Managing Systemic Financial Crises: New Lessons and Lessons Relearned

Managing Systemic Financial Crises: New Lessons and Lessons Relearned. Marina Moretti; Marc C Dobler; Alvaro Piris. IMF Departmental Paper No. 20/05, February 11, 2020. https://www.imf.org/en/Publications/Departmental-Papers-Policy-Papers/Issues/2020/02/10/Managing-Systemic-Financial-Crises-New-Lessons-and-Lessons-Relearned-48626

Chapter 1 Introduction
Systemic financial crises have been a recurring feature of economies in mod­ern times. Panics, wherein collapsing trust in the banking system and credi­tor runs have significant negative consequences for economic activity—rare events in any one country—have occurred relatively frequently across the IMF membership. Common causes include high leverage, booming credit, an erosion of underwriting standards, exposure to rapidly rising prop­erty prices and other asset bubbles, excessive exposure to the government, inadequate supervision, and often a high external current account deficit. Financial distress typically lasts several years and is associated with large economic contractions and high fiscal costs (Laeven and Valencia 2018). Figure 1 shows the prevalence of systemic financial crises over the past 30 years, including the number of crisis episodes each year. The global financial crisis (GFC) was just such a panic, albeit one that transcended national and regional boundaries.
IMF staff experience in helping countries manage systemic banking crises has evolved over time. Major financial sector problems have been addressed in the context of IMF-supported programs primarily in emerging market econ­omies, developing countries and, more recently, in some advanced economies during the GFC. The IMF approach to managing these events was summa­rized in a 2003 paper (Hoelscher and Quintyn 2003) before there was inter­national consensus on legal frameworks, preparedness, and policy approaches, and when practices varied widely across the membership. The principles out­lined in that paper built on staff experience in a range of countries—notably, Indonesia, Republic of Korea, Russia, and Thailand in the late 1990s; and Argentina, Ecuador, Turkey, and Uruguay in the early 2000s. It emphasized that managing a systemic banking crisis is a complex, multiyear process and presented tools available as part of a comprehensive framework for addressing systemic banking problems while minimizing taxpayers’ costs. Although these core concepts and principles remain largely valid today, they merit a revisit following the experiences and lessons learned from the GFC.
The GFC shared similarities with past systemic crises, albeit with an impact felt well beyond directly affected countries (Claessens and others 2010). As in previous episodes of financial distress, the countries most affected by the GFC—the US starting in 2008 and several countries in Europe—saw cred­itor runs and contagion across institutions, significant fiscal and quasi-fiscal outlays, and a sharp contraction in credit and economic activity (see Fig­ure 1). The reason the impact was more widely felt across the global econ­omy: the crisis originated in advanced economies with large financial sectors. These countries embodied a substantial portion of global economic output, trade, and financial activity and affected internationally active financial firms providing significant cross-border services. The speed of transmission of financial distress across borders was unprecedented, given the complex and opaque financial linkages between financial firms. These factors introduced new challenges, as they impacted the effectiveness of many existing crisis management tools.
Reflecting these new challenges, individual country responses during the GFC differed from past experiences in important respects (Table 1):
The size and scope of liquidity support provided by major central banks was unprecedented. More liquidity was provided to more counterparties for longer periods against a wider range of collateral. Much of this support was through liquidity facilities open to all market participants, while some was provided as emergency liquidity assistance (ELA) to individual institutions. This occurred against the backdrop of accommodative monetary policy and quantitative easing.
Explicit liability guarantees were more selectively deployed than in past crises, when blanket guarantees covering a wide set of liabilities were more commonly used by authorities. During the GFC (with some notable excep­tions), explicit liability guarantees typically applied only to specific institu­tions, new debt issuance, specific asset classes, or were capped (for example, a higher level of deposit insurance). However, implicit guarantees were widespread, as demonstrated by the extensive public solvency support pro­vided to financial institutions and markets. Systemic financial institutions were rarely liquidated or resolved,1 and, of those that were, some proved destabilizing for the broader financial system. This trend reflected in part inadequate powers to resolve such firms in an orderly way.
Difficulties in achieving effective cross-border cooperation in resolution between authorities in different countries came to the fore, given the global footprint of some weak institutions. The lack of mechanisms to enforce resolution measures on a cross-border basis and cooperate more broadly led, in some cases, to the breakup of cross-border groups into national components.
More emphasis was placed on banks’ ability to manage nonperforming assets internally or through market disposals, with less reliance on central­ized asset management companies (AMCs)—public agencies that purchase and manage nonperforming loans (NPLs). Protracted weak growth in some countries, the large scale of the problem, and gaps in legal frameworks also meant that progress in addressing distressed assets and deleveraging private sector balance sheets was slower in some countries than in previous crises.

Table 1. Lessons on the Design of the Financial Safety Net•What is Similar?                                                                  ••What is New?
• Escalating early intervention and enforcement measures  •• More intrusive supervision and early intervention powers
 
• Special resolution regimes for banks                                 •• A new international standard on resolution regimes for systemic financial institutions requiring a range of resolution powers and tools

• Establishing deposit insurance (if prior conditions enable)1 with adequate ex ante funding, available to fund resolution on a least cost basis           •• An international standard on deposit insurance, requiring ex ante funding and no coinsurance
                                                                                              •• Desirability of depositor preference
 
• Capacity to provide emergency liquidity to banks, at the discretion of the central bank  •• Liquidity assistance frameworks with broader eligibility conditions, collateral, and safeguards
 
1 IMF staff does not recommend establishing a deposit insurance system in countries with weak banking supervision, ineffective resolution regimes, and identifiably weak banks. Doing so would expose a nascent scheme to significant risk, (when it has yet to build adequate funding and operational capacity) and could undermine depositor confidence.
The GFC was a watershed. Policymakers were confronted with the gaps and weaknesses in their legal and policy frameworks to address bank liquidity and solvency problems, their understanding of systemic risk in institutions and markets, and domestic and international cooperation. Under these constraints, the policy responses that were deployed put substantial public resources at risk. While ultimately successful in stabilizing financial sys­tems and the macroeconomy, the fiscal and economic costs were high. The far-reaching impact of the GFC provided impetus for a major overhaul of financial sector oversight (Financial Stability Forum 2008; IMF 2018). The regulatory reform agenda agreed to by the Group of Twenty leaders in 2009 elevated the discussions to the highest policy level and kept international attention focused on establishing a stronger set of globally consistent rules. The new architecture aimed to (1) enhance capital buffers and reduce lever­age and financial procyclicality; (2) contain funding mismatches and currency risk; (3) enhance the regulation and supervision of large and interconnected institutions, including by expanding the supervisory perimeter; (4) improve the supervision of a complex financial system; (5) align governance and com­pensation practices of banks with prudent risk taking; (6) overhaul resolution regimes of large financial institutions; and (7) introduce macroprudential policies. Through its multilateral and bilateral surveillance of its member­ship, including the Financial Sector Assessment Program (FSAP), Article IV missions, and its Global Financial Stability Reports, the IMF has contributed to implementing the regulatory reform agenda.
This paper summarizes the general principles, strategies, and techniques for preparing for and managing systemic banking crises, based on the views and experience of IMF staff, considering developments since the GFC. The paper does not summarize the causes of the GFC, its evolution, or the policy responses adopted; these concepts have been well documented elsewhere.2 Moreover, it does not cover the full reform agenda since the crisis, rather, only two parts—one on key elements of a legal and operational framework for crisis preparedness (the “financial safety net”) and the other on oper­ational strategies and techniques to manage systemic crises if they occur. Each section summarizes relevant lessons learned during the GFC and other recent episodes of financial distress, merging them with preexisting advice to give a complete picture of the main elements of IMF staff advice to member countries on operational aspects of crisis preparedness and management. The advice builds on and is consistent with international financial standards, tai­lored to country-specific circumstances based on IMF staff crisis experience. The advice recognizes that every crisis is different and that managing systemic failures is exceptionally challenging, both operationally and politically. None­theless, better-prepared authorities are less likely to resort to bailing out bank shareholders and creditors when facing such circumstances.
Part I, on crisis preparedness, outlines the design and operational features of a well-designed financial safety net. It discusses how staff advice on these issues has evolved, drawing from the international standards and good practice that emerged in the aftermath of the GFC. Effective financial safety nets play an important role in minimizing the risk of systemwide financial distress—by increasing the likelihood that failing financial institutions can be resolved without triggering financial instability. However, they cannot eliminate that risk, particularly at times of severe stress.
Part II, on crisis management, discusses aspects of a policy response to a full-blown banking crisis. It details the evolution of IMF advice in light of what worked well—or less well—during the GFC, reflecting the experience of IMF staff in actual crisis situations. The narrative is organized around poli­cies for dealing with three distinct aspects3 of systemic banking crisis:

*  Containment—strategies and techniques to stem creditor runs and stabilize financial sector liquidity in the acute phase of panic and high uncertainty. This phase is typically short-lived, with an escalating policy response as needed to avoid the collapse of the financial system.
*  Restructuring and resolution—strategies and techniques to diagnose bank soundness and viability, and to recapitalize or resolve failing financial insti­tutions, which are typically implemented over the following year or more, depending on the severity of the situation.
*  Dealing with distressed assets—strategies and techniques to clean up pri­vate sector balance sheets that first identify and then remove impediments to effective resolution of distressed assets, with implementation likely to stretch over several years.

IMF member countries have continued to cope with financial panics and widespread financial sector weakness. The IMF remains fully engaged on these issues, often in the context of IMF-supported programs, with a sig­nificant focus on managing systemic problems and financial sector reforms. Staff continue to provide support and advice on supervisory practice, reso­lution, deposit insurance, and emergency liquidity in IMF member coun­tries learning from experience and adapt policy advice to developments and country-specific circumstances.


Box 9. Dealing with Excessive Related-Party Exposures

Excessive related-party exposures present a major risk to financial stability. Related-party loans that go unreported conceal credit and concentration risk and may be on pre­ferred terms, reducing bank profitability and solvency. Persistently high related-party exposures also hold down economic growth by tying up capital that could otherwise be used to provide lending to legitimate, creditworthy businesses on an arms-length basis. Related-party exposures complicate bank resolution, as shareholders whose rights have been suspended have an incentive to default on their loans to the bank.

Opaque bank ownership greatly facilitates the hiding of related-party exposures and trans­actions. Opaque ownership is associated with poor governance, AML/CFT violations, and fraudulent activities. Banks without clear ultimate beneficial owners cannot count on share­holder support in times of crisis, and the quality of their capital cannot be verified. Moreover, unknown owners cannot be held accountable for criminal actions leading to a bank’s failure.
Resolving these problems requires a three-pillar approach. Legal reforms are needed to lay the foundation for targeted bank diagnostics and effective enforcement actions:

*  Legal reforms to introduce international standards for transparent disclosure and mon­itoring of bank owners and related parties—including prudent limits, strict conflict of interest rules on the processes and procedures for dealing with related parties, and esca­lating enforcement measures. Non-transparent ownership should be made a legal ground for license revocation or resolution, and the supervisor authorized to presume a related party under certain circumstances. This shifts from supervisors to banks the “burden of proof”—to demonstrate that a suspicious transaction is not with a related party.

*  Bank diagnostics are targeted at identifying ultimate beneficial owners and related-party exposures and transactions and assessing compliance with prudential lending limits for related-party and large exposures. The criteria for identification include control, economic dependency, and acting in concert. Identification of related-party transactions should also consider their risk-related features, such as the existence of preferential terms, the quality of documentation, and internal controls over the transactions.

*  Enforcement actions are taken to (1) remove unsuitable bank shareholders—that is, shareholders whose ultimate beneficial owner is not identified, or are otherwise found to be unsuitable; and (2) unwind excessive related-party exposures through repayment or disposal of the exposure, or resolution of the relationship (change in ownership of the bank or the borrower).

The three-pillar approach is best implemented in the context of a comprehensive financial sec­tor strategy. There may not be enough time to implement legal reforms during early interven­tion or the resolution of systemic banks. In such situations, suspected related-party exposures and liabilities must be swiftly identified and ringfenced. Once the system is stabilized, however, the three-pillar approach should be implemented for all banks (including those in liquidation).

Source: Karlsdóttir and others (forthcoming).