MANAGING SYSTEMIC BANKING CRISES Luis Cortavarria International Monetary Fund Monetary and Financial Systems Department

Banking Problems Worldwide 1980–2003 Banking Crisis Significant Banking Problems No Significant Banking Problems/Insufficient Information

Crisis Management: Complexity vs. Simplifications Banking crises are chaotic events: They emerge suddenly. They are intertwined with political and social problems. Crisis management in this environment is complex: There is no time. Conditions of banks are unknown. There are legal and institutional limitations. Challenge: Design a comprehensive program consistent with local conditions without time and information.

Crisis Management Framework Treatment of systemic crises differ from treatment of individual bank failures. Tools appropriate for one may aggravate the other. Systemic crisis management—three stages: Crisis containment Bank restructuring Asset management

Stage One: Crisis Containment Containment must be an immediate priority. Reforms not effective in face of generalized panic Measures cannot last forever Available tools: Emergency liquidity assistance Blanket guarantees Immediate bank intervention Administrative measures

Stage One: Crisis Containment These tools are controversial. Legitimate concerns about costs and misuse. How to avoid pitfalls?

Emergency Liquidity Aim Restore depositor and creditor confidence. Pitfalls Macroeconomic pressure Increase monetary aggregates Can support insolvent banks Losses to the central bank Prone to abuse

Emergency Liquidity Options Sterilize liquidity injections Introduce liquidity triggers Enhanced supervision of recipient banks

Blanket Guarantee Aim Pitfalls Stabilize creditor fear, give time to design policies Pitfalls Not credible if government fiscal position is weak. High cost in case of large solvency. Moral hazard if prolonged, if no restructuring.

Administrative Measures Aim Stop liquidity outflows when confidence is not restored. Types: Deposit freezes Deposit restructuring Capital and exchange controls

Administrative Measures Pitfalls Extremely disruptive to: Payment system Economic activity Private sector confidence Exemptions Unwinding process Must be viewed as a final, desperate measure to stop runs if all other tools have failed

Stage Two: Bank Restructuring Aim Restore banking system profitability and solvency Steps Diagnosis and triage Restructuring the banking system: Resolution of unviable banks Restructuring of viable but undercapitalized banks.

Diagnosis and Triage Aim Pitfalls Identify banks in need of restructuring/resolution Pitfalls Data limitations

Diagnosis and Triage How can pitfalls be addressed? Use concept of “medium-term viability” in addition to solvency. Require banks to produce forward-looking business plans: common assumptions and worst-case scenario analysis; and stress tests and simulations to confirm viability. Audits Classify banks

Bank classification: Sound and solvent Undercapitalized Insolvent but viable Insolvent and nonviable

Bank diagnosis: Continue Viable? Yes No Fail? under MOU No Yes Bank Resolution Shareholders Recapitalize

Bank Restructuring Aims: Options: Remove unviable banks from the system. Return viable banks to profitability. Options: Private sector Public sector Combination

Bank Restructuring Pitfalls Delays Excessive forbearance No losses imposed on shareholders Partial resolution (while “praying for redemption”) Limitations in the legal framework: Inability to wipe out shareholders Restrictions for sale of assets P & A transactions Lack of protection for supervisors

Bank Restructuring How can pitfalls be addressed? Planning—think through how crises will be managed. Aim for least cost-restructuring outcome: Private sector solutions Restricted public sector-assisted solutions Single authority to oversee crisis management Strengthen legal and regulatory system (difficult during a crisis).

Bank Restructuring Ensure political consensus (possible but difficult) Avoid inadequate tools Proper communication Accountability

Bank Restructuring Limitations to this approach If misused, costly, can cause moral hazard. Alternatives have been proposed: Allow illiquid banks to fail one by one. Apply depositor haircuts on restructured banks. Rarely used in practice. Does irreversible damage to potentially healthy sections. May not be least cost: economic costs > fiscal costs Very high social and political costs.

Stage Three Asset Management Aim Allow banks to focus on banking. Options: Private asset management companies (AMCs) Centralized (public) AMCs Difficulties: Weak market demand for distressed assets Weak property rights Unrealistic expectations about recovery rates Weak legal frameworks Poor loan documentation

Conclusions Crisis management is a balancing act. Need to act quickly under extreme uncertainty. Lessons from past crises must be combined with deep country-specific knowledge. Planning is key to successful crisis management. Bank restructuring is a long and painful process. Strategy should be comprehensive. Clear independence of the banking authorities.

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