International Banking Standards and Financial Sector Regulation

Mark M. SpiegelMark M. SpiegelVice PresidentVice President

International ResearchInternational ResearchFederal Reserve Bank of Federal Reserve Bank of

San FranciscoSan Francisco

Prepared for conference on Prepared for conference on ““Capital Flows and Global External ImbalancesCapital Flows and Global External Imbalances”” ArpilArpil, 2006, , 2006, Paris. Views expressed are my own and do not necessarily reflectParis. Views expressed are my own and do not necessarily reflect those of the Federal those of the Federal Reserve SystemReserve System

“Panics do not destroy capital; they merely reveal the extent to

which it has been previously destroyed by its betrayal into

hopelessly unproductive works.”

John Stuart Mill, 1867John Stuart Mill, 1867

Outline

I. I. Role of Banks in FinanceRole of Banks in FinanceII. II. Sources of Banking CrisesSources of Banking CrisesIII. Bank Regulatory ProblemsIII. Bank Regulatory ProblemsIV. Example: Korea 1992IV. Example: Korea 1992--19971997

I. Role of Banks in Finance

Primary Function of Banks is Asset Conversion

Transform ShortTransform Short--term Liquid Assets of term Liquid Assets of Households into LongHouseholds into Long--Term Illiquid Term Illiquid Investments by FirmsInvestments by FirmsDiversify Risk by Pooling Assets of a Large Diversify Risk by Pooling Assets of a Large Number of HouseholdsNumber of HouseholdsReduce Transactions Costs by Screening Reduce Transactions Costs by Screening and Monitoring Borrowersand Monitoring Borrowers

Asymmetric Information

Information is Information is ““asymmetricasymmetric”” when one when one party has more than anotherparty has more than anotherExample: Banks Example: Banks vsvs BorrowersBorrowers

Borrowers know more about potential Borrowers know more about potential quality of loanquality of loanBorrowers know more about Borrowers know more about ““efforteffort”” put put into making investment successfulinto making investment successful

Adverse Selection

Borrowers whose projects are particularly Borrowers whose projects are particularly risky will have greatest demand for loansrisky will have greatest demand for loansReason is that they are most likely to Reason is that they are most likely to defaultdefaultInterest terms which are fair for Interest terms which are fair for ““averageaverage””projects are good deals for bad projects and projects are good deals for bad projects and bad deals for good projectsbad deals for good projects

Moral Hazard

When Borrowers default, part of loss is When Borrowers default, part of loss is borne by the bankborne by the bankThis gives Borrowers an incentive to make This gives Borrowers an incentive to make less than the optimal level of effort for less than the optimal level of effort for project successproject successBorrowers also have an incentive to choose Borrowers also have an incentive to choose as risky a project as possibleas risky a project as possible

Banks are Designed to Partially Address These Problems

Banks enter into longBanks enter into long--term relationships term relationships which mitigate information problemswhich mitigate information problemsBanks invest in monitoring activities Banks invest in monitoring activities which mitigate moral hazardwhich mitigate moral hazardIn developing countries where information In developing countries where information problems are worse, role of banks is even problems are worse, role of banks is even greater greater

However, Banking Panics are Still Relatively Common

Lindgren (1996): TwoLindgren (1996): Two--thirds of IMF thirds of IMF member countries experienced significant member countries experienced significant banking difficultiesbanking difficultiesFrequency of banking crises appears toFrequency of banking crises appears tohave increased in last two decadeshave increased in last two decades

II. Sources of Banking Crises

A. Crises From Bad Fundamentals

Maturity Mismatches

Conversion of shortConversion of short--term claims to longterm claims to long--term term assets implies possibility of illiquidity assets implies possibility of illiquidity

Asset side of bank balance sheet is illiquidAsset side of bank balance sheet is illiquidLiability side is very liquidLiability side is very liquid

Maturity mismatch implies that a bank can suffer a Maturity mismatch implies that a bank can suffer a severe balance sheet downturn in an environment severe balance sheet downturn in an environment of rising interest ratesof rising interest rates

Currency Mismatches

Many developing nations are said to be victims of Many developing nations are said to be victims of ““original sinoriginal sin””These nations are often unable to borrow in their These nations are often unable to borrow in their own currencyown currencyIf these nations abandon their exchange rate peg, If these nations abandon their exchange rate peg, many firms and households will see domestic many firms and households will see domestic currency values of their debt obligations risecurrency values of their debt obligations riseEx: ArgentinaEx: Argentina

Lending Distortions

Government policies can leave banks more Government policies can leave banks more susceptible to runs by actively deteriorating their susceptible to runs by actively deteriorating their asset qualityasset qualityDirected lendingDirected lending

East Asia: Banks pressured to loan to particular East Asia: Banks pressured to loan to particular sectorssectorsChina: Banks forced to keep StateChina: Banks forced to keep State--owned owned enterprises afloatenterprises afloatJapan: Banks forced to maintain large holdings Japan: Banks forced to maintain large holdings of equity in client firmsof equity in client firms

Weak Regulatory Conditions

Rapid changes in banking environment may place Rapid changes in banking environment may place banks in unfamiliar activities banks in unfamiliar activities Rapid growth in banking activity may reduce Rapid growth in banking activity may reduce relative power of regulatory institutions relative power of regulatory institutions (Ex: US S&L crisis)(Ex: US S&L crisis)Poor regulatory conditions can lead toPoor regulatory conditions can lead to

Poor assessment of credit qualityPoor assessment of credit qualityExcessive concentration of riskExcessive concentration of riskOutright fraudOutright fraud

Lack of TransparencyPoor accounting practicesPoor accounting practices

Bad assets incorrectly classified as performingBad assets incorrectly classified as performingClassification often based on loan payment status rather Classification often based on loan payment status rather than accurate assessment of borrowerthan accurate assessment of borrower’’s financial s financial conditionconditionCollateral values not marked to marketCollateral values not marked to market

Can exacerbate financial crisisCan exacerbate financial crisisDifficult to distinguish between healthy and unhealthy Difficult to distinguish between healthy and unhealthy banks [banks [VishwanathVishwanath and Kaufman (2001)]and Kaufman (2001)]

BCL (2004): Transparency even more important than BCL (2004): Transparency even more important than quality of regulatory regime in determining fragility of quality of regulatory regime in determining fragility of banking sectorbanking sector

Weak Legal Institutions

Bankruptcy proceduresBankruptcy proceduresDifficult to seize assets in event of defaultDifficult to seize assets in event of defaultEven collateralized loans are riskyEven collateralized loans are riskyEx: Eastern Europe Ex: Eastern Europe

BCL (2004): BCL (2004): Protection of shareholder rights and active Protection of shareholder rights and active market for corporate control very important to market for corporate control very important to health of banking sectorhealth of banking sector

B. Crises From Self-Fulfilling Poor Expectations

Liquidity vs Solvency

Solvency: Value of assets exceeds value of Solvency: Value of assets exceeds value of liabilitiesliabilities

Liquidity: Value of Liquidity: Value of currently availablecurrently availableassets exceeds value of current liabilitiesassets exceeds value of current liabilities

Banks can therefore be solvent, but not Banks can therefore be solvent, but not liquidliquid

“Sequential Service” Constraint

Sequential service implies that those who Sequential service implies that those who remove funds from bank first receive all remove funds from bank first receive all of their assetsof their assetsImplication is that solvent, but illiquid Implication is that solvent, but illiquid banks may be subject to runsbanks may be subject to runsHerding effect: If you believe that others Herding effect: If you believe that others are going to pull their money out of bank, are going to pull their money out of bank, you should tooyou should too

C. Third-Generation Crises

3rd Generation Models of Banking Crises

Synthesis of FundamentalsSynthesis of Fundamentals--based and Selfbased and Self--fulfilling crisesfulfilling crisesRange of exposure to selfRange of exposure to self--fulfilling crisisfulfilling crisisHowever, uncertain within that range However, uncertain within that range whether or not crisis will occurwhether or not crisis will occurRole for contagion effects, panicsRole for contagion effects, panicsStill, quality of regulatory regime mattersStill, quality of regulatory regime matters

0 5 10 15 20 25 30

Capital Flight

Dutch Disease

Asset Bubble

Recession

Terms of Trade Drop

Weak Judiciary

Bank Runs

Fraud

Lending to State Enterprises

Connected Lending

Political Interference

Deficient Bank Management

Poor Supervision and Regulation

Macroeconomic factors

Microeconomic factors

24

716

20

2

2

6

6

9

1120

26

Note: Shows the number of times each factor was cited in twenty-nine country cases; twenty-nine is the maximum number of citations possible. Source: Caprio and Klingebiel 1996

Factors behind Twenty-Nine Bank Insolvencies

III. Bank Regulatory Issues

A. Deposit Insurance

Deposit Insurance

Deposit Insurance commonly considered Deposit Insurance commonly considered important Policy to eliminate banking important Policy to eliminate banking panicspanicsHowever, if depositorsHowever, if depositors’’ funds are funds are guaranteed, they need not worry about bank guaranteed, they need not worry about bank soundness soundness Monitoring role of depositors is diminishedMonitoring role of depositors is diminished

Empirical Evidence

DemirgDemirgüçüç--KuntKunt and and DetragiacheDetragiache (2002): (2002): Explicit deposit insurance tends to Explicit deposit insurance tends to increaseincrease the likelihood of banking crisesthe likelihood of banking crisesEffect is stronger in countries with weak Effect is stronger in countries with weak regulatory regimesregulatory regimesSuggests that moral hazard implications Suggests that moral hazard implications of deposit insurance are importantof deposit insurance are important

B. Other Regulatory Policies

Lender of last resort

Government, usually central bank, supports Government, usually central bank, supports insolvent or illiquid bankinsolvent or illiquid bankGovernment supports a merger in which Government supports a merger in which deposit values are carried at pardeposit values are carried at parMoral hazard issues arise if bailout is Moral hazard issues arise if bailout is anticipatedanticipated

“Too Big to Fail”

Some banks are so large that their failure would Some banks are so large that their failure would lead to lead to ““systemicsystemic”” problems, i.e. threaten the problems, i.e. threaten the entire banking systementire banking systemRegulators may rationally choose to Regulators may rationally choose to ““bail outbail out””these types of insolvent banksthese types of insolvent banksThese banks therefore enjoy even greater These banks therefore enjoy even greater government guarantees, and have greater government guarantees, and have greater incentives to take on risky loansincentives to take on risky loansMoral hazard again pervasiveMoral hazard again pervasive

“Forbearance”

Leaving an insolvent bank in operation (zombies)Leaving an insolvent bank in operation (zombies)Regulation is effective only if regulators respond Regulation is effective only if regulators respond to compliance failures with to compliance failures with ““prompt corrective prompt corrective actionaction””Problems with forbearanceProblems with forbearance

Moral hazard among insolvent banks severeMoral hazard among insolvent banks severeBad example for other banks Bad example for other banks May decrease willingness of banks to foreclose May decrease willingness of banks to foreclose on problem borrowerson problem borrowers

Agency Problems

Interests of regulators may not coincide Interests of regulators may not coincide directly with those of taxpayersdirectly with those of taxpayersRegulators may pursue forbearance policies Regulators may pursue forbearance policies in hopes that banks will recover in hopes that banks will recover ““bureaucratic gamblingbureaucratic gambling”” [Kane (1989)][Kane (1989)]Regulators may face pressure to resist Regulators may face pressure to resist closure of insolvent banksclosure of insolvent banks

Minor Severe or moderate5

6

7

8

9

10

Property rightsEnforcementCorruption

Source: Caprio and Honohan

Inde

x

Quality of Administration and Recent Crises

Role of Implicit Government Guarantees

Governments implicitly backed investments Governments implicitly backed investments made by financial intermediariesmade by financial intermediariesThe capacity of governments to finance The capacity of governments to finance these guarantees is limited these guarantees is limited ““CronyismCronyism”” (or in some cases outright (or in some cases outright corruption) may play a rolecorruption) may play a role

Changing role of International Financial Institutions

Argentine default has altered perception of role of Argentine default has altered perception of role of IMF in international workoutsIMF in international workouts

Argentina successfully resisted efforts to Argentina successfully resisted efforts to encourage it to negotiate with holdoutsencourage it to negotiate with holdoutsUnclear what the current regime isUnclear what the current regime is

““If we do not reach an agreement soon with the If we do not reach an agreement soon with the IMF, we are going to stop considering it as a IMF, we are going to stop considering it as a preferred creditor.preferred creditor.””

President KirchnerPresident Kirchner

IV. Example: Korea 1992-1997

(Dooley and Shin)(Dooley and Shin)

Financial Liberalization

In early 1990s, capital account liberalization In early 1990s, capital account liberalization became an important Korean policy goalbecame an important Korean policy goal

1991: Domestic firms allowed to issue 1991: Domestic firms allowed to issue offshore debtoffshore debt1992: Korean stock market open to 1992: Korean stock market open to foreign investorsforeign investorsBanks allowed to open and expand Banks allowed to open and expand overseas branchesoverseas branches

Capital Inflows

Korea received about $120 billion in capital Korea received about $120 billion in capital inflows from 1992 through midinflows from 1992 through mid--1997199719941994--1996: Capital inflows at 3.5 percent of 1996: Capital inflows at 3.5 percent of GDPGDPBecause of quantitative controls on other Because of quantitative controls on other forms of finance, bulk of capital inflows forms of finance, bulk of capital inflows channeled through bankschanneled through banks

Composition of Portfolio Investment in Korea 1992-1998

57%

36%

47%

66%65% 85%

-10

-5

0

5

10

15

20

1992 1993 1994 1995 1996 1997 1998

Equity Debt

$billion

Increased Riskiness

From 1992 through 1996, banksFrom 1992 through 1996, banks’’ assets more than assets more than doubleddoubledOver same period, stock market performance was Over same period, stock market performance was poor, and relatively little new equity was issuedpoor, and relatively little new equity was issuedResult was decline in capitalResult was decline in capital--asset ratioasset ratioDooley and Shin also provide evidence that loans Dooley and Shin also provide evidence that loans to banks had little correlation with bank asset to banks had little correlation with bank asset qualityquality

Capital Asset and Equity Ratios of Korean Banks 1987-1998

0

2

4

6

8

10

12

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Capital Stock to Total Assets Shareholders' Equity to Total Asset

percent

Foreign “run” on Korea

Foreigners started taking assets out of Korea in Foreigners started taking assets out of Korea in November of 1997.November of 1997.Bank of Korea provided foreign currency to Bank of Korea provided foreign currency to Korean banks equal to $15 billionKorean banks equal to $15 billion

Bailout exhausted BOK foreign reservesBailout exhausted BOK foreign reserves$9 billion went straight to foreign branches of $9 billion went straight to foreign branches of Korean banksKorean banks

Foreign investors removed $30 billion from Foreign investors removed $30 billion from Korean Banks in 1998Korean Banks in 1998

Lessons from Korea

KoreaKorea’’s experience shows pervasive influence of s experience shows pervasive influence of even implicit government guaranteeseven implicit government guaranteesForeign run triggered KoreaForeign run triggered Korea’’s financial crisis, but s financial crisis, but foreign investors were left wholeforeign investors were left wholeAs this preferential treatment was anticipated, it As this preferential treatment was anticipated, it led to moral hazard during capital inflow eraled to moral hazard during capital inflow era

Imprudent lending practicesImprudent lending practicesDistortions in forms of financingDistortions in forms of financing

Cross-sectional evidence that fiscal outlays increase costs of resolution

ClaessensClaessens, et al (2004): , et al (2004): ““accomodativeaccomodative”” policies policies increase fiscal cost of resolutionincrease fiscal cost of resolution

Explicit deposit insuranceExplicit deposit insuranceforbearanceforbearance

No apparent tradeoff between high fiscal outlays No apparent tradeoff between high fiscal outlays and output lossand output lossHowever, good institutions, such as judicial However, good institutions, such as judicial efficiency and political stability measurably efficiency and political stability measurably reduce cost of crisesreduce cost of crises

Conclusion

Because of the informationBecause of the information--gathering service they gathering service they provide, financial activity is prone to crisesprovide, financial activity is prone to crisesPolicies which limit severity of crises, such as Policies which limit severity of crises, such as financial safety nets, can give agents bad financial safety nets, can give agents bad incentives ex anteincentives ex antePolicy challenge is therefore to mitigate these Policy challenge is therefore to mitigate these crises without stifling the valuable service that crises without stifling the valuable service that banks providebanks provideEvidence suggests that our success so far has been Evidence suggests that our success so far has been mixedmixed