often quickly spreads to the real economy, negatively affecting household wealth. Declines in banks’ net worth, which may result in bank failures, reduces their ability to supply loans to households and firms, and at a minimum increases the cost of borrowing. At the same time, initial declines in economic activity that begin as a normal recession become larger as declines in borrowers’ income and net worth destroy bank net worth, creating a vicious cycle of wealth destruction that in the past has often led affected economies into deep recession. It is for this reason that financial crises call for swift policy responses. Sound policies today will avoid even larger fiscal and economic costs tomorrow.

Little agreement on best practice

Choosing the best way of resolving a financial crisis and accelerating economic recovery is far from unproblematic. There has been little agreement on what constitutes best practice or even good practice. Policy responses depend on the nature of the crisis.

So let’s first agree on the underlying problem of the current crisis. Markets appear unable to resolve the uncertainty about the value of bank assets and associated counterparty risk between banks. This problem is intensified by the low levels of capital in banks.

This market failure requires government intervention. But what kind of intervention and on what scale?

Regulatory forbearance and bank liquidity support can backfire

Governments have employed a broad range of policies to deal with financial crises. They typically start with regulatory forbearance and generous liquidity support to banks. Forbearance, however, does not really solve the underlying problems of too little bank capital and therefore a key component of almost every systemic banking crisis is bank restructuring plan. All too often, government intervention in financial institutions is delayed because regulatory capital forbearance and liquidity support are used for too long to deal with insolvent financial institutions in the hope that they will recover, ultimately increasing the stress on the financial system and the real economy.

Central to identifying sound policy approaches to financial crises is the recognition that policy responses that reallocate wealth toward banks and debtors and away from taxpayers face a key trade-off.

Such reallocations of wealth can help to restart productive investment, but they have large costs. These costs include taxpayers’ wealth that is spent on financial assistance and indirect costs from misallocations of capital and distortions to incentives that may result from encouraging banks and firms to abuse government protections.

Those distortions may worsen capital allocation and risk management after the resolution of the crisis. For example, government recapitalisations of insolvent banks may lead shareholders of the bank to “gamble for resurrection” at the expense of other stakeholders of the bank.

More generally, government bailouts generate moral hazard as they increase the perception that bailouts will occur next time around. While policymakers should take these tradeoffs into account when crafting their bailout plans, they do not have the luxury to wait for the perfect solution.

Conclusion

The economic cost of no action can be enormous, making even $700 billion sound like a small number. Let’s hope the money will be spent wisely.

References

Felton, A. and C. Reinhart, 2008 “The First Global Financial Crisis of the 21st Century”, A VoxEU Publication.
Laeven, L. and F. Valencia, 2008. “Systemic Banking Crises: A New Database”, Working Paper No. 08/224, International Monetary Fund.

Disclaimer: The author is a staff member of the International Monetary Fund. The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

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Topics:  Financial markets

Tags:  subprime crisis, financial crisis, bailout, fiscal cost

Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow

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