The Use of Guarantees in Resolving Systemic Banking Crises Stefan Ingves Director, Monetary and Financial Systems Department International Monetary Fund Norges Bank Conference on Banking Crisis Resolution–Theory and Policy June 16–17, 2005 Oslo, Norway

2 Outline of Presentation 1. Types of Depositor Protection 2. Features of General Guarantees 3. Conditions for Effective Implementation 4. Measures to Limit Distortions 5. Unwinding Guarantees 6. Conclusions

3 Types of Depositor Protection Comes in many forms 1. Explicit denial of protection 2. Implicit coverage (ambiguous coverage) 3. Explicit limited coverage 4. General guarantee of all creditors or depositors A continuum from first to last References to 16 countries in the paper

4 Types of Depositor Protection In stable times, the first three alternatives 1. An explicit denial of protection 2. Implicit coverage (ambiguous coverage) 3. Explicit limited coverage However, in systemic crises, general guarantees  Nordic countries (early 1990s)  Asian crisis countries (late 1990s)  Turkey (2000–02)

5 Types of Depositor Protection Four types of General Guarantee 1. De facto guarantees 2. Statement of policy 3. Legally binding guarantee of financial institutions solvency 4. Legally binding commitment to pay depositors

6 Types of Depositor Protection Four types of General Guarantee 1. De facto guarantees  No public policy announcements  Failed banks resolved so no depositor loses  Argentina (2002–03), the Dominican Republic (2003–04), and Russia (1998–99)

7 Types of Depositor Protection Four types of General Guarantee 2. Statement of policy  A clear statement of public policy  Not legally binding  Norway (1991–93) no blanket guarantee issued, but public promise to secure depositors

8 Types of Depositor Protection Four types of General Guarantee 3. Guarantee of financial institutions solvency  Institutions, not depositors protected Legally binding commitment Details never spelled out Bank resolution agencies transfer deposits to viable institutions with assets, or take over and recapitalize banks  Sweden (1991–93), Turkey (2000–02)

9 Types of Depositor Protection Four types of General Guarantee 4. Legally binding commitment to pay depositors  Depositors directly protected  Depositors paid directly by authorities  Indonesia and Thailand

10 Types of Depositor Protection What determines choice? Institutional capacity  Degree of public sector credibility  Strength of legal traditions Policy objectives  Desire to maintain policy flexibility  Importance of ambiguity in policy formulation Magnitude of crisis Degree of Uncertainty

11 Features of General Guarantees Deposit Coverage  Depositors (possibly creditors) but not shareholders  Foreign currency deposits covered in local currency Institutions  Depends on structure of financial system  Commercial banks  Near-bank deposit-taking institutions (finance companies in Thailand and merchant banks in Korea)  Overseas branches (Korea, Malaysia, and Sweden)

12 Conditions for Effective Implementation Political Commitment Information Strategy Credibility  Manageable fiscal and monetary policies  Sustainable debt levels  Non-dollarized economy

13 Conditions for Effective Implementation General guarantees have been controversial  High costs  Market distortions  Moral hazard Governments must ensure benefits outweigh costs  Need for estimate of solvency  The worse financial conditions, the higher the cost  Higher the cost, the stronger must be the fiscal

14 A Last Resort Two types  Ex ante, well-defined last resort (Japan today)  Truly last resort, lack of other functioning legal framework Coordinated effort  Ministry of Finance, Central Bank, Supervisor, Debt Officer, Bank Restructuring Agency “Owner of Last Resort”

15 Indonesia: Banking System Ownership Source: Bank Indonesia and Fund staff estimates (1996 totals based on credit, not assets. All State totals include IBRA.)

16 Measures to Limit Distortions Coverage and Transparency  Minimum necessary protection  Explicit binding guarantees more credible than implicit arrangements  Coverage clearly explained

17 Measures to Limit Distortions Minimize moral hazard  Exclude shareholders, related parties and subordinated debt holders  Intensify bank supervision  Institute controls to avoid abuse Legal issues  Remove legal impediments to enforcement  Institute controls to prevent fraud

18 Measures to Limit Distortions Need adequate package of measures  General guarantee alone will not contain crisis  Comprehensive approach helps contain costs Adequate package includes  Adopt a comprehensive strategy  Evaluate financial condition of banking system  Rapid bank interventions if needed

19 Measures to Limit Distortions General guarantee becomes one pillar of bank resolution framework  Central bank as lender of last resort  Government as owner of last resort  General guarantee as additional tool to ensure financial stability following systemic crisis

20 Unwinding Guarantees The longer in place, greater are distortions A plan for eliminating guarantee is needed  Concrete timetable is difficult given uncertainty  Some set expiration date at establishment Ecuador, Korea  Some linked expiration date to stabilization Mexico Information strategy

21 Conclusions Decisions when crisis breaks out Are preconditions present?  Can guarantee be credible?  Sufficient fiscal capacity?  Acceptable costs of the guarantee? Does value of maintaining stability exceed costs?

22 Conclusions Design features of the guarantee  Time period  Which creditors  Exclude shareholders and related parties  Strengthen supervision Design of supportive reform program  Macroeconomic stabilization  Bank restructuring

Thank you