Lessons from Financial Crises Crises Stefan Ingves Moscow March 2009

Content of Presentation Structure of Crises - in general Crisis Management Crisis Resolution How to get out of the crisis? What have we learnt? Some Practical Solutions Conclusion

Structure of Crises The general structure of financial crises does not vary much. Types of crises: - Banking - Currency - Sovereign - Political

Structure of crises Weak credit granting; risk concentration; excess liquidity; low risk premiums; regulatory gaps Property and other bubbles burst; macro economic downturn; risk aversion increases Loss of confidence leads to dried-up markets, interbank lending and household deposits. Private and public measures to reduce extent of crisis and to reduce costs to participants incl. society at large.

Similarities between Crises Many similarities on all components of the crises structure: Weak credit granting; excess liquidity; excessive risk appetite; regulatory gaps; property bubbles which burst in an economic downturn. Recognized ex post Moral hazard vs ”Had no idea!”

New Features in Present Crisis The interlinkages of markets (credit, securities, liquidity etc.). The increasingly global character of the financial system. The opacity of certain instruments and organisational structures. The new business model of banks.

Crisis Management – Generally Valid Principles - Swift and forceful actions by authorities, often based on insufficient information. - Transparent and predictable solutions. - Openness and active communication to explain the situation. - Close coordination between authorities and between political parties. - Provide incentives (sticks and carrots) for private sector to act,”the common good”. - State financial support to banks; non-trivial.

Crisis Management - Differences Liquidity squeeze across markets and countries. Need to restore confidence (State guarantees) and to infuse liquidity (central bank facilities in local currency and in USD). Coordinated actions between countries both for liquidity and solvency support. Stigma when using certain facilities – so this must be taken into account when ”constructing” them.

Crisis Resolution - Similarities All the basic alternatives are still valid and are being used: Private solutions Lloyds bought HBOS Facilitated solutions Bear Stearns Bridge bank IndyMac P & A Bradford & Bingley Open bank assistance IKB (Germany) Nationalisation Northern Rock However, crisis resolution have now been expanded to new categories of institutions such as invextment banks, insurance, Gov’t sponsored agencies.

Current Plans Intensive international activity now going on: May reduce risk for future crises but not for the current one. More urgent: Focus must be on restoring confidence so banks may fund themselves and expand lending again. Some of the national and international measures so far have not led to expected results since they are misconstrued (e.g. incorrect pricing policies for guarantees).

What have we learnt? Basic mistakes led again to a crisis: Lax lending; flawed risk assessments; concentration risk; inadequately explored instruments and models. Lending based on optimistic assumptions on property prices. Crisis resolution: Tough decisions by banks and authorities cannot be avoided. The challenge is to distribute the losses so that the overall cost (not only financial) is minimized.

What have we learnt ? Restoring confidence is paramount. Transparency is crucial; Proper valuation of assets; Clear rules and incentives for dealing with distressed institutions.

How to get out of this crisis? Full transparency about balance sheets; set realistic values. More equity is needed but not enough. Homeopatic palliatives should be avoided. (Changing accounting or prudential regulations).

The Swedish Model Structured framework for bank resolution High degree of transparency Political consensus Rescuing banks, not owners Gov’t interventions in banks as needed Gov’t “upside” Active use of AMCs

Practical Solutions in Present Crisis The Problem: Lack of confidence The Cure: Restore confidence by transparency bank-by-bank - Identify all toxic or otherwise weak assets and transfer them at conservative values to AMCs, which could be free-standing or within the bank. - Recapitalise the good bank and the AMC. - Work with outside and neutral experts on true valuation of toxic/weak assets. Publish the results.

Practical Solutions Should the Gov’t buy assets or recapitalise? ”Both”. Asset transfers at conservative prices leads to need for recap. Bank must be adequately capitalized to dare to lend. A tempting but unworkable method is to transfer assets at overly optimistic values. This may stifle asset markets for many years.

Practical Solutions Choice of method for restructuring a bank: - Each bank needs a customized solution, but there should be a general framework to ensure fairness and predictability. - Perform due diligence to assess the situation and needs of each bank. - Use a ”triage” method to assess a bank’s viability and restructuring alternative.

A Non- Solution Experience has shown that some methods do not work, for instance: Cuddling shareholders or management by letting them hold on to a failed bank (or buying it back at a low price) in spite of State’s capital infusion. The bank’s weaknesses will not be rectified. This does not mean that the State as a major shareholder should run a bank on other than commercial terms and by professional staff.

Conclusions The present crisis is different … global, across markets, complex instruments and opaque valuations, …but proven principles for crisis resolution are still valid, …and the crisis cannot be resolved until there is full transparency at the micro level. Bank restructuring is essentially corporate finance