The curse of advanced economies in resolving banking crises

Luc Laeven, Fabian Valencia 09 July 2012

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Countries typically resort to a mix of policies to contain and resolve banking crises, ranging from macroeconomic stabilisation to financial sector restructuring policies and institutional reforms. However, despite many commonalities in the origins of crises (Reinhart and Rogoff 2009), existing crisis management strategies have been met with mixed success.

Successful crisis resolutions have been characterised by transparency and resoluteness in terms of resolving insolvent institutions, thus removing uncertainty surrounding the viability of financial institutions. This requires a triage of strong and weak institutions, with full disclosure of bad assets and recognition of losses, followed by the recapitalisation of viable institutions and the removal of bad assets and unviable institutions from the system (Honohan and Laeven 2005).

Sweden’s experience during its banking crisis in the early 1990’s is often hailed as an example of successful crisis resolution. The Swedish government moved swiftly to liquidate failing banks, recapitalise viable institutions, and remove bad assets from the system, avoiding large-scale forbearance and evergreening of assets. As a result, Sweden avoided prolonged stagnation that lingering bad assets would have entailed, achieving a quick recovery from the crisis, supported by external demand.

Yet, not all countries achieve Sweden’s rate of success. Japan is a case in point. Instead of acknowledging the true extent of losses at troubled banks early on, authorities allowed insolvent institutions to continue to operate as “zombie” banks, evergreening bad credits, and using deferred tax accounting to bolster their regulatory capital positions (Caballero et al. 2008). The reluctance of these banks to resolve bad assets contributed to the Japanese lost decade.

While conventional wisdom would have it that advanced economies with their stronger macroeconomic frameworks and institutional setting would have an edge in crisis resolution, the record thus far supports the opposite: advanced economies have been slow to resolve banking crises, with the average crisis lasting about twice as long as in developing and emerging market economies (Table 1).

While differences in initial shocks and financial system size surely contribute to these different outcomes, in a recent working paper (Laeven and Valencia 2012), we suggest that the greater reliance by advanced economies on macroeconomic policies as crisis management tools may delay financial restructuring, with the risk of prolonging the crisis. We refer to this as the ‘curse’ of advanced economies.

This is not to say that macroeconomic policies should not be used to support the broader economy during a crisis. Macroeconomic policies should be the first line of defence. They stimulate aggregate demand and sustain asset prices, thus supporting output and employment, and indirectly a country’s financial system. This helps prevent a disorderly deleveraging and gives way for balance sheet repair, buying time to address solvency problems head on. However, by masking balance sheet problems of financial institutions, they may also reduce incentives for financial restructuring, with the risk of dampening growth and prolonging the crisis. A similar point is made in BIS (2012).

Indeed, crisis responses to date in advanced economies have favoured accommodative monetary and fiscal policy, with the increase in public debt and monetary expansion amounting to about 21% and 8% of GDP, respectively – compared with about 10% and 1% of GDP, respectively, in developing and emerging market economies (see Table 1 below). In this context, monetary expansion, measured as the percentage increase in reserve money, should not be understood narrowly as conventional monetary policy, but also as capturing central bank liquidity support and unconventional measures to the extent that they increase reserve money.

Table 1. Banking crises outcomes, 1970–2011 (median values across countries)

Country Output loss Increase in debt Monetary expansion Fiscal costs Duration
In % of GDP  In years
All 23.0 12.1 1.7 6.8 2.0
Advanced 32.9 21.4 8.3 3.8 3.0
Emerging 26.0 9.1 1.3 10.0 2.0
Developing 1.6 10.9 1.2 10.0 1.0

 

Source: Laeven and Valencia (2012)

Advanced economies are generally well placed to resort to macroeconomic policies to manage crises without being overly concerned about their impact on the exchange rate, inflation, or public debt. Advanced economies benefit from well-anchored inflation expectations and reserve currencies benefit from flight to quality effects during financial crises. Emerging market economies, on the other hand, may not have the fiscal space or the access to finance to support accommodative fiscal policy, while excessive monetary expansion can quickly translate into inflation and large decreases in the value of the currency, impairing balance sheets further in the presence of currency mismatches.

Political economy considerations also favour macroeconomic policies over deep financial restructuring policies such as bank recapitalisations. The latter are generally seen by the public as enriching bankers, while accommodative monetary policy, although less targeted to the underlying problem of insufficient bank capital, is more likely to harbour broad based support: low interest rates will support asset prices for investors and house prices for home owners, and will lower the debt burden for mortgage holders and other debtors.

Moreover, initially, a country’s crisis response will be limited to tools that are readily available and do not require institutional reforms or parliamentary approval. The restructuring of financial institutions will often involve parliamentary approval for government programmes to purchase assets or recapitalise banks and the resolution of banks often faces institutional and legal challenges, such as the lack of a resolution framework or the inability to intervene in ailing institutions. For example, many countries did not have the tools in place to resolve complex financial institutions, including non-banks, prior to the crisis. Macroeconomic policies, and especially monetary policy, are the obvious first line of defence also from this perspective.

The crisis response during the on-going global financial crisis, dominated by advanced economies, has also heavily relied on monetary and fiscal policy. These countries also used a much broader range of policy measures compared to past crisis episodes, including unconventional monetary policy measures, asset purchases and guarantees, and significant fiscal stimulus packages, in part reflecting the better macroeconomic and institutional setting of the countries involved. These policies were combined with substantial government guarantees on non-deposit bank liabilities and ample liquidity support for banks, often at concessional penalty rates and at reduced collateral requirements. Liquidity support has been particularly large in the Eurozone (Table 2), indicating the significant role played by the Eurosystem in managing the crisis. The absence of a common fiscal authority surely also plays a role here.

Taken together, these actions have mitigated the financial turmoil and contained the crisis. But it means that the bulk of the cost of this crisis has simply been transferred to the future, in the form of higher public debt and possibly a dampened economic recovery due to residual uncertainty about the health of banks and continued high private sector indebtedness. While monetary policy has avoided an even sharper contraction in economic activity, it has also discouraged more active bank restructuring. The lingering bad assets and uncertainty about the health of financial institutions risk prolonging the crisis and depressing growth for a prolonged period of time. Macroeconomic stabilisation policies should supplement and support, not displace financial restructuring.

Table 2. Crises Outcomes and Resolution in the Euro Area and the US since 2007

 

Country Output loss Increase in debt Monetary expansion Fiscal costs Peak liquidity Liquidity support Peak NPLs
In % of GDP In percent of profits and foreign liabilities In percent of total loans
Euro area 23.0 19.9 8.3 3.9 19.3 13.3 3.8
US 31.0 23.6 7.9 4.5 4.7 4.7 3.9

Source: Laeven and Valencia (2012).

While the authors of this note are staff members of the International Monetary Fund, the views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

References

Bank for International Settlements, (2012), “The limits of monetary policy”, Chapter 4, BIS Annual Report, 24 June.

Caballero, Ricardo, Takeo Hoshi, and Anil Kashyap (2008), “Zombie lending and depressed restructuring in Japan”, American Economic Review, 98:1943-1977.

Honohan, Patrick and Luc Laeven (2005), Systemic Financial Crises: Containment and Resolution, Cambridge University Press.

Laeven, Luc and Fabian Valencia (2012), “Systemic Banking Crises Database: An Update”, IMF Working Paper 12/163, June.

Reinhart, Carmen and Kenneth Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.

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Topics:  Global crisis Macroeconomic policy

Tags:  Sweden, Japan, financial crises, banking crises, global crisis, Eurozone crisis

Deputy Division Chief in the Research Department of the International Monetary Fund and CEPR Research Fellow

Economist, IMF Research Department