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Banking Crisis Resolution: Lessons Learnt Franklin Allen Banking Crisis Resolution: Theory and Policy Norges Bank, June 16-17, 2005.

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Presentation on theme: "Banking Crisis Resolution: Lessons Learnt Franklin Allen Banking Crisis Resolution: Theory and Policy Norges Bank, June 16-17, 2005."— Presentation transcript:

1 Banking Crisis Resolution: Lessons Learnt Franklin Allen Banking Crisis Resolution: Theory and Policy Norges Bank, June 16-17, 2005

2 2 Basic Issue When and how should central banks and other government entities intervene in times of financial crisis?

3 3 Benchmark Case Intervention is not necessary when –financial markets and –financial contracts are perfect and complete.

4 4 Deviations When we have a deviation from this ideal state we may (but may not) have –a financial crisis –a market or contracting failure that may justify ex ante or ex post intervention

5 5 Key Issues What failures caused the crisis? Can you trust market prices in the sense that they reflect future cash flows?

6 6 Factors that contribute to crises 1.Positive asset price bubbles 2.Negative asset price bubbles 3.Macro factors such as currency regimes or inconsistent government policies 4.Moral hazard problems 5.Panics 6.Risky investments and growth

7 7 1. Positive asset price bubbles Simple theory suggests Asset price = Discounted PV of cash flows Often this does not seem to hold e.g. Norway and Japan

8 8 1. Positive bubbles (cont.) What is the market failure that leads to asset price bubbles? Irrational agents –In this case shouldn’t rely on markets –This was the rationale for much of the financial repression that occurred from 1945- 1970’s

9 9 1. Positive bubbles (cont.) Other (rational) explanations Agency problems –Investing with borrowed money creates an incentive for the borrower to take risks if the lender cannot assess the risk of the investment

10 10 1. Positive bubbles (cont.) Asymmetric information –Heterogeneous beliefs –Lack of common knowledge These factors interact with credit expansion

11 11 1. Positive bubbles (cont.) Whatever their cause, positive asset price bubbles sow the seeds of future financial crises –Collateral values are inflated –Distorted asset prices lead to inefficient investment and future NPLs

12 12 1. Positive bubbles (cont.) Important factor in Norway and particularly Japan for subsequent banking crisis –Avoid if possible –If an asset price bubble does cause a banking crisis it is important to solve the banking crisis and move on as quickly as possible

13 13 1. Positive bubbles (cont.) Scandinavian countries did things well –Banks’ balance sheets were corrected quickly –Costs from doing this were not high (Norwegian government arguably made a profit!) –Part of the reason they were able to do this is that the banks collapsed quickly

14 14 1. Positive bubbles (cont.) Japan was less fortunate in that its banks were stronger and kept going after the asset price collapse –Debt overhang arguably caused immense problems for the Japanese economy –Traditional Keynesian stimulation policies caused Japan to go from one of the least indebted countries to being the most indebted

15 15 Sign of Economic Recovery Real GDP growth

16 16 1. Positive bubbles (cont.) Great reluctance to spend public money on cleaning up problems in the financial sector but no reluctance to spend enormous sums on public works programs Current levels of government debt will cause significant problems going forward Would focused intervention in the financial sector to eliminate debt overhangs have worked better?

17 17 1. Positive bubbles (cont.) A comparison of the Scandinavian and Japanese experience after asset price bubbles underlines the importance of prompt and effective crisis resolution Who should be punished?

18 18 2. Negative asset price bubbles Often in banking and other financial crises asset prices fall to very low levels and after a short while rebound quite substantially, e.g. Asian crises These low asset prices can cause great damage to the financial infrastructure E.g. LTCM

19 19 2. Negative bubbles (cont.) How do such “negative bubbles” occur? Consider the case with no central bank to provide liquidity then the market for long term high return assets must provide incentives for participants to hold liquidity

20 20 2. Negative bubbles (cont.) Suppose no participants held liquidity then during a crisis when the long assets are sold there would be nobody able to buy them and their price would fall to zero This cannot be an equilibrium because somebody could hold some cash or liquidity and buy a large amount of assets cheaply – this is the incentive to hold liquidity

21 21 2. Negative bubbles (cont.) In equilibrium some market participants hold a small amount of cash to purchase assets in crisis times –There is an opportunity cost of holding liquid assets in non-crisis times –When the crisis occurs the price falls to “fire sale” levels and they (just) recoup their opportunity cost of holding liquid assets by purchasing at this low price

22 22 2. Negative bubbles (cont.) There is “cash in the market pricing” and asset prices do not reflect future payoffs of the asset Instead the asset prices in the crisis state provide incentives to hold liquidity Not an efficient solution – efficiency involves complete markets ex ante

23 23 2. Negative bubbles (cont.) This is why banks and other financial institutions may be solvent but illiquid Current prices of the assets are low but this does not reflect their future earning power or the ability of a bank to cover its future liabilities

24 24 2. Negative bubbles (cont.) What if there’s a central bank? Can’t the central bank provide liquidity through open market operations rather than have private participants holding it? In many cases the answer is yes but in segmented markets with asymmetric information the answer is no – LTCM again

25 25 2. Negative bubbles (cont.) Implications for crisis resolution: If liquidity is scarce and open market operations cannot supply it in times of need don’t trust market prices Lender of last resort function may be one way to solve this problem

26 26 2. Negative bubbles (cont.) When prices cannot be trusted then distinctions between illiquid, solvent and insolvent become very difficult If there will be substantial spillovers to the real economy of a disruption it is better to save the institution in the short run and find out find out more information

27 27 2. Negative bubbles (cont.) The IASB and FASB have suggested that a move towards mark-to-market accounting is desirable but banks and insurance companies have resisted If negative price bubbles are a problem then cost based accounting will be better

28 28 3. Macro driven crises As Patrick Honohan pointed out many of the crises that we observe appear to be driven by macro factors such as unsustainable currency regimes or inconsistent macro policies or widespread systemic fraud Many of the emerging country crises discussed yesterday were of this type

29 29 3. Macro driven crises (cont.) Here problem is to solve underlying macro problem as well as solve the banking problem Banking crises are more of a symptom than a cause Resolution issue: restore the functioning of the financial sector as soon as possible to minimize spillovers into the real economy

30 30 4. Moral hazard problems One of the factors that we hear a great deal about is the problem of moral hazard and crises The basic idea is that if there are government guarantees or IMF guarantees then banks or borrowers or somebody else who benefits from the guarantees will have an incentive to take risks – they obtain the upside if the risks pay off while the guarantor bears the downside

31 31 4. Moral hazard problems (cont.) The incentive to take risks leads to a crisis eventually There appear to be a number of examples where this kind of moral hazard has been important, e.g. US S&L debacle in the 1980s

32 32 4. Moral hazard crises (cont.) If moral hazard is the cause of the crisis then it’s important this be taken account of when designing the crisis resolution Important to ensure shareholders and subordinated debt holders receive nothing and top management should be replaced and their rewards should be limited

33 33 5. Panics Much of the theory of crises has focused on crises as panics (Kindleberger 1978, Diamond and Dybvig 1983) –If people believe there will be a crisis then it can be self-fulfilling –If they believe there will be no crisis then their beliefs will again be fulfilled

34 34 5. Panics (cont.) In cases where panics are the important driving force then policies should be designed to rule out the bad equilibria, e.g. deposit insurance Important empirical issue of how many crises are panics rather than being fundamental driven

35 35 5. Panics (cont.) Resolution issue: Design policies to try to eliminate multiple equilibria

36 36 6. Risky investment crises and growth There is some empirical evidence that countries that have occasional crises grow faster than countries without crises (Ranciere, Tornell and Westermann 2003) Countries which have financial systems that allow investment in large amount of high return – high risk assets may have faster growth and more crises, e.g. late 19 th century US

37 37 6. Risky investment crises and growth (cont.) Crises driven by good risk taking are relatively little analyzed and understood Here issue is not to punish people as in moral hazard crises but rather to help share risk so that more can be borne and higher returns earned

38 38 6. Risky investment crises and growth (cont.) Much more analysis of this type of crisis and its implications for crisis resolution is needed

39 39 Problems Going Forward Bankruptcy of a large multinational financial conglomerate may lead to a systemic crisis (Herring 2003) Bankhaus Herstatt Drexel Burnham Lambert BCCI Barings

40 40 Problems Going Forward (cont.) Next crisis in an advanced economy may well be quite different than previously E.g. 1 Hedge fund melt down E.g. 2 Problems over Taiwan lead to large sales of US Treasuries E.g. 3 Global imbalances lead to large exchange rate movements

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