Saturday, February 26, 2011

Preparing for future banking crises

"An overhaul of financial regulation .... will be a failure if we could not contemplate the failure of a firm such as Goldman Sachs" (said Federal Reserve Chairman Ben Bernanke). “That is, there needs to be a system by which Goldman Sachs will go bankrupt and Goldman Sachs’ creditors could lose money" (15 Feb 2011 Bloomberg).

While the intention to design such a system (a.o. living wills, bail-in mechanism) deserves supports, in practice, hurting creditors or permitting a bank to bust outrightly, let alone a big one, will remain a very rare decision. I still believe the current financial crisis was immediately set off by the collapse of Lehman Brothers and that the potential cost of its rescue would have been much less than the cost of the global financial crisis that followed, in terms of economic activity and public finance.

This said, rescuing a bank using public money would always be controversial. In Indonesia, we know the case of Bank Century, which, probably by hindsight, should have been liquidated instead because it was too small to trigger a systemic crisis, especially when the coverage of the deposit insurance was high enough to ease depositors' worry at that time.

Revisiting the lessons to be learned
A banking crisis can arrive anytime anywhere in current environments.  
In the last few days, South Korea's financial regulator has temporarily suspended seven savings banks to avert an overall systemic crisis (WSJ, 22 February 2011). 
Those banks have insufficient liquidity to meet a surge of withdrawals and inadequate solvency due to their exposures to the weak South Korean real estate market. The embattled saving banks have to solve their problems on their own or seek to be acquired by large commercial banks.

In preventing it from developing into a systemic crisis, the Korean regulator has acted early enough and found no need to involve public money. Though in a different stage and extent of savings banks crisis, similar responsiveness and decisiveness have been demonstrated by Spain's government in dealing with beleaguered  savings banks, 'Cajas' (FT) that are excessively exposed to the distressed property sector.

Spain's regulatory regime had received recognition for its prudence before the 2008 crisis (e.g. application of forward looking loan provisioning) - at least until recently - and I think its banking sector has defied additional pressures in the last few months relatively ok.
Of course, the Spanish case is not necessarily an ideal reference for the point that is being made here. For instance, the government may still need to nationalize Cajas if they fail to timely raise fresh capital. Or losses could turn out to be much greater than expected due to the severity of the real estate crisis.

On that note, allow me to underscore the lessons from the past and the recent experiences when contemplating possible banking crises in the future:

1. When bail-out decision is called upon, then it is two to midnight. The correct decision is most likely to approve the bail-out because the economic cost is likely to be lower and very often, the beleaguered banks tend to be deemed 'more systemic' in turmoil than in normal economic condition. Rating agencies (e.g. S&Ps) seem to have understood this rationale by planning to modify its rating methodology in order to give more weights to the state support rating component.
2.  But 'systemic' banks can also be too big to rescue. Irish banks for example turn out to be too-big-to-save for the nation's indebtedness capacity.

It follows from the above that any meaningfully sizeable bank (incl. small-medium size) in any country will likely be considered too big too fail, or too inteconnected to fail. But they can also tend to be too big to save, yes also in Indonesia. For guidance to assess systemic importance of banks, here.

The road ahead to find a system, such as the one desired by the Fed Chairman to avoid a Lehman Brothers redux is daunting. Although a resolution that imposes losses on non-common capital instruments is better than a bail-out that uses public funds, establishing living wills for the largest institutions, for instance, is a complex and multi-faceted undertaking (for a discussion on living will see here). We need more time and study to ensure that the wind down plans will work from the cost-versus-benefit perspective.

That is why, it is of paramount importance that regulatory institutions and policy makers employ robust early warning signals, promote prompt corrective actions,  and minimize sources of moral hazard in the financial system while they still can.... Because one cannot fight moral hazard when the financial sector is in turmoil.

In continuation to the points stressed in the previous posts, moral hazard and adverse selections should be addressed by appropriate institutional designs and policies. For example (no particular order), by an independent supervisory and monetary policy making body,  smaller coverage of deposit insurance & risk based deposit insurance premium setting, high quality of risk disclosures, sound corporate governance and remuneration schemes....

For a range of possible approaches the Fed Chairman might have in mind to offset moral hazard created by systemic banks, see an FSA's paper here