Banking Crises, Regulatory Reform and Resolution

1
Banking Crises, Regulatory Reform and Resolution

• Charles Calomiris
• May 11, 2010

2
Macroeconomics and Banking

• View that banks are sources of shocks and
  propagators of shocks in the macroeconomy was
  rediscovered in 1980s, and has received more
  attention in the past decade, especially after
  the Asian and Mexican crises.
• This view has substantial historical precedent,
  and supporting historical evidence, and is only
  new in the sense that it was ignored by most
  macroeconomists in 1950s, 1960s and 1970s.

3
Why the Rediscovery?

• Banking instability became more of an issue in
  macroeconomics.
• Key trends
• Frequency of banking crises
• Coinciding of banking crises/capital crunches
  with macroeconomic declines
• Mixing of banking crises with exchange rate or
  sovereign crises.

4
EM Banks Especially Unstable

• Fiscal costs of banking crises in EMs amounted to
  about 1 trillion in the 1980s and 1990s, which
  was equal to all foreign assistance transfers
  from developed countries from 1950-2001.
• Many of these collapses also involve twin crises
  (collapses of both exchange rate and banking
  systems), with dire macroeconomic consequences.
• Why is this happening? What can be done?

5
Central Questions about Bank Risk and Prudential
Regulation

• Why are crises so common and so severe now?
• Are banking crises and their causes the same or
  different from those of the past?
• Are crises inherent in the function and structure
  of banks?
• Which supervision and regulation rules work?
• Should government pursue counter-cyclical
  forbearance policies, or procyclical prudential
  regulation?

6
Bank Function and Structure

• Banks control risk via intensive screening,
  contracting, and monitoring, involving private
  information production.
• Bank function and structure
• Delegated monitoring on asset side, liquidity
  creation on liability side
• Maturity and liquidity transformation
• First-come-first-served rule
• Essential structure and function of banks has
  created a special role for debt market discipline
  of banks, in contrast to other firms.
• Does this make banks risky? Does that explain EM
  banking crises?
• Alternative view Insider lending, moral hazard,
  politics of bailouts (Populism meets cronyism)

7
Crises have different shapes

• Currency depreciation only, reflecting an
  overvaluation of the currency, but without
  effects on banking system
• Brazil 1999 overvalued currency, lack of fiscal
  discipline, but banks relatively healthy, no
  resurrection risk betting
• Banking collapse only
• Australia 1893 costs of losses in banks absorbed
  by stockholders and depositors, not taxpayers
• Twin crises, in which banking collapses and
  exchange rate collapses happen together. The new
  phenomenon of twin crises (only a handful were
  observed in pre-1980 era). But twin crises can
  also be distinguished according to the dominant
  direction of causation
• fiscal crisis gt banking instability as in
  Argentina 2001, where government lacked the
  safety valve of inflationary monetary policy, and
  thus stole bank capital as last resort means of
  financing
• or banking instability gt fiscal crisis, as in
  Mexico 1994 and East Asia 1997, although in these
  cases there was also an overvaluation problem of
  real exchange rate, in Mexico because of boom in
  demand, and in Asia because of cumulative decline
  in productivity

8
Financial system feedback during crises
Currency devaluation
Rapid rise in interest rates
Capital outflow
Overextended banks and firms
9
Risk factors show themselves during crises

• Law inability to have orderly workout in
  financial distress leads to backlog of unresolved
  debts reversal of privatization contracts,
  redenomination of contracts, limits on capital
  flows, nationalization of assets.
• Information markets react dramatically to crises
  (shut down of orderly information processing,
  high adverse selection costs)
• Fiscal policy lack of political will to reduce
  expenditures, improve tax collection, avoid
  inflation tax.
• Banking desire to protect bankers, who are often
  borrowers and political allies, too, leads to
  lack of credible discipline ex ante, and big
  bailouts ex post. Quasi privatization can be
  worse than public banks from the standpoint of
  the severity of crises.
• KEY POINT All these risks can be observed in
  advance of the crisis!

10
Recent crises forecasted in particular countries

• Mexico The dog that did not bark in December
  1994.
• Fiscal spending and bank lending, election year
• Overvaluation (Dornbusch)
• Bank privatizations, lack of recapitalizations
• Recession began in 1993
• Sterilization, reserve outflows, tesobonos
  liquidity risk
• East Asia Diminishing returns / cronyism
• Weak bank balance sheets, high corporate leverage
  were known
• Low or negative return on invested capital due to
  crony banking
• Overvaluation related to declining productivity
• Recessions reflecting declining productivity,
  overvaluation
• Brazil Insufficient fiscal reform
• Overvaluation
• Old story of unsustainable peg given rising
  inflation
• Argentina Insufficient fiscal reform
• Coparticipation
• Labor, tax policies, recession (overvaluation-indu
  ced deflation)
• Destruction of banking sector

11
Causation in Mexico

• Spending, weak privatized banks (Haber article),
  off-balance sheet exposures raise debt and
  expected monetization.
• As reserves are drained, central bank
  sterilizers, thereby increasing current money
  supply.
• Rise in money and expected money drive up prices,
  leading to overvaluation and increasing pressure
  on exchange rate.
• Zedillos non-reform leads market to realize
  inevitability of collapse, and run begins.
• FX exposure is combination of direct bets and
  defaults linked to dollar debt.
• Banks double bets on FX by having lots of both
  (in violation of regs, done with swaps via Wall
  Street).
• Uncanny (forecasted) replay of Chile 1982-83
  crisis.

12
Rising Debt, Sterilization
13
Sterilization had been the rule
14
Inflation and base growth linked
15
Inflation increasingly threatened exchange rate
16
Mexican Devaluation
17
Asian Crises

• March and April 1997, the Economist and FT have
  special reports on declining fortunes of Asian
  banks, and possible crises there.
• Alwyn Young writes about declining productivity
  as threat to sustainability of so-called Asian
  miracle in 1994-95.
• Short-term borrowing in dollars increases as risk
  rises (largely interbank, protected?, and with
  different weights according to Basel).
• IMF assistance bails out those debts.

18
Bank Losses in Asian Crises

• Thailand Indonesia
  Korea
• 1997NPL/TL 19 17 16
• 1997NPL/GDP 30 10 22
• Cleanup Cost / 42 55 20
• 1999 GDP

19
Diminishing Returns gt Increasingly Inefficient
Capital Investment in East Asia in 1980s, 1990s

• Return on Capital
• Employed Minus
• Interest Rate, 1992
• Indonesia -12
• Korea - 3
• Malaysia 3
• Philippines -13
• Thailand - 9
• Source Pomerleano (1998)

20
Micro Level Stylized Facts
As the 1990s progressed . . .

• Asian corporations experienced a decline in
  performance.

• Asian corporate managers increased the leverage
  of their firms.

• Asian corporate managers borrowed substantially
  from international capital markets in foreign
  currencies (US Dollars).

21
How Can You Bet the Country?

• Government bailouts are anticipated,
  intermediated by governments relationship with
  the IMF, which injects dollars to government,
  which pays them to crony firms with outstanding
  short-term debts.
• Taxpayers pick up the pieces.
• High leverage of ex ante insolvent banks and
  firms indicates that both borrowers and US,
  Japanese, and European bank lenders anticipated
  this.
• Note Capital flows, per se, are not the problem,
  but rather the allocation of risk by government
  associated with those flows. There is an argument
  for waiting to liberalize capital flows until
  incentives and financial regulation have been
  fixed.
• This is a particularly important issue for China,
  given that it could repeat the Asian crisis
  pattern, given diminishing returns and lack of
  market discipline in banking system.

22
Trends in Corporate Leverage RatiosCountry
Comparisons
Rating Ratio AAA 13.4 AA 21.9 A 32.7 BBB
43.4 BB 53.9 B 65.9
23
Brazils Controlled Devaluation (Healthy banks)
24
Argentinas Crisis Anticipated
Interest Rates on 30-Day Time Deposits in Pesos
and Dollars
Sources J.P. Morgan Chase Co. Banco Central
de la República Argentina, Interest Rates on
Deposits (available at http//www.bcra.gov.ar/).
25
Argentinas Crisis Anticipated
Difference Between Interest Rates on 30-Day Time
Deposits in Argentina in Pesos and Dollars vs.
EMBI Argentina Strip Spread
Sources J.P. Morgan Chase Co. Banco Central
de la República Argentina, Interest Rates on
Deposits (available at http//www.bcra.gov.ar/).
26
Deposit Outflows
Monthly Dollar Deposits in Argentina, 2001
Source Argentina Ministry of Economy
Production, Macroeconomic Statistics (available
at http//www.mecon.gov.ar/peconomica/basehome/inf
oeco_ing.html).
27
International Reserve Outflows, 2001
Note Because of a change in the BCRAs
definition of international reserves, data after
October 31, 2001 includes public bonds involved
in reverse repo-operations. Data before October
31 does not include these bonds. Source Banco
Central de la República Argentina, International
Reserves and BCRAs Financial Liabilities
(available at http//www.bcra.gov.ar/).
28
Annual Capital Inflows by Type

Note Equity inflow was not available until 1992.
I use the following variables from the IMFs
International Financial Statistics as components
of capital inflows 1) FDI line 78bed (Direct
Investment in the Reporting Economy, n.i.e.) 2)
Equity line 78bmd (Equity Securities
Liabilities) 3) Debt line 78bnd (Debt Securities
Liabilities). 4) Other line 78bid (Other
Investment Liabilities, n.i.e.) Source
International Monetary Fund, International
Financial Statistics, June 2004.
29
Argentine Devaluation
30
Role of fixed exchange rates

• All of the problems discussed would still be
  problems under flexible exchange rates
• But fixed exchange rates make things worse by
  create sudden adjustments, and thus big
  accumulations of risk.
• This not only causes sudden problems, it also
  worsens resurrection risk taking by giving banks
  and firms something to bet on.

31
Panics vs. Insolvencies

• Concern that too much, unwarranted, sudden market
  discipline can create undesirable social costs
  from contraction of bank deposits during panics
  is the primary justification for bank safety nets
  in theory and in history (deposit insurance, and
  lender of last resort).
• Such systemic panics (as distinct from periods of
  high bank failure) resulted from a combination of
  observable shocks and unobservable incidence of
  shocks, in combination with the structure of
  banks (liquidity transformation, fcfs rule).

32
U.S. Experience with Panics

• 1857, 1873, 1884, 1890, 1893, 1896, 1907
• Observable shock was a dual threshold of 9 stock
  market decline over a quarter, and 50 increase
  in seasonally adjusted liabilities of failed
  business (NEWS RELEVANT FOR BANKS)
• Some shocks originated in NYC and were related to
  securities markets, use of funds by NYC banks In
  1857, loans to bond dealers, connections to RRs,
  was the problem. Some shocks may relate more to
  peripheral areas (perhaps 1893).

33
Dealing with Panics

• Costly bank panics were almost exclusively a U.S.
  phenomenon by the mid-19th century. Market
  discipline, along with inter-bank cooperation and
  lending, central banks, and clearing house
  actions to share risks dealt with threat of
  panics effectively, except in U.S. where
  branching limits, pyramiding of reserves created
  concentrations of risk, and made coordination
  difficult.
• Desire to keep unit banking, and risk of panics
  explains why U.S. originates deposit insurance.

34
Dealing with Panics (Contd)

• Banks assisted each other, sometimes through
  formal clearing house actions.
• Market discipline kept risky banks in check, and
  made other banks see advantage to identifying and
  punishing risky banks quickly.
• Suspension was used as a last resort, and market
  discipline created incentives to restore
  convertibility quickly.
• Resumption of convertibility would occur when
  secondary market discounts on bank paper
  approached zero.

35
Historical Banking System Collapses

• Panics in U.S. did not produce banking collapses,
  because the combination of market discipline,
  clearing house support, and temporary suspension
  of convertibility (until asymmetric information
  was resolved) insulated banks from costs.
• 1893, worst of U.S. panics, coincided with large
  exogenous agricultural problems, but bank
  failures produced negative net worth of failed
  banks of only 0.1 of GDP.

36
Historical Collapses (Contd)

• Worldwide, from 1873 to 1913, there were no more
  than seven episodes of severe bank failure
  worldwide (defined as collapses that produced
  banking losses where negative net worth of failed
  banks in a country exceeded 1 of GDP)
• Argentina 1890 (10), Australia 1893 (10),
  Norway 1900 (3), Italy 1893 (1), Brazil
  various (hard to measure, but all much less than
  10). Only 2-3 of these are twin crises.

37
Historical Comparison between Today and Pre-WWI
Era Appropriate?

• 1870s-1913 is a time when capital flows to
  emerging markets were high relative to GDP,
  limited liability banking was growing rapidly
  around the world, countries relied on fixed
  exchange rates, and macroeconomic climate was
  very volatile.
• This suggests that according to some explanations
  of crises (exchange rate fixed, free chartering
  of banks, multiple equilibria due to foreign
  capital flows) we should see more then than now.
  But we do not.h

38
Historical Collapses (Contd)

• Land booms and busts underlay these collapses,
  and often bank risk was subsidized by government
  in one way or another. Argentina, Italy
  subsidized risky bank lending on land Norway and
  Australia promoted land booms in other ways.
• Banking collapses for some U.S. states also
  directly traced to safety net policies.
  Agriculture boom and busts and banking collapses
  were much more severe in states with deposit
  insurance (WWI price bets).
• Twin crises in Italy and Argentina in 1890s
  reflected feedback from banking crises to fiscal
  collapse of government (foreshadowing todays
  crises).

39
State-Level Deposit Insurance in 1920s

• 3 Insured 15 Controls
• Asset Size 320 622
• Equity / Assets 0.11 0.13
• Growth during Boom 185 128
• Loans / Assets 0.76 0.70
• Negative NW of fails
• / Survivors NW 3.5 0.5
• Source Calomiris JEH 1990.

40
How the Safety Net Causes Bank Collapses

• Safety net removes market discipline that used to
  operate, both as a check on conscious risk
  taking, and on quality of bank management making
  risk taking decisions. Both effects are
  important.
• These two channels do not operate with constant
  adverse effects, but rather, their effects vary
  over the cycle.
• Conscious risk taking increases in wake of losses
  (resurrection bets on unlikely outcomes with high
  risk premia, especially in currency markets,
  which deepens extent of twin crises through
  feedback effects).
• Management quality problem can be most hazardous
  during booms, and becomes visible during busts
  (WWI grain price bets).

41
Why Few Twin Crises Historically?

• Other than those exceptions, fiscal discipline
  coincided with and reinforced benefits of market
  discipline over banks.
• Governments adhering to gold standard had access
  to international capital markets, and could act
  to protect banks with classical lender of last
  resort liquidity assistance.
• Mexico 1907 and Russia 1899-1900 are prime
  examples of successful assistance
• Assistance was limited by credible commitment to
  stay on gold standard, which in turn ensured
  access to funds as needed. (Contrast to IMF)

42
What About the Great Depression?

• New research (Calomiris and Mason, 1997, 2003)
  shows that panics were not nationwide phenomenon
  until very late (early 1933)
• For the most part, fundamental shocks
  (deflationary monetary policy, gold standard,
  agric. distress, other bad economic policies)
  caused insolvencies by many banks, not panics.
• And, despite the severe shocks and many failures,
  losses of failed banks 1930-1933 only about 3-4
  of GDP.

43
Banking Collapses Today

• In contrast, about 150 episodes since 1978 of
  banking system collapses with costs of more than
  1 of GDP, more than 20 with costs in excess of
  10 of GDP, and many of those have costs in
  excess of 20 of GDP.
• This is unprecedented. Collapses often coincide
  with currency collapse due to fiscal implications
  of banking collapse for government. This reflects
  changes in political economy of banking systems
  (similar to Eichengreen 1996 argument on
  inflation process).
• Like Italy and Argentina pre-WWI, these severe
  collapses have been directly traced to incentives
  from government policies protecting banks from
  market discipline.

44
How Did / Do Disciplined Systems Behave?

• Old-Fashioned Disciplined Banking
• Equity/Assets and Asset risk managed to target
  low default risk on debt of bank. During good
  times, equity capital is cheap (no lemons
  problems) and lending opportunities are good, so
  both risk and equity capital rise.
• When shock hits, banks face prospect of loss of
  deposits due to combination of risk aversion and
  need for liquidity of depositors, and asymmetric
  information problem about losses within bank.
• As banks lose deposits they act to restore
  confidence by contracting loans, cutting
  dividends, and expanding cash asset holdings.

45
NYC Bank Capital and Risk 1920-1936
46
NYC Banks Loans/Cash, Equity, Dividends

• Loans/Cash Equity/Assets Dividends
• 1922 2.1 0.18
• 1929 3.3 0.33 392m
• 1933 1.0 0.15
• 1940 0.3 0.10 162m
• Source Calomiris-Wilson JB 2004.

47
Discipline Reflected on Liability Side

• If discipline exists, it appears in three forms
• Interest cost of debt goes up with risk
• Rationing effect deposits decline
• Shift to high-cost, monitored marginal funds
• These effects are consistently visible
  historically, as well as currently, in all types
  of countries.
• Bank liability data, and liability interest rate
  data are the most reliable, consistently reported
  data on balance sheets, which helps make them
  especially useful as indicators.

48
Example Chicago 1932

• 1932 Failures 1932 Survivors
• Number 46 62
• 1931 RD 2 1
• 1931 Borr/Debts 12 2
• 1931 Dep growth -45 -33
• Source Calomiris-Mason 1997 AER.

49
Example Argentina 1995

• 1995 Failures 1995 Survivors
• RD paid in 1993 13 9.5

50
Example Mexico 1996

• Even though there was 100 deposit insurance, the
  losses were so large, and the political debate so
  uncertain, that insured deposits were not
  necessarily protected.
• Banamex (marginally solvent) paid 17 on its
  funds, on average, but Bank Serfin (deeply
  insolvent) paid 29

51
Market Discipline Even with Insurance

• All banks Banamex Serfin
• 1996 Dep. Int. 25.2 17.4 28.9
• 1994 branches 5,051 710 561
• 1996 branches 6,264 912 578

52
Contrast Old (Stable) System with Protected
(Unstable) System

• Old, disciplined system reduced bank risk in
  response to shocks.
• New system sees banks increasing risks in
  response to shock (doubling their bets),
  especially taking on exchange risk.
• Chile 1982-1983
• U.S. Savings and Loans in 1980s
• Mexico 1993-1994
• Japan 1990-1997
• Korea, Thailand, etc. 1995-1997

53
Risk-Based Capital Regulation

• Basel and similar systems supposedly target
  risk-based capital, which is similar to targeting
  default risk of debt, although measurement of
  risk and capital are imperfect (to say the least)
  and ratios are arbitrary.
• If this is successful, it results in regulatory
  discipline with effects similar to market
  discipline When a bank loses capital, it
  contracts risk, cuts dividends, in order to
  comply with standard and in doing so reduces
  default risk.

54
Procyclical Effects?

• If effective, this sort of capital regulation
  necessarily exacerbates the business cycle, since
  losses of capital (during onset of recession)
  produce contraction of bank loan supply, which
  aggravates the recession.
• Calomiris and Mason (AER 2003) estimate that
  market discipline during U.S. Great Depression
  was responsible for income declines roughly
  one-third as large in percentage terms as the
  percentage declines in loan supply. These are
  very large effects.

55
Procyclical Effects (Contd)

• Two points warrant emphasis
• First, any prudent risk-managing bank will have
  to contract risk in response to loss, so
  procyclicality is an inevitable feature of a
  well-managed banking system.
• Second, forebearance (the decision by
  regulators to relax requirements because of a
  concern about loan supply) tends to produce a
  larger procyclical effect, because resurrection
  risk taking leads to systemic collapse, and often
  unproductive risk taking prior to collapse.

56
Policy in the Real World

• Even though policy makers are aware that
  forbearance is counterproductive, they still do
  it.
• Politics tends to produce strong incentives for
  protection of banks and forbearance, more in some
  countries than in others (Demirguc-Kunt, Kane and
  Laeven 2007).
• Book capital requirements invite discretionary
  forbearance, as do reliance on supervisory
  judgments when measuring risk and capital.
• Also, policymakers may lack timely information,
  or incentive to put forth effort to collect it,
  so some forbearance may be inadvertent.
• SR fails. Barth-Caprio-Levine find that
  regulatory and supervisory practices, other than
  practices that introduce market discipline, make
  no difference for banking sector growth or
  stability. Market discipline promotes both
  greater stability and higher growth.

57
Institutional EnvironmentDemocratic, Political
Structure/System
The Public
Politicians
Corruption
Judicial, Legal, Regulatory Environment
Market Structure
Media
corruption
Regulators andsupervisors
Banks
The MarketDepositors,creditors,rating agencies
corruption
Borrowers, counterparties
Technology, Information Infrastructure
A Framework for Bank Regulation, Barth Caprio and
Levine
58
Barth et al Book

• Study of regulatory practices across 150
  countries, asking whether regulations improve
  bank stability and growth and also exploring how
  regulations reflect and alter political economy
  and corruption.
• Variation in regulatory practice is enormous
  (capital regulation, deposit insurance coverage,
  government ownership of banks, foreign entry
  permitted, bank powers allowed).
• Evidence favors the private interest (or
  grabbing hand) view over the public interest
  (or helping hand) view of bank regulation and
  supervision in EMs.

59
Barth et al Findings

• Across the different statistical approaches, we
  find that empowering direct official supervision
  of banks and strengthening capital standards do
  not boost bank development, improve bank
  efficiency, reduce corruption in lending, or
  lower banking system fragility. Indeed, the
  evidence suggests that fortifying official
  supervisory oversight and disciplinary powers
  actually impedes the efficient operation of
  banks, increases corruption in lending, and
  therefore hurts the effectiveness of capital
  allocation without any corresponding improvement
  in bank stability.
• In contrast to these findingsbank supervisory
  and regulatory policies that facilitate private
  sector monitoring of banks improve bank
  operations.

60
Barth et al Details Univariate Regressions

• Dependent Var Bank Credit to Private Sector/GDP
• (Controls not reported)
• Entry Req. Index Negative Insignificant
• Limits on For. Entry Negative Significant
• Entry Appl. Denied Negative Significant
• Activities Restrictions Negative Significant
• Capital Regulations Positive Marginal
• Prompt Corrective Power Negative Insignificant
• Official Supervisory Power Negative Significant
• Supervisory Independence Negative Insignificant
• Government-Owned Banking Negative Significant
• Private Monitoring Index Positive Significant

61
Barth et al Multivariate Regression

• Dependent Var Bank Credit to Private Sector/GDP
• (Controls not reported)
• Entry Req. Index Positive Insignificant
• Activities Restrictions Negative Significant
• Capital Regulations Positive Insignificant
• Official Supervisory Power Positive
  Insignificant
• Government-Owned Banking Negative Insignificant
• Private Monitoring Index Positive Significant

62
Barth et al Multivariate Regression

• Dependent Var Bank Crisis Probability (logit)
• (Controls not reported)
• Entry Req. Index Positive Insignificant
• Activities Restrictions Positive Significant
• Capital Regulations Negative Insignificant
• Official Supervisory Power Negative
  Insignificant
• Government-Owned Banking Positive Marginal
• Moral Hazard Index Positive Significant
• Political Openness Positive Insignificant
• MH x PO Negative Significant
• Moral Hazard Dep Insurance Generosity

63
Barth et al Multivariate Regression

• Dependent Var Corruption of Banking Officials
• (Controls not reported)
• Official Supervisory Power Positive Significant
• Government-Owned Banking Positive Significant
• Private Monitoring Negative Significant

64
Other Evidence on Foreign Bank Entry

• Greater supply of credit (Goldberg, Dages, Kinney
  2000), although based more on hard information
  than soft information (Mian 2003)
• Less local presence gt greater volatility of
  credit (Herrero and Peria 2005)
• Giannetti and Ongena (2005) find that foreign
  presence reduces connected lending problems,
  improves access of funds to efficient
  non-connected borrowers, and improves efficiency
  of capital allocation, although effect seems
  confined to medium and large firms
• Similarly, Bonin and Imai (2005) show that sale
  of Korean banks to foreign lenders had large
  negative effects on stock returns of related
  borrowers.

65
Banking System Foreign-Controlled (IMF 2000)

• 1994 1999
• Czech Rep. 5.8 49.3
• Hungary 19.8 56.6
• Poland 2.1 52.8
• Argentina 17.9 48.6
• Brazil 8.4 16.8
• Chile 16.3 53.6
• Colombia 6.2 17.8
• Mexico 1.0 18.8
• Peru 6.7 33.4
• Venezuela 0.3 41.9
• Korea 0.8 4.3
• Malaysia 6.8 11.5
• Thailand 0.5 5.6

66
How can bank regulatory policy help?

• Repeal the safety net. Perhaps a good idea (a
  vast body of empirical evidence indicates deposit
  insurance makes systems more prone to failure,
  not less), but this is hard to do, and there is
  often implicit insurance even when explicit
  insurance is repealed.
• Narrow banking. This is repeal in disguise.
• Internal Models. Regulators incentives are still
  to forbear, and thus credibility is lacking.
  Regulation and supervision become extremely
  complicated. For developing countries, the cost
  of implementing complex regulatory apparatus is
  very high, because banking systems are small (100
  countries with banking system deposits under 10
  billion).

67
Combining Safety Nets, SR, and Elements of
Market Discipline

• Once the government is involved in protecting
  banks, markets have little incentive to take
  risks, and thus little incentive to monitor, or
  to act upon information.
• SR can incorporate market discipline if it finds
  a way to (1) require banks to offer some
  component of risky debt to finance themselves,
  (2) ensure that the pricing of that instrument is
  observable to them and the market, and (3)
  establish rules that force SR to act upon the
  information produced by the market.

68
What Is NOT Market Discipline

• Disclosure rules, by themselves, are of little
  use, since market may have little reason to care
  about disclosure.
• The presence of uninsured debt is not necessarily
  indicative of market discipline because the debt
  may effectively have the option to leave when
  things go wrong, or because government may use
  mergers or other protection to bail it out,
  justified by least cost resolution policy
• Insiders holdings of debt (which can be hard to
  track), or outsiders holdings protected via
  derivatives written by the bank, wont provide
  discipline.

69
Getting Market Discipline to Work The Integrated
Approach of Argentina c. 1999

• An integrated approach to SR, in which credible
  market discipline is required, and produced by a
  combination of reforms, is the best approach.
• One of the best examples of this approach was
  Argentina in the late 1990s. The collapse of the
  system in 2001-2002 was not due to regulatory
  failure, but rather its success. Cavallo seized
  bank equity in 2001 to alleviate the governments
  fiscal problems because domestic banks were only
  place to find the money.

70
Argentina 1992-2000

• Free foreign entry (competitive pressure, skills)
• Encouragement of privatization of loss-making
  provincial banks (pay provinces to privatize and
  renounce bank chartering). 18 privatized 1992-99.
• No explicit deposit insurance (modified in 1995)
• Book equity capital requirement depends on loan
  interest rate
• VAR to set capital requirement for market risk
  based on market volatility
• Liquidity requirement can be satisfied with
  standbys (rewards banks that command market
  confidence)
• Aggressive NPL policy

71
Argentina (Contd)

• BASIC System Integration of rules for
  information creation, disclosure, and use.
• Central de riesgo information pool (crafted to
  minimize free riding, while allowing banks to
  avoid bad credits, and avoid double pledging of
  collateral).
• Auditing supervised, bonded.
• Subordinated debt requirement forces banks to
  issue 2 of deposits in the form of uninsured
  subordinated debt held at arms length.
  (Concentration of uninsured claim may be
  desirable, as more informed, and harder to renege
  if amount is smallno systemic excuse.)
• Banks rated by approved rating agencies (good
  intentions, bad outcome).
• Ratings reform proposals today.

72
Argentina (Contd)

• Subordinated debt is not occurring in a vacuum,
  but rather alongside other capital and liquidity
  rules, and other rules, that give market opinions
  power in the regulatory process.
• Problems with implementation of sub debt rule.
• Lack of compliance penalized in theory, but not
  clear whether penalized in practice.
• No clear regulatory actions (e.g., closure)
  required based on high yields or inadequate
  issuance. No public information on yields,
  amount, compliance.
• Not exempted from least-cost resolution.
• Arms length holding not enforced effectively.

73
Argentina (Contd)

• Still, there is evidence that sub debt helped
• Low compliance was indicative of bank weakness,
  and central bank realized this, so it gave them a
  signal, but not one that the public had access to
  (so no discipline on regulatory forbearance).
  Source Calomiris-Powell 2001.
• 1996-99 1996-99
• High compliance Low compliance
• RD 7 8
• NPL 14 25
• Equity ratio 0.157 0.183

74
Argentina (Contd)

• More generally, Argentina showed healthy signs of
  operating with prudent (old-fashioned) risk
  management.
• One indication of the effectiveness of the system
  is the fact that deposit growth rates reflect
  deposit risk, and that deposit risk is related to
  book measures of asset risk and equity capital.
• Another indication of effectiveness is that
  banks that experienced increases in their
  interest cost of debt acted quickly to reduce
  risk, and thus bring interest cost back down.

75
Argentina (Contd)

• Dependent Variable Quarterly Deposit Growth
• Regressor Coefficient Stand.Error
• Eq Ratio (-1) 0.277 0.074
• Loan Int. Rate -0.254 0.121
• Loans/Cash -0.0032 0.0007
• Sample period 19933-19991
• Number of Observations 1,138
• Adjusted R-Squared 0.31

76
Argentina (Contd)

• Deposit Interest Rate Autoregression
• Dependent Variable Quarterly Deposit Interest
  Cost
• Regressor Coefficient Stand.Error
• RD (-1) -1.29 0.04
• Adjusted R-Squared 0.58
• Number of Observations 688

77
Broad Conclusions

• Safety net is major source of risk, market
  discipline is the ONLY credible mitigator of
  risk.
• Market discipline is best introduced with an
  integrated approach that results in the creation,
  disclosure and use of credible information in the
  marketplace.
• Government regulatory transparency is as
  important as government mandates for promoting
  market discipline.
• Market discipline is a complement, not a
  substitute for SR (e.g., insider holdings).

78
Specific Recommendations

• Good ideas for bringing markets into SR process
• Free entry, privatization of SOBs, limited safety
  net
• Use of loan interest rate to set capital
  requirement
• Reform of credit ratings numbers with penalties.
• Standbys abroad should substitute for cash
  reserves
• BASIC Argentine system (except use of credit
  ratings)
• Improve on Argentine sub debt to avoid back door
  bailouts, insider holdings, derivatives to
  enforce public disclosure and to establish
  prompt corrective action rules to limit
  forbearance in response to failure to gain market
  confidence (defined by market yields, flows on
  debt)
• Sub debts form can be flexible (e.g., two year
  maturity CDs held by banks abroad) depending on
  environment, and contingent capital certificates
  are an improvement on sub debt (discussed further
  below).

79
Cutting Edge IdeasCoCos

• Require on top of higher common/assets minimum
  requirement of 12, a CoCo requirement of 10 of
  quasi market value of firm (face value debt MVE)
• Trigger must be credible, predictable, timely,
  and based on comprehensive view of bank.
• Goldman proposes book value, but it is not
  credible or timely.
• Cumulative market value decline trigger would
  work (say, 40 from peak).
• Dilution risk would force voluntary preemptive
  issues of common stock ahead of triggers.
• Result would be that banks almost never go under.
• Design Prompt Corrective Action (PCA) trigger
  based on similar cumulative value decline basis.

80
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82
Macro Prudential Rules

• Macro prudential regulation that raises capital
  requirements during normal times in order to
  lower them during recessions.
• Additional macro prudential regulatory triggers
  that increase regulatory requirements for
  capital, liquidity, or provisioning as a function
  of credit growth, asset price growth, and
  possibly other macroeconomic risk measures.
  (Borio Drehman paper.)

83
Case Study Colombia 2006-2008

• Financial system loans annual growth rose from
  10 in December 2005 to 27 by December 2006.
• Core CPI rose gradually relative to credit (from
  3.5 in April 2006 to 4.8 in April 2007).
• Real GDP growth in 2007 was 8.
• Current account deficit rose from 1.8 GDP in
  second half of 2006 to 3.6 GDP in first half of
  2007.
• Monetary authority reacted directly to credit
  growth in real time Interest rates were
  increased 400 bps from April 2006 to July 2008.
• But central bank saw too small a market response
  to this, so it
• increased reserve requirements for banks and
• convinced superintendency to raise provisioning
  for credit,
• imposed measures to raise costs of borrowing
  short-term from abroad (deposit requirement
  reactivated), and
• limited not only currency mismatches of banks and
  other FX exposure in the system, but also gross
  currency positions (to avoid counterparty risks).
• Credit growth is now only 13 risk-weighted
  capital ratio for banks is 13.9, and first half
  2008 is 4.9 above first half of 2007, expected
  to fall to about 3.5 for 2008 as a whole.

84
Fix Too Big To Fail

• CoCos for large banks probably will take care of
  much of the problem.
• Regulatory surcharge (which takes the form of
  higher required capital, higher required
  liquidity, or more aggressive provisioning) on
  large, complex banks.
• Detailed regularly updated plans for intervention
  and resolution of large, complex institutions
  prepared by them, which specify how control the
  banks operations when transferred to a
  prepackaged bridge bank if the bank became
  severely undercapitalized.
• Hybrid reliance on bankruptcy with special
  resolution authority triggered by credible
  determination of real systemic risk. Key problem
  how to keep unwarranted resolutions from
  happening?

85
Aftermath of crises

• Does crisis tend to lay groundwork for more or
  less liberalization?
• It can go either way, depending on domestic
  political environment (Mexico, East Asia and
  Brazil vs. Argentina)
• How to deal with massive insolvencies?
• There are many possible mechanisms
• Liquidation via market (but adverse selection
  problems, legal system and information limits)
• AMCs a solution? No, since they also must
  liquidate, and same problems plague them also
  corruption plagues them, much more than in U.S.
  or Scandinavia.
• Creative solutions that work with market
  incentives (Punto Final program in Mexico)
• Assistance to recapitalize banks (RFC vs. Japan)
• Foreign entry of banks to speed reestablishment
  of credit.
• Debt moratorium (cultura de no pago in Mexico)
• Debt redenomination (Argentina U.S. precedents)

86
US Bank Assistance in 1930s vs. Japans in 1990s
(w/ Mason)

• US Banking problems
• Real shocks, not runs (until 1933)
  (Calomiris-Mason 2003a)
• Market discipline ? Capital crunch
  (Calomiris-Wilson 2004)
• Depositor preferences (active vs. passive)
• Loan supply contracts
• Dividends cut
• Large adverse macroeconomic consequences of
  credit contraction (Calomiris-Mason 2003b)
• Asset market illiquidity problems, too, from
  liquidation of bank assets, which slowed
  resolution

87
US in 1930s (Contd)

• Policy Response
• RFC lending (inadequate)
• RFC preferred stock begins in 1933
• Selective Targeting marginal banks, field office
  autonomy seems to have limited abuse
• Limits behavior Dividends, capital, voting on
  management issues Regression evidence suggests
  that RFC conditionality mattered
• Seems to be effective, reduces failure risk

88
Comparison

• RFC Recipients Non-Recipients
• Fail Prob 31 0.147 0.096
• Fail Prob 34 0.011 0.004
• Div Pay 34 0.001 0.008

89
Japan in the 1990s

• Little deposit market discipline
• Convoy system spreads assistance
• Dividend payments to common stock remain large
  (liquidity for Keiretsu firms)
• Banks do not have to accumulate additional
  capital to get assistance
• Assistance seems to have had no effect on failure
  risk or lending, and NPLs have grown over time

90
What might have worked better?

• Conditional Assistance
• Dividend limits
• Capital plan with matching requirement (note that
  this is self-selecting)
• Introduce Market Discipline in Regulation
• Minimum sub debt or other uninsured debts
• Interest rate-sensitive capital requirements
• High reserve requirements, but allow offshore
  SLOCs in lieu of reserve requirements

91
Debt redenomination US in 1860s, US in 1930s

• In both cases, this was a convenient way of using
  the change in numeraire of debt to restore net
  worth of banks and borrowers.
• Civil War legal tender acts saved banks after
  shock of December 1861 by making bank liabilities
  decline with bank assets (govt. bonds).
• Great Depression elimination of gold clauses
  actually increased values of bonds, implying that
  effect on default premium outweighed effect on
  face value.
• Key advantages speed, no reliance on
  institutional quality.

92
Argentinas Redenomination 2002

• Does same logic apply to Argentina 2002?
• Fiscal crisis leads to arm twisting of banks to
  buy bonds, then eventual collapse of banks and
  exchange rate.
• Pesification of debt could provide relief to
  borrowers, especially high dollar debt firms in
  non-tradables sector.
• Asymmetric aspect of pesification hurt banks and
  had clear political element, but we can
  conceptually separate it from pesification.

93
Argentina (Contd)

• Argentinas peculiar vulnerability to devaluation
  
• Investment evidence
• Stock market reactions
• Conclusion There seems to have been a
  significant positive effect on market and on
  non-tradable producers with high dollar debt
  exposures.
• Net benefit?

94
Figure 1C Reinhart-Rogoff-Savastano Composite
Dollarization Index Level vs. Exports-to-GDP
Ratio for Reinhart-Rogoff-Savastanos Fifty
Highest Dollarized Countries
95
  Non-Tradable Firms Non-Tradable Firms Non-Tradable Firms Tradable Firms Tradable Firms Tradable Firms
Mexico  Mean Firms Std. Dev Mean Firms Std. Dev
High-Dollar Debt Firms 0.0711 7 0.0669 0.1460 23 0.1460
Low-Dollar Debt Firms 0.1625 28 0.2141 0.1224 25 0.0893
Dif -0.0914   0.0236  
T-Stat -1.9155   0.6695  
Pr(Dif 0) 0.0324     0.7463    
96
  Non-Tradable Firms Non-Tradable Firms Non-Tradable Firms Tradable Firms Tradable Firms Tradable Firms
Argentina Mean Firms Std. Dev Mean Firms Std. Dev
High-Dollar Debt Firms 0.0724 6 0.0959 0.1817 7 0.1579
Low-Dollar Debt Firms 0.0644 5 0.0397 0.2155 7 0.1537
Dif 0.0080   -0.0339  
T-Stat 0.1862   -0.4069  
Pr(Dif 0) 0.5712     0.3456    
97
DDAt-1 -0.1449 -1.79
(0.0809) 0.076
DDAt-1 x ARG 0.2192 1.63
(0.1346) 0.106
TR x DDAt-1 0.1242 1.21
(0.1029) 0.230
TR x DDAt-1 x ARG -0.2684 -1.64
  (0.1638) 0.104
98

EVENT STUDY Dependent Variable Dependent Variable Dependent Variable Dependent Variable
Cumulative Raw Returns Cumulative Raw Returns Cumulative Abnormal Returns Cumulative Abnormal Returns
Independent Variables Coefficient (Std. Error) T-Stat Pgtt Coefficient (Std. Error) T-Stat Pgtt
TR 0.1561 3.82 0.1249 2.37
(0.0409) 0.001 (0.0528) 0.026
DDAt-1 0.2447 2.33 0.3473 2.56
(0.1051) 0.028 (0.1356) 0.017
Constant -0.0255 -0.49 -0.0959 -1.42
  (0.0524) 0.631 (0.0676) 0.168

Regression Statistics
Observations 29 29
R2 0.4070 0.2912
Adjusted R2 0.3613 0.2367
Root MSE 0.1009   0.1301