World Bank/IMF/SEACEN Regional Seminar Comparative Experiences in Confronting Banking Sector Problems in the Asia/Pacific Region 2 – 3 December 2003 Kuala Lumpur, Malaysia Reflections on Financial Sector Restructuring Andrew Sheng Chairman Securities and Futures Commission, Hong Kong Paper co-authored with Ms GL Tan – all views and errors are personal to authors 1
Historical Overview of Financial Crises • 1980s and 1990s were decades of financial crises – 1980s revealed external debt crises of Latin America and first signs of endemic NPLs in LDC banks – 1990s saw Mexican crisis, followed by Asian crisis, and then problems in Argentina – Asian crisis was not public debt crisis, but private debt crisis, hence consensus on key role of corporate governance – Asian crisis saw rapid contagion – local pain can cause global pain, hence strengthening of architecture • Since then, considerable cumulative experience in crisis management – International financial architecture/surveillance strengthened at both domestic and IFI level, e.g. FSF and FSAPs – World Bank/IMF/BIS/OECD etc have greater technical experience and working together better – Greater awareness of importance of global standards, transparency and accountability at all levels 2
Restructuring, Recovery and Fatigue • Y2K and 9/11 2001 revealed operational risks from globally linked markets – Markets are networks – Systemic failures are actually network failures • Asian Restructuring since 1997 has been painful – Costs up to 50% of GDP – Basically, private sector NPLs were carved out to AMCs and funded by public debt – Major emphasis on corporate governance reforms • Generally Asia is in better shape after post-crisis reforms and current recovery is gaining strength But why are NPLs still high despite growth? Are the problems more fundamental and structural? 3
Banking Crises and Resolution • Crisis is an event, the culmination of many factors interacting together • Bank restructuring and resolution is a process • Process involves four major steps: – Diagnosis – Damage Control – Loss Allocation – Rebuilding Profitability and Getting the Incentives Right How have we performed since Asian Crisis? 4
What is a Financial Crisis? • The eruption of an event (e.g. failure of a corporation or financial institution) that triggers a systemic distress, panic or wealth loss that spreads within domestic markets or abroad • Crises are caused by internal frailties or weaknesses that allow systemic breakdown as a result of internal or external shocks • Because financial system is a network, need to distinguish between liquidity crisis [flow] from solvency crisis [stock] • Banking system need lender of last resort, precisely because Central Bank can step in to prevent a liquidity crisis from triggering a solvency crisis. 5
Stocks and Flows of National Economy • Financial system is “blood circulation system” of national economy. Financial network links the following four other sectors together: – Corporate sector – Household sector – Public sector – External Sector • Each has its balance sheet and flow statements • Financial sector fulfils four basic functions: – Resource allocation – Price discovery – Risk Management – Corporate Governance • Crisis occurs when weaknesses in real and financial sectors are exposed by event/shock (globalization creates network shock) 6
Vicious Cycle of Financial Distress Asian crisis: private debt mismatches Latin American crisis: excessive public debt and inflation Enterprises experience foreign exchange and loan losses Devaluation occurs The fiscal impact Commercial creates a need for banks are bank recapitalization decapitalized Inflation rises higher than the world rate Central bank refinancing leads to money creation 7
Ultimately, Financial Crisis Ends Up as Quasi-fiscal Deficit • Banks have implicit or explicit deposit insurance, i.e. moral hazard risks • Depositors or foreign creditors cannot absorb losses without huge political implications • Both banks or borrowers can be “Too Large to Fail” – government is concerned that failure can have systemic problems • Hence, banks or borrowers transfer their stock or flow losses to the Government via Government guarantees, Asset Management Companies (AMC), or bail-outs • Relationship is known as Troika model • Borrower insolvency passed on to become bank insolvency (NPLs) – if LOLR also perceived as insolvent (i.e. no dollars to settle local convertible currency), then capital flight 8
The Troika Model BUDGET Tax derived from Tax and borrow corporations from banks Recapitalize through AMCs Banks exposed to corporate debt BANKS CORPORATES deposits Trade credit Enterprises 1 9
Much Written on Bank Restructuring World Bank: • Financial Crisis and Financial Restructuring – 18 papers presently posted on website http://www1.worldbank.org/finance/html/fp-financial_crises_and_financ.html • World Bank Finance Research: Bankruptcy and Resolution of Financial Distress – 3 papers currently posted http://econ.worldbank.org/programs/finance/topic/bankruptcy/ IMF: • Lessons from Systemic Bank Restructuring Claudia Dziobek and Ceyla Pazarbasioglu http://econ.worldbank.org/programs/finance/topic/bankruptcy/ • FSAPs useful source on financial health http://www.imf.org/external/np/fsap/fsap.asp • David S. Hoelscher and Marc Quintyn, Managing Systemic Banking Crises, IMF Occasional Paper (forthcoming) • McKinsey (2003): Banking in Asia: Acquiring a Profit Mindset (2 nd Edition) 10
Crises have both Macro and Micro Origins • Poor macro policies, e.g. fiscal deficits, inflation, balance of payments deficits • Weak institutional structures – Lack of deep debt and capital markets – Lack of credit culture – Outdated laws, weak judicial systems – Poor corporate governance • Lax enforcement, poor risk management, connected or directed lending, weak loan recovery, deposit guarantees, and distorted tax policies all show up in weak balance sheets Weak players, low standards of performance and efficiency, insufficient oversight and unclear rules of game, make financial network vulnerable to shocks 11
Lessons of the 1980s’ Banking Crises • Financial stability rests on maintaining stable currency • Banks fail because of losses in real sector, compounded by poor risk management and fraud • Liberalisation overlooks wealth effects of relative price changes; losses worsened by inadequate supervision • Bank losses often become quasi-fiscal deficits • Failure recognition is important as banking crisis is a solvency problem, not a liquidity issue • Stopping the flow of future losses is critical • Method of loss allocation determines success of restructuring • Success depends on sufficient real sector resources to absorb losses, financial sector reforms, and budget’s ability to tax “winners” and wind down “losers” with monetary stability • Good policies, reliable management and strong institutional framework needed to rebuild safe and profitable banking systems • Time and timing are of the essence Source: Sheng (ed) Bank Restructuring: Lessons from the 1980s, The World Bank, 1996 12
Asian Crisis vs 1980s lessons • Stable currency vital – volatility concern in 1990s • Real sector issues – crony capitalism blamed for poor corporate governance • Hasty liberalisation – balance sheet effects of interest rate and exchange rate volatility overlooked • Bank losses often became quasi-fiscal deficits – cost of resolution up to 50% of GDP in crisis economies • Solvency problem, not a liquidity issue – yes • Stopping future losses critical – did not ensure bank standstill in time • Loss allocation – basically governments underwrote loss through debt swap or AMC • Reform success – by and large crisis over in three years • Rebuilding safe and profitable banking systems – profitability back, but so are bad habits • Time and timing are of the essence – cannot be complacent 13
How Good is Diagnosis? • Institutional strengthening – Coordinated surveillance by IFIs, FSF, FSAP – International standards set by BIS, IOSCO, IAIS, IMF – Strengthened supervisory framework and cooperation at national and international level • Adoption and implementation of international standards by local networks would strengthen overall network, eg IAS, OECD corporate governance codes, insolvency laws • Generally getting better at diagnosis, but informational difficulties remain: – Asset valuation is difficult as there are no market prices for loans – Collateral valuation also serious problem in estimating provision needs – Inadequate provisioning due to tax changes that need reform – Banks generally reluctant to reveal extent of losses, unless forced by crisis or incentive to shift loss to AMC • NPL estimates by market vary and at least double official data 14
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