1. Banking Crises, Regulatory Reform and Resolution Charles Calomiris May 11, 2010

2. Macroeconomics and Banking View that banks are sources of shocks and propagators of shocks in the macroeconomy was “rediscovered” in 1980s, and has received more attention in the past decade, especially after the Asian and Mexican crises. View that banks are sources of shocks and propagators of shocks in the macroeconomy was “rediscovered” in 1980s, and has received more attention in the past decade, especially after the Asian and Mexican crises. This view has substantial historical precedent, and supporting historical evidence, and is only “new” in the sense that it was ignored by most macroeconomists in 1950s, 1960s and 1970s. This view has substantial historical precedent, and supporting historical evidence, and is only “new” in the sense that it was ignored by most macroeconomists in 1950s, 1960s and 1970s.

3. Why the Rediscovery? Banking instability became more of an issue in macroeconomics. Banking instability became more of an issue in macroeconomics. Key trends Key trends Frequency of banking crises Frequency of banking crises Coinciding of banking crises/capital crunches with macroeconomic declines Coinciding of banking crises/capital crunches with macroeconomic declines Mixing of banking crises with exchange rate or sovereign crises. Mixing of banking crises with exchange rate or sovereign crises.

4. EM Banks Especially Unstable Fiscal costs of banking crises in EMs amounted to about $1 trillion in the 1980s and 1990s, which was equal to all foreign assistance transfers from developed countries from 1950-2001. Fiscal costs of banking crises in EMs amounted to about $1 trillion in the 1980s and 1990s, which was equal to all foreign assistance transfers from developed countries from 1950-2001. Many of these collapses also involve twin crises (collapses of both exchange rate and banking systems), with dire macroeconomic consequences. Many of these collapses also involve twin crises (collapses of both exchange rate and banking systems), with dire macroeconomic consequences. Why is this happening? What can be done? Why is this happening? What can be done?

5. Central Questions about Bank Risk and Prudential Regulation Why are crises so common and so severe now? Why are crises so common and so severe now? Are banking crises and their causes the same or different from those of the past? Are banking crises and their causes the same or different from those of the past? Are crises inherent in the function and structure of banks? Are crises inherent in the function and structure of banks? Which supervision and regulation rules work? Which supervision and regulation rules work? Should government pursue counter-cyclical forbearance policies, or procyclical prudential regulation? Should government pursue counter-cyclical forbearance policies, or procyclical prudential regulation?

6. Bank Function and Structure Bank Function and Structure Banks control risk via intensive screening, contracting, and monitoring, involving private information production. Banks control risk via intensive screening, contracting, and monitoring, involving private information production. Bank function and structure Bank function and structure Delegated monitoring on asset side, liquidity creation on liability side Delegated monitoring on asset side, liquidity creation on liability side Maturity and liquidity transformation Maturity and liquidity transformation First-come-first-served rule First-come-first-served rule Essential structure and function of banks has created a special role for debt market discipline of banks, in contrast to other firms. Essential structure and function of banks has created a special role for debt market discipline of banks, in contrast to other firms. Does this make banks risky? Does that explain EM banking crises? Does this make banks risky? Does that explain EM banking crises? Alternative view: Insider lending, moral hazard, politics of bailouts (Populism meets cronyism) Alternative view: Insider lending, moral hazard, politics of bailouts (Populism meets cronyism)

7. Crises have different shapes Currency depreciation only, reflecting an overvaluation of the currency, but without effects on banking system Currency depreciation only, reflecting an overvaluation of the currency, but without effects on banking system Brazil 1999: overvalued currency, lack of fiscal discipline, but banks relatively healthy, no resurrection risk betting Brazil 1999: overvalued currency, lack of fiscal discipline, but banks relatively healthy, no resurrection risk betting Banking collapse only Banking collapse only Australia 1893: costs of losses in banks absorbed by stockholders and depositors, not taxpayers Australia 1893: costs of losses in banks absorbed by stockholders and depositors, not taxpayers Twin crises, in which banking collapses and exchange rate collapses happen together. The new phenomenon of twin crises (only a handful were observed in pre-1980 era). But twin crises can also be distinguished according to the dominant direction of causation Twin crises, in which banking collapses and exchange rate collapses happen together. The new phenomenon of twin crises (only a handful were observed in pre-1980 era). But twin crises can also be distinguished according to the dominant direction of causation fiscal crisis => banking instability as in Argentina 2001, where government lacked the safety valve of inflationary monetary policy, and thus stole bank capital as last resort means of financing; fiscal crisis => banking instability as in Argentina 2001, where government lacked the safety valve of inflationary monetary policy, and thus stole bank capital as last resort means of financing; or banking instability => fiscal crisis, as in Mexico 1994 and East Asia 1997, although in these cases there was also an overvaluation problem of real exchange rate, in Mexico because of boom in demand, and in Asia because of cumulative decline in productivity or banking instability => fiscal crisis, as in Mexico 1994 and East Asia 1997, although in these cases there was also an overvaluation problem of real exchange rate, in Mexico because of boom in demand, and in Asia because of cumulative decline in productivity

8. Financial system feedback during crises Overextended banks and firms Rapid rise in interest rates Capital outflow Currency devaluation

9. Risk factors show themselves during crises Law: inability to have orderly workout in financial distress leads to backlog of unresolved debts; reversal of privatization contracts, redenomination of contracts, limits on capital flows, nationalization of assets. Law: inability to have orderly workout in financial distress leads to backlog of unresolved debts; reversal of privatization contracts, redenomination of contracts, limits on capital flows, nationalization of assets. Information: markets react dramatically to crises (shut down of orderly information processing, high adverse selection costs) Information: markets react dramatically to crises (shut down of orderly information processing, high adverse selection costs) Fiscal policy: lack of political will to reduce expenditures, improve tax collection, avoid inflation tax. Fiscal policy: lack of political will to reduce expenditures, improve tax collection, avoid inflation tax. Banking: desire to protect bankers, who are often borrowers and political allies, too, leads to lack of credible discipline ex ante, and big bailouts ex post. Quasi privatization can be worse than public banks from the standpoint of the severity of crises. Banking: desire to protect bankers, who are often borrowers and political allies, too, leads to lack of credible discipline ex ante, and big bailouts ex post. Quasi privatization can be worse than public banks from the standpoint of the severity of crises. KEY POINT: All these risks can be observed in advance of the crisis! KEY POINT: All these risks can be observed in advance of the crisis!

10. Recent crises forecasted in particular countries Mexico: The dog that did not bark in December 1994. Mexico: The dog that did not bark in December 1994. Fiscal spending and bank lending, election year Fiscal spending and bank lending, election year Overvaluation (Dornbusch) Overvaluation (Dornbusch) Bank privatizations, lack of recapitalizations Bank privatizations, lack of recapitalizations Recession began in 1993 Recession began in 1993 Sterilization, reserve outflows, tesobonos liquidity risk Sterilization, reserve outflows, tesobonos liquidity risk East Asia: Diminishing returns / cronyism East Asia: Diminishing returns / cronyism Weak bank balance sheets, high corporate leverage were known Weak bank balance sheets, high corporate leverage were known Low or negative return on invested capital due to crony banking Low or negative return on invested capital due to crony banking Overvaluation related to declining productivity Overvaluation related to declining productivity Recessions reflecting declining productivity, overvaluation Recessions reflecting declining productivity, overvaluation Brazil: Insufficient fiscal reform Brazil: Insufficient fiscal reform Overvaluation Overvaluation Old story of unsustainable peg given rising inflation Old story of unsustainable peg given rising inflation Argentina: Insufficient fiscal reform Argentina: Insufficient fiscal reform Coparticipation Coparticipation Labor, tax policies, recession (overvaluation-induced deflation) Labor, tax policies, recession (overvaluation-induced deflation) Destruction of banking sector Destruction of banking sector

11. Causation in Mexico Spending, weak privatized banks (Haber article), off- balance sheet exposures raise debt and expected monetization. Spending, weak privatized banks (Haber article), off- balance sheet exposures raise debt and expected monetization. As reserves are drained, central bank sterilizers, thereby increasing current money supply. As reserves are drained, central bank sterilizers, thereby increasing current money supply. Rise in money and expected money drive up prices, leading to overvaluation and increasing pressure on exchange rate. Rise in money and expected money drive up prices, leading to overvaluation and increasing pressure on exchange rate. Zedillo ’ s non-reform leads market to realize inevitability of collapse, and run begins. Zedillo ’ s non-reform leads market to realize inevitability of collapse, and run begins. FX exposure is combination of direct bets and defaults linked to dollar debt. FX exposure is combination of direct bets and defaults linked to dollar debt. Banks double bets on FX by having lots of both (in violation of regs, done with swaps via Wall Street). Banks double bets on FX by having lots of both (in violation of regs, done with swaps via Wall Street). Uncanny (forecasted) replay of Chile 1982-83 crisis. Uncanny (forecasted) replay of Chile 1982-83 crisis.

12. Rising Debt, Sterilization

13. Sterilization had been the rule

14. Inflation and base growth linked

15. Inflation increasingly threatened exchange rate

16. Mexican Devaluation

17. Asian Crises March and April 1997, the Economist and FT have special reports on declining fortunes of Asian banks, and possible crises there. March and April 1997, the Economist and FT have special reports on declining fortunes of Asian banks, and possible crises there. Alwyn Young writes about declining productivity as threat to sustainability of so- called Asian miracle in 1994-95. Alwyn Young writes about declining productivity as threat to sustainability of so- called Asian miracle in 1994-95. Short-term borrowing in dollars increases as risk rises (largely interbank, “ protected ” ?, and with different weights according to Basel). Short-term borrowing in dollars increases as risk rises (largely interbank, “ protected ” ?, and with different weights according to Basel). IMF assistance bails out those debts. IMF assistance bails out those debts.

18. Bank Losses in Asian Crises Thailand Indonesia Korea Thailand Indonesia Korea 1997NPL/TL 19% 17% 16% 1997NPL/GDP 30% 10% 22% Cleanup Cost / 42% 55% 20% 1999 GDP

19. Diminishing Returns => Increasingly Inefficient Capital Investment in East Asia in 1980s, 1990s Return on Capital Employed Minus Interest Rate, 1992 Indonesia-12% Korea - 3% Malaysia 3% Philippines-13% Thailand- 9% Source: Pomerleano (1998)

20. Micro Level Stylized Facts As the 1990s progressed... Asian corporations experienced a decline in performance. Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars). Asian corporate managers increased the leverage of their firms.

21. How Can You Bet the Country? Government bailouts are anticipated, intermediated by government ’ s relationship with the IMF, which injects dollars to government, which pays them to crony firms with outstanding short-term debts. Government bailouts are anticipated, intermediated by government ’ s relationship with the IMF, which injects dollars to government, which pays them to crony firms with outstanding short-term debts. Taxpayers pick up the pieces. Taxpayers pick up the pieces. High leverage of ex ante insolvent banks and firms indicates that both borrowers and US, Japanese, and European bank lenders anticipated this. High leverage of ex ante insolvent banks and firms indicates that both borrowers and US, Japanese, and European bank lenders anticipated this. Note: Capital flows, per se, are not the problem, but rather the allocation of risk by government associated with those flows. There is an argument for waiting to liberalize capital flows until incentives and financial regulation have been fixed. Note: Capital flows, per se, are not the problem, but rather the allocation of risk by government associated with those flows. There is an argument for waiting to liberalize capital flows until incentives and financial regulation have been fixed. This is a particularly important issue for China, given that it could repeat the Asian crisis pattern, given diminishing returns and lack of market discipline in banking system. This is a particularly important issue for China, given that it could repeat the Asian crisis pattern, given diminishing returns and lack of market discipline in banking system.

22. Trends in Corporate Leverage Ratios Country Comparisons RatingRatio AAA 13.4 AA 21.9 A 32.7 BBB 43.4 BB53.9 B65.9

23. Brazil ’ s Controlled Devaluation (Healthy banks)

24. Argentina ’ s Crisis Anticipated Interest Rates on 30-Day Time Deposits in Pesos and Dollars Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).

25. Argentina ’ s Crisis Anticipated Difference Between Interest Rates on 30-Day Time Deposits in Argentina in Pesos and Dollars vs. EMBI+ Argentina Strip Spread Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).

26. Deposit Outflows Monthly Dollar Deposits in Argentina, 2001 Source: Argentina Ministry of Economy & Production, Macroeconomic Statistics (available at http://www.mecon.gov.ar/peconomica/basehome/infoeco_ing.html).

27. International Reserve Outflows, 2001 Note: Because of a change in the BCRA’s definition of international reserves, data after October 31, 2001 includes public bonds involved in reverse repo-operations. Data before October 31 does not include these bonds. Source: Banco Central de la República Argentina, International Reserves and BCRA’s Financial Liabilities (available at http://www.bcra.gov.ar/).

28. Annual Capital Inflows by Type Note: Equity inflow was not available until 1992. I use the following variables from the IMF’s International Financial Statistics as components of capital inflows: 1) FDI: line 78bed (Direct Investment in the Reporting Economy, n.i.e.) 2) Equity: line 78bmd (Equity Securities Liabilities) 3) Debt: line 78bnd (Debt Securities Liabilities). 4) Other: line 78bid (Other Investment Liabilities, n.i.e.) Source: International Monetary Fund, International Financial Statistics, June 2004.

29. Argentine Devaluation

30. Role of fixed exchange rates All of the problems discussed would still be problems under flexible exchange rates All of the problems discussed would still be problems under flexible exchange rates But fixed exchange rates make things worse by create sudden adjustments, and thus big accumulations of risk. But fixed exchange rates make things worse by create sudden adjustments, and thus big accumulations of risk. This not only causes sudden problems, it also worsens resurrection risk taking by giving banks and firms something to bet on. This not only causes sudden problems, it also worsens resurrection risk taking by giving banks and firms something to bet on.

31. Panics vs. Insolvencies Concern that too much, unwarranted, sudden market discipline can create undesirable social costs from contraction of bank deposits during “panics” is the primary justification for bank safety nets in theory and in history (deposit insurance, and lender of last resort). Concern that too much, unwarranted, sudden market discipline can create undesirable social costs from contraction of bank deposits during “panics” is the primary justification for bank safety nets in theory and in history (deposit insurance, and lender of last resort). Such systemic panics (as distinct from periods of high bank failure) resulted from a combination of observable shocks and unobservable incidence of shocks, in combination with the structure of banks (liquidity transformation, fcfs rule). Such systemic panics (as distinct from periods of high bank failure) resulted from a combination of observable shocks and unobservable incidence of shocks, in combination with the structure of banks (liquidity transformation, fcfs rule).

32. U.S. Experience with Panics 1857, 1873, 1884, 1890, 1893, 1896, 1907 1857, 1873, 1884, 1890, 1893, 1896, 1907 Observable shock was a dual threshold of 9% stock market decline over a quarter, and 50% increase in seasonally adjusted liabilities of failed business (NEWS RELEVANT FOR BANKS) Observable shock was a dual threshold of 9% stock market decline over a quarter, and 50% increase in seasonally adjusted liabilities of failed business (NEWS RELEVANT FOR BANKS) Some shocks originated in NYC and were related to securities markets, use of funds by NYC banks: In 1857, loans to bond dealers, connections to RRs, was the problem. Some shocks may relate more to peripheral areas (perhaps 1893). Some shocks originated in NYC and were related to securities markets, use of funds by NYC banks: In 1857, loans to bond dealers, connections to RRs, was the problem. Some shocks may relate more to peripheral areas (perhaps 1893).

33. Dealing with Panics Costly bank panics were almost exclusively a U.S. phenomenon by the mid-19 th century. Market discipline, along with inter- bank cooperation and lending, central banks, and clearing house actions to share risks dealt with threat of panics effectively, except in U.S. where branching limits, pyramiding of reserves created concentrations of risk, and made coordination difficult. Costly bank panics were almost exclusively a U.S. phenomenon by the mid-19 th century. Market discipline, along with inter- bank cooperation and lending, central banks, and clearing house actions to share risks dealt with threat of panics effectively, except in U.S. where branching limits, pyramiding of reserves created concentrations of risk, and made coordination difficult. Desire to keep unit banking, and risk of panics explains why U.S. originates deposit insurance. Desire to keep unit banking, and risk of panics explains why U.S. originates deposit insurance.

34. Dealing with Panics (Cont’d) Banks assisted each other, sometimes through formal clearing house actions. Banks assisted each other, sometimes through formal clearing house actions. Market discipline kept risky banks in check, and made other banks see advantage to identifying and punishing risky banks quickly. Market discipline kept risky banks in check, and made other banks see advantage to identifying and punishing risky banks quickly. Suspension was used as a last resort, and market discipline created incentives to restore convertibility quickly. Suspension was used as a last resort, and market discipline created incentives to restore convertibility quickly. Resumption of convertibility would occur when secondary market discounts on bank paper approached zero. Resumption of convertibility would occur when secondary market discounts on bank paper approached zero.

35. Historical Banking System Collapses Panics in U.S. did not produce banking collapses, because the combination of market discipline, clearing house support, and temporary suspension of convertibility (until asymmetric information was resolved) insulated banks from costs. Panics in U.S. did not produce banking collapses, because the combination of market discipline, clearing house support, and temporary suspension of convertibility (until asymmetric information was resolved) insulated banks from costs. 1893, worst of U.S. panics, coincided with large exogenous agricultural problems, but bank failures produced negative net worth of failed banks of only 0.1% of GDP. 1893, worst of U.S. panics, coincided with large exogenous agricultural problems, but bank failures produced negative net worth of failed banks of only 0.1% of GDP.

36. Historical Collapses (Cont’d) Worldwide, from 1873 to 1913, there were no more than seven episodes of severe bank failure worldwide (defined as collapses that produced banking losses where negative net worth of failed banks in a country exceeded 1% of GDP) Worldwide, from 1873 to 1913, there were no more than seven episodes of severe bank failure worldwide (defined as collapses that produced banking losses where negative net worth of failed banks in a country exceeded 1% of GDP) Argentina 1890 (~10%), Australia 1893 (~10%), Norway 1900 (~3%), Italy 1893 (~1%), Brazil various (hard to measure, but all much less than 10%). Only 2-3 of these are “twin crises.” Argentina 1890 (~10%), Australia 1893 (~10%), Norway 1900 (~3%), Italy 1893 (~1%), Brazil various (hard to measure, but all much less than 10%). Only 2-3 of these are “twin crises.”

37. Historical Comparison between Today and Pre-WWI Era Appropriate? 1870s-1913 is a time when capital flows to emerging markets were high relative to GDP, limited liability banking was growing rapidly around the world, countries relied on fixed exchange rates, and macroeconomic climate was very volatile. 1870s-1913 is a time when capital flows to emerging markets were high relative to GDP, limited liability banking was growing rapidly around the world, countries relied on fixed exchange rates, and macroeconomic climate was very volatile. This suggests that according to some explanations of crises (exchange rate fixed, free chartering of banks, multiple equilibria due to foreign capital flows) we should see more then than now. But we do not.h This suggests that according to some explanations of crises (exchange rate fixed, free chartering of banks, multiple equilibria due to foreign capital flows) we should see more then than now. But we do not.h

38. Historical Collapses (Cont’d) Land booms and busts underlay these collapses, and often bank risk was subsidized by government in one way or another. Argentina, Italy subsidized risky bank lending on land; Norway and Australia promoted land booms in other ways. Land booms and busts underlay these collapses, and often bank risk was subsidized by government in one way or another. Argentina, Italy subsidized risky bank lending on land; Norway and Australia promoted land booms in other ways. Banking collapses for some U.S. states also directly traced to safety net policies. Agriculture boom and busts and banking collapses were much more severe in states with deposit insurance (WWI price bets). Banking collapses for some U.S. states also directly traced to safety net policies. Agriculture boom and busts and banking collapses were much more severe in states with deposit insurance (WWI price bets). Twin crises in Italy and Argentina in 1890s reflected feedback from banking crises to fiscal collapse of government (foreshadowing today’s crises). Twin crises in Italy and Argentina in 1890s reflected feedback from banking crises to fiscal collapse of government (foreshadowing today’s crises).

39. State-Level Deposit Insurance in 1920s 3 Insured 15 Controls Asset Size $320$622 Equity / Assets 0.110.13 Growth during Boom 185%128% Loans / Assets 0.760.70 Negative NW of fails / Survivors NW 3.50.5 Source: Calomiris JEH 1990.

40. How the Safety Net Causes Bank Collapses Safety net removes market discipline that used to operate, both as a check on conscious risk taking, and on quality of bank management making risk taking decisions. Both effects are important. Safety net removes market discipline that used to operate, both as a check on conscious risk taking, and on quality of bank management making risk taking decisions. Both effects are important. These two channels do not operate with constant adverse effects, but rather, their effects vary over the cycle. These two channels do not operate with constant adverse effects, but rather, their effects vary over the cycle. Conscious risk taking increases in wake of losses (resurrection bets on unlikely outcomes with high risk premia, especially in currency markets, which deepens extent of twin crises through feedback effects). Conscious risk taking increases in wake of losses (resurrection bets on unlikely outcomes with high risk premia, especially in currency markets, which deepens extent of twin crises through feedback effects). Management quality problem can be most hazardous during booms, and becomes visible during busts (WWI grain price bets). Management quality problem can be most hazardous during booms, and becomes visible during busts (WWI grain price bets).

41. Why Few Twin Crises Historically? Other than those exceptions, fiscal discipline coincided with and reinforced benefits of market discipline over banks. Other than those exceptions, fiscal discipline coincided with and reinforced benefits of market discipline over banks. Governments adhering to gold standard had access to international capital markets, and could act to protect banks with classical lender of last resort liquidity assistance. Governments adhering to gold standard had access to international capital markets, and could act to protect banks with classical lender of last resort liquidity assistance. Mexico 1907 and Russia 1899-1900 are prime examples of successful assistance Mexico 1907 and Russia 1899-1900 are prime examples of successful assistance Assistance was limited by credible commitment to stay on gold standard, which in turn ensured access to funds as needed. (Contrast to IMF) Assistance was limited by credible commitment to stay on gold standard, which in turn ensured access to funds as needed. (Contrast to IMF)

42. What About the Great Depression? New research (Calomiris and Mason, 1997, 2003) shows that panics were not nationwide phenomenon until very late (early 1933) New research (Calomiris and Mason, 1997, 2003) shows that panics were not nationwide phenomenon until very late (early 1933) For the most part, fundamental shocks (deflationary monetary policy, gold standard, agric. distress, other bad economic policies) caused insolvencies by many banks, not panics. For the most part, fundamental shocks (deflationary monetary policy, gold standard, agric. distress, other bad economic policies) caused insolvencies by many banks, not panics. And, despite the severe shocks and many failures, losses of failed banks 1930-1933 only about 3-4% of GDP. And, despite the severe shocks and many failures, losses of failed banks 1930-1933 only about 3-4% of GDP.

43. Banking Collapses Today In contrast, about 150 episodes since 1978 of banking system collapses with costs of more than 1% of GDP, more than 20 with costs in excess of 10% of GDP, and many of those have costs in excess of 20% of GDP. In contrast, about 150 episodes since 1978 of banking system collapses with costs of more than 1% of GDP, more than 20 with costs in excess of 10% of GDP, and many of those have costs in excess of 20% of GDP. This is unprecedented. Collapses often coincide with currency collapse due to fiscal implications of banking collapse for government. This reflects changes in political economy of banking systems (similar to Eichengreen 1996 argument on inflation process). This is unprecedented. Collapses often coincide with currency collapse due to fiscal implications of banking collapse for government. This reflects changes in political economy of banking systems (similar to Eichengreen 1996 argument on inflation process). Like Italy and Argentina pre-WWI, these severe collapses have been directly traced to incentives from government policies protecting banks from market discipline. Like Italy and Argentina pre-WWI, these severe collapses have been directly traced to incentives from government policies protecting banks from market discipline.

44. How Did / Do Disciplined Systems Behave? Old-Fashioned Disciplined Banking Old-Fashioned Disciplined Banking Equity/Assets and Asset risk managed to target low default risk on debt of bank. During good times, equity capital is cheap (no lemons problems) and lending opportunities are good, so both risk and equity capital rise. Equity/Assets and Asset risk managed to target low default risk on debt of bank. During good times, equity capital is cheap (no lemons problems) and lending opportunities are good, so both risk and equity capital rise. When shock hits, banks face prospect of loss of deposits due to combination of risk aversion and need for liquidity of depositors, and asymmetric information problem about losses within bank. When shock hits, banks face prospect of loss of deposits due to combination of risk aversion and need for liquidity of depositors, and asymmetric information problem about losses within bank. As banks lose deposits they act to restore confidence by contracting loans, cutting dividends, and expanding cash asset holdings. As banks lose deposits they act to restore confidence by contracting loans, cutting dividends, and expanding cash asset holdings.

45. NYC Bank Capital and Risk 1920-1936

46. NYC Banks’ Loans/Cash, Equity, Dividends Loans/Cash Equity/Assets Dividends Loans/Cash Equity/Assets Dividends 19222.10.18 19293.30.33$392m 19331.00.15 19400.30.10$162m Source: Calomiris-Wilson JB 2004.

47. Discipline Reflected on Liability Side If discipline exists, it appears in three forms: If discipline exists, it appears in three forms: Interest cost of debt goes up with risk Interest cost of debt goes up with risk Rationing effect: deposits decline Rationing effect: deposits decline Shift to high-cost, “monitored” marginal funds Shift to high-cost, “monitored” marginal funds These effects are consistently visible historically, as well as currently, in all types of countries. These effects are consistently visible historically, as well as currently, in all types of countries. Bank liability data, and liability interest rate data are the most reliable, consistently reported data on balance sheets, which helps make them especially useful as indicators. Bank liability data, and liability interest rate data are the most reliable, consistently reported data on balance sheets, which helps make them especially useful as indicators.

48. Example: Chicago 1932 1932 Failures 1932 Survivors 1932 Failures 1932 Survivors Number 46 62 1931 R D 2% 1% 1931 Borr/Debts 12% 2% 1931 Dep growth -45% -33% Source: Calomiris-Mason 1997 AER.

49. Example: Argentina 1995 1995 Failures 1995 Survivors 1995 Failures 1995 Survivors R D paid in 1993 13% 9.5% R D paid in 1993 13% 9.5%

50. Example: Mexico 1996 Even though there was 100% deposit insurance, the losses were so large, and the political debate so uncertain, that insured deposits were not necessarily protected. Even though there was 100% deposit insurance, the losses were so large, and the political debate so uncertain, that insured deposits were not necessarily protected. Banamex (marginally solvent) paid 17% on its funds, on average, but Bank Serfin (deeply insolvent) paid 29% Banamex (marginally solvent) paid 17% on its funds, on average, but Bank Serfin (deeply insolvent) paid 29%

51. Market Discipline Even with Insurance All banks Banamex Serfin All banks Banamex Serfin 1996 Dep. Int. 25.2% 17.4% 28.9% 1994 branches 5,051 710 561 1996 branches 6,264 912 578

52. Contrast Old (Stable) System with Protected (Unstable) System Old, disciplined system reduced bank risk in response to shocks. Old, disciplined system reduced bank risk in response to shocks. New system sees banks increasing risks in response to shock (doubling their bets), especially taking on exchange risk. New system sees banks increasing risks in response to shock (doubling their bets), especially taking on exchange risk. Chile 1982-1983 Chile 1982-1983 U.S. Savings and Loans in 1980s U.S. Savings and Loans in 1980s Mexico 1993-1994 Mexico 1993-1994 Japan 1990-1997 Japan 1990-1997 Korea, Thailand, etc. 1995-1997 Korea, Thailand, etc. 1995-1997

53. Risk-Based Capital Regulation Basel and similar systems supposedly target risk-based capital, which is similar to targeting default risk of debt, although measurement of risk and capital are imperfect (to say the least) and ratios are arbitrary. Basel and similar systems supposedly target risk-based capital, which is similar to targeting default risk of debt, although measurement of risk and capital are imperfect (to say the least) and ratios are arbitrary. If this is successful, it results in regulatory discipline with effects similar to market discipline: When a bank loses capital, it contracts risk, cuts dividends, in order to comply with standard and in doing so reduces default risk. If this is successful, it results in regulatory discipline with effects similar to market discipline: When a bank loses capital, it contracts risk, cuts dividends, in order to comply with standard and in doing so reduces default risk.

54. Procyclical Effects? If effective, this sort of capital regulation necessarily exacerbates the business cycle, since losses of capital (during onset of recession) produce contraction of bank loan supply, which aggravates the recession. If effective, this sort of capital regulation necessarily exacerbates the business cycle, since losses of capital (during onset of recession) produce contraction of bank loan supply, which aggravates the recession. Calomiris and Mason (AER 2003) estimate that market discipline during U.S. Great Depression was responsible for income declines roughly one-third as large in percentage terms as the percentage declines in loan supply. These are very large effects. Calomiris and Mason (AER 2003) estimate that market discipline during U.S. Great Depression was responsible for income declines roughly one-third as large in percentage terms as the percentage declines in loan supply. These are very large effects.

55. Procyclical Effects (Cont’d) Two points warrant emphasis: Two points warrant emphasis: First, any prudent risk-managing bank will have to contract risk in response to loss, so procyclicality is an inevitable feature of a well- managed banking system. First, any prudent risk-managing bank will have to contract risk in response to loss, so procyclicality is an inevitable feature of a well- managed banking system. Second, “forebearance” (the decision by regulators to relax requirements because of a concern about loan supply) tends to produce a larger procyclical effect, because resurrection risk taking leads to systemic collapse, and often unproductive risk taking prior to collapse. Second, “forebearance” (the decision by regulators to relax requirements because of a concern about loan supply) tends to produce a larger procyclical effect, because resurrection risk taking leads to systemic collapse, and often unproductive risk taking prior to collapse.

56. Policy in the Real World Even though policy makers are aware that forbearance is counterproductive, they still do it. Even though policy makers are aware that forbearance is counterproductive, they still do it. Politics tends to produce strong incentives for protection of banks and forbearance, more in some countries than in others (Demirguc-Kunt, Kane and Laeven 2007). Politics tends to produce strong incentives for protection of banks and forbearance, more in some countries than in others (Demirguc-Kunt, Kane and Laeven 2007). Book capital requirements invite discretionary forbearance, as do reliance on supervisory judgments when measuring risk and capital. Book capital requirements invite discretionary forbearance, as do reliance on supervisory judgments when measuring risk and capital. Also, policymakers may lack timely information, or incentive to put forth effort to collect it, so some forbearance may be inadvertent. Also, policymakers may lack timely information, or incentive to put forth effort to collect it, so some forbearance may be inadvertent. S&R fails. Barth-Caprio-Levine find that regulatory and supervisory practices, other than practices that introduce market discipline, make no difference for banking sector growth or stability. Market discipline promotes both greater stability and higher growth. S&R fails. Barth-Caprio-Levine find that regulatory and supervisory practices, other than practices that introduce market discipline, make no difference for banking sector growth or stability. Market discipline promotes both greater stability and higher growth.

57. Institutional Environment Democratic, Political Structure/System Technology, Information Infrastructure Judicial, Legal, Regulatory Environment Market Structure Media The Market: Depositors,creditors, rating agencies Politicians Regulators and supervisors Borrowers, counterparties Corruption corruption Banks The Public corruption A Framework for Bank Regulation, Barth Caprio and Levine

58. Barth et al Book Study of regulatory practices across 150 countries, asking whether regulations improve bank stability and growth; and also exploring how regulations reflect and alter political economy and corruption. Study of regulatory practices across 150 countries, asking whether regulations improve bank stability and growth; and also exploring how regulations reflect and alter political economy and corruption. Variation in regulatory practice is enormous (capital regulation, deposit insurance coverage, government ownership of banks, foreign entry permitted, bank powers allowed). Variation in regulatory practice is enormous (capital regulation, deposit insurance coverage, government ownership of banks, foreign entry permitted, bank powers allowed). Evidence favors the “private interest” (or “grabbing hand”) view over the “public interest” (or “helping hand”) view of bank regulation and supervision in EMs. Evidence favors the “private interest” (or “grabbing hand”) view over the “public interest” (or “helping hand”) view of bank regulation and supervision in EMs.

59. Barth et al Findings “Across the different statistical approaches, we find that empowering direct official supervision of banks and strengthening capital standards do not boost bank development, improve bank efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending, and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability. In contrast to these findings…bank supervisory and regulatory policies that facilitate private sector monitoring of banks improve bank operations.”

60. Barth et al Details: Univariate Regressions Dependent Var: Bank Credit to Private Sector/GDP (Controls not reported) Entry Req. IndexNegative Insignificant Limits on For. EntryNegative Significant Entry Appl. DeniedNegative Significant Activities RestrictionsNegative Significant Capital RegulationsPositive Marginal Prompt Corrective PowerNegative Insignificant Official Supervisory PowerNegative Significant Supervisory IndependenceNegative Insignificant Government-Owned BankingNegative Significant Private Monitoring IndexPositive Significant

61. Barth et al: Multivariate Regression Dependent Var: Bank Credit to Private Sector/GDP (Controls not reported) Entry Req. IndexPositive Insignificant Activities RestrictionsNegative Significant Capital RegulationsPositive Insignificant Official Supervisory PowerPositive Insignificant Government-Owned BankingNegative Insignificant Private Monitoring IndexPositive Significant

62. Barth et al: Multivariate Regression Dependent Var: Bank Crisis Probability (logit) (Controls not reported) Entry Req. IndexPositive Insignificant Activities RestrictionsPositive Significant Capital RegulationsNegative Insignificant Official Supervisory PowerNegative Insignificant Government-Owned BankingPositive Marginal Moral Hazard IndexPositive Significant Political OpennessPositive Insignificant MH x PONegative Significant Moral Hazard = Dep Insurance Generosity

63. Barth et al: Multivariate Regression Dependent Var: Corruption of Banking Officials (Controls not reported) Official Supervisory PowerPositive Significant Government-Owned BankingPositive Significant Private MonitoringNegative Significant

64. Other Evidence on Foreign Bank Entry Greater supply of credit (Goldberg, Dages, Kinney 2000), although based more on “hard” information than “soft” information (Mian 2003) Greater supply of credit (Goldberg, Dages, Kinney 2000), although based more on “hard” information than “soft” information (Mian 2003) Less local presence => greater volatility of credit (Herrero and Peria 2005) Less local presence => greater volatility of credit (Herrero and Peria 2005) Giannetti and Ongena (2005) find that foreign presence reduces connected lending problems, improves access of funds to efficient non- connected borrowers, and improves efficiency of capital allocation, although effect seems confined to medium and large firms Giannetti and Ongena (2005) find that foreign presence reduces connected lending problems, improves access of funds to efficient non- connected borrowers, and improves efficiency of capital allocation, although effect seems confined to medium and large firms Similarly, Bonin and Imai (2005) show that sale of Korean banks to foreign lenders had large negative effects on stock returns of related borrowers. Similarly, Bonin and Imai (2005) show that sale of Korean banks to foreign lenders had large negative effects on stock returns of related borrowers.

65. % Banking System Foreign-Controlled (IMF 2000) 1994 1999 1994 1999 Czech Rep. 5.849.3 Hungary19.856.6 Poland 2.152.8 Argentina17.948.6 Brazil 8.416.8 Chile16.353.6 Colombia 6.217.8 Mexico 1.018.8 Peru 6.733.4 Venezuela 0.341.9 Korea 0.8 4.3 Malaysia 6.811.5 Thailand 0.5 5.6

66. How can bank regulatory policy help? Repeal the safety net. Perhaps a good idea (a vast body of empirical evidence indicates deposit insurance makes systems more prone to failure, not less), but this is hard to do, and there is often implicit insurance even when explicit insurance is repealed. Repeal the safety net. Perhaps a good idea (a vast body of empirical evidence indicates deposit insurance makes systems more prone to failure, not less), but this is hard to do, and there is often implicit insurance even when explicit insurance is repealed. Narrow banking. This is repeal in disguise. Narrow banking. This is repeal in disguise. Internal Models. Regulators’ incentives are still to forbear, and thus credibility is lacking. Regulation and supervision become extremely complicated. For developing countries, the cost of implementing complex regulatory apparatus is very high, because banking systems are small (100 countries with banking system deposits under $10 billion). Internal Models. Regulators’ incentives are still to forbear, and thus credibility is lacking. Regulation and supervision become extremely complicated. For developing countries, the cost of implementing complex regulatory apparatus is very high, because banking systems are small (100 countries with banking system deposits under $10 billion).

67. Combining Safety Nets, S&R, and Elements of Market Discipline Once the government is involved in protecting banks, markets have little incentive to take risks, and thus little incentive to monitor, or to act upon information. Once the government is involved in protecting banks, markets have little incentive to take risks, and thus little incentive to monitor, or to act upon information. S&R can incorporate market discipline if it finds a way to (1) require banks to offer some component of risky debt to finance themselves, (2) ensure that the pricing of that instrument is observable to them and the market, and (3) establish rules that force S&R to act upon the information produced by the market. S&R can incorporate market discipline if it finds a way to (1) require banks to offer some component of risky debt to finance themselves, (2) ensure that the pricing of that instrument is observable to them and the market, and (3) establish rules that force S&R to act upon the information produced by the market.

68. What Is NOT Market Discipline Disclosure rules, by themselves, are of little use, since market may have little reason to care about disclosure. Disclosure rules, by themselves, are of little use, since market may have little reason to care about disclosure. The presence of uninsured debt is not necessarily indicative of market discipline because the debt may effectively have the option to leave when things go wrong, or because government may use mergers or other protection to bail it out, justified by “least cost resolution policy” The presence of uninsured debt is not necessarily indicative of market discipline because the debt may effectively have the option to leave when things go wrong, or because government may use mergers or other protection to bail it out, justified by “least cost resolution policy” Insiders’ holdings of debt (which can be hard to track), or outsiders’ holdings protected via derivatives written by the bank, won’t provide discipline. Insiders’ holdings of debt (which can be hard to track), or outsiders’ holdings protected via derivatives written by the bank, won’t provide discipline.

69. Getting Market Discipline to Work: The Integrated Approach of Argentina c. 1999 An integrated approach to S&R, in which credible market discipline is required, and produced by a combination of reforms, is the best approach. An integrated approach to S&R, in which credible market discipline is required, and produced by a combination of reforms, is the best approach. One of the best examples of this approach was Argentina in the late 1990s. The collapse of the system in 2001-2002 was not due to regulatory failure, but rather its success. Cavallo seized bank equity in 2001 to alleviate the government’s fiscal problems because domestic banks were only place to find the money. One of the best examples of this approach was Argentina in the late 1990s. The collapse of the system in 2001-2002 was not due to regulatory failure, but rather its success. Cavallo seized bank equity in 2001 to alleviate the government’s fiscal problems because domestic banks were only place to find the money.

70. Argentina 1992-2000 Free foreign entry (competitive pressure, skills) Free foreign entry (competitive pressure, skills) Encouragement of privatization of loss-making provincial banks (pay provinces to privatize and renounce bank chartering). 18 privatized 1992-99. Encouragement of privatization of loss-making provincial banks (pay provinces to privatize and renounce bank chartering). 18 privatized 1992-99. No explicit deposit insurance (modified in 1995) No explicit deposit insurance (modified in 1995) Book equity capital requirement depends on loan interest rate Book equity capital requirement depends on loan interest rate VAR to set capital requirement for market risk based on market volatility VAR to set capital requirement for market risk based on market volatility Liquidity requirement can be satisfied with standbys (rewards banks that command market confidence) Liquidity requirement can be satisfied with standbys (rewards banks that command market confidence) Aggressive NPL policy Aggressive NPL policy

71. Argentina (Cont’d) BASIC System: Integration of rules for information creation, disclosure, and use. BASIC System: Integration of rules for information creation, disclosure, and use. Central de riesgo information pool (crafted to minimize free riding, while allowing banks to avoid bad credits, and avoid double pledging of collateral). Central de riesgo information pool (crafted to minimize free riding, while allowing banks to avoid bad credits, and avoid double pledging of collateral). Auditing supervised, bonded. Auditing supervised, bonded. Subordinated debt requirement forces banks to issue 2% of deposits in the form of uninsured subordinated debt held at arms length. (Concentration of uninsured claim may be desirable, as more informed, and harder to renege if amount is small…no systemic excuse.) Subordinated debt requirement forces banks to issue 2% of deposits in the form of uninsured subordinated debt held at arms length. (Concentration of uninsured claim may be desirable, as more informed, and harder to renege if amount is small…no systemic excuse.) Banks rated by approved rating agencies (good intentions, bad outcome). Banks rated by approved rating agencies (good intentions, bad outcome). Ratings reform proposals today. Ratings reform proposals today.

72. Argentina (Cont’d) Subordinated debt is not occurring in a vacuum, but rather alongside other capital and liquidity rules, and other rules, that give market opinions power in the regulatory process. Subordinated debt is not occurring in a vacuum, but rather alongside other capital and liquidity rules, and other rules, that give market opinions power in the regulatory process. Problems with implementation of sub debt rule. Problems with implementation of sub debt rule. Lack of compliance penalized in theory, but not clear whether penalized in practice. Lack of compliance penalized in theory, but not clear whether penalized in practice. No clear regulatory actions (e.g., closure) required based on high yields or inadequate issuance. No public information on yields, amount, compliance. No clear regulatory actions (e.g., closure) required based on high yields or inadequate issuance. No public information on yields, amount, compliance. Not exempted from least-cost resolution. Not exempted from least-cost resolution. Arms length holding not enforced effectively. Arms length holding not enforced effectively.

73. Argentina (Cont’d) Still, there is evidence that sub debt helped Still, there is evidence that sub debt helped Low compliance was indicative of bank weakness, and central bank realized this, so it gave them a signal, but not one that the public had access to (so no discipline on regulatory forbearance). Source: Calomiris-Powell 2001. Low compliance was indicative of bank weakness, and central bank realized this, so it gave them a signal, but not one that the public had access to (so no discipline on regulatory forbearance). Source: Calomiris-Powell 2001. 1996-99 1996-99 1996-99 1996-99 High compliance Low compliance High compliance Low compliance R D 7% 8% R D 7% 8% NPL 14% 25% NPL 14% 25% Equity ratio 0.157 0.183 Equity ratio 0.157 0.183

74. Argentina (Cont’d) More generally, Argentina showed healthy signs of operating with prudent (old- fashioned) risk management. More generally, Argentina showed healthy signs of operating with prudent (old- fashioned) risk management. One indication of the effectiveness of the system is the fact that deposit growth rates reflect deposit risk, and that deposit risk is related to book measures of asset risk and equity capital. One indication of the effectiveness of the system is the fact that deposit growth rates reflect deposit risk, and that deposit risk is related to book measures of asset risk and equity capital. Another indication of effectiveness is that banks that experienced increases in their interest cost of debt acted quickly to reduce risk, and thus bring interest cost back down. Another indication of effectiveness is that banks that experienced increases in their interest cost of debt acted quickly to reduce risk, and thus bring interest cost back down.

75. Argentina (Cont’d) Dependent Variable: Quarterly Deposit Growth RegressorCoefficientStand.Error Eq Ratio (-1) 0.277 0.074 Loan Int. Rate -0.254 0.121 Loans/Cash -0.0032 0.0007 Sample period: 1993:3-1999:1 Number of Observations: 1,138 Adjusted R-Squared: 0.31

76. Argentina (Cont’d) Deposit Interest Rate Autoregression Dependent Variable: Quarterly Deposit Interest Cost RegressorCoefficientStand.Error R D (-1) -1.29 0.04 Adjusted R-Squared: 0.58 Number of Observations: 688

77. Broad Conclusions Safety net is major source of risk, market discipline is the ONLY credible mitigator of risk. Safety net is major source of risk, market discipline is the ONLY credible mitigator of risk. Market discipline is best introduced with an integrated approach that results in the creation, disclosure and use of credible information in the marketplace. Market discipline is best introduced with an integrated approach that results in the creation, disclosure and use of credible information in the marketplace. Government regulatory transparency is as important as government mandates for promoting market discipline. Government regulatory transparency is as important as government mandates for promoting market discipline. Market discipline is a complement, not a substitute for S&R (e.g., insider holdings). Market discipline is a complement, not a substitute for S&R (e.g., insider holdings).

78. Specific Recommendations Good ideas for bringing markets into S&R process: Good ideas for bringing markets into S&R process: Free entry, privatization of SOBs, limited safety net Free entry, privatization of SOBs, limited safety net Use of loan interest rate to set capital requirement Use of loan interest rate to set capital requirement Reform of credit ratings: numbers with penalties. Reform of credit ratings: numbers with penalties. Standbys abroad should substitute for cash reserves Standbys abroad should substitute for cash reserves BASIC Argentine system (except use of credit ratings) BASIC Argentine system (except use of credit ratings) Improve on Argentine sub debt to avoid back door bailouts, insider holdings, derivatives; to enforce public disclosure; and to establish prompt corrective action rules to limit forbearance in response to failure to gain market confidence (defined by market yields, flows on debt) Improve on Argentine sub debt to avoid back door bailouts, insider holdings, derivatives; to enforce public disclosure; and to establish prompt corrective action rules to limit forbearance in response to failure to gain market confidence (defined by market yields, flows on debt) Sub debt’s form can be flexible (e.g., two year maturity CDs held by banks abroad) depending on environment, and contingent capital certificates are an improvement on sub debt (discussed further below). Sub debt’s form can be flexible (e.g., two year maturity CDs held by banks abroad) depending on environment, and contingent capital certificates are an improvement on sub debt (discussed further below).

79. Cutting Edge Ideas CoCos Require on top of higher common/assets minimum requirement of 12%, a CoCo requirement of 10% of quasi market value of firm (face value debt +MVE) Require on top of higher common/assets minimum requirement of 12%, a CoCo requirement of 10% of quasi market value of firm (face value debt +MVE) Trigger must be credible, predictable, timely, and based on comprehensive view of bank. Trigger must be credible, predictable, timely, and based on comprehensive view of bank. Goldman proposes book value, but it is not credible or timely. Goldman proposes book value, but it is not credible or timely. Cumulative market value decline trigger would work (say, 40% from peak). Cumulative market value decline trigger would work (say, 40% from peak). Dilution risk would force voluntary preemptive issues of common stock ahead of triggers. Dilution risk would force voluntary preemptive issues of common stock ahead of triggers. Result would be that banks almost never go under. Result would be that banks almost never go under. Design Prompt Corrective Action (PCA) trigger based on similar cumulative value decline basis. Design Prompt Corrective Action (PCA) trigger based on similar cumulative value decline basis.

82. Macro Prudential Rules Macro prudential regulation that raises capital requirements during normal times in order to lower them during recessions. Macro prudential regulation that raises capital requirements during normal times in order to lower them during recessions. Additional macro prudential regulatory triggers that increase regulatory requirements for capital, liquidity, or provisioning as a function of credit growth, asset price growth, and possibly other macroeconomic risk measures. (Borio Drehman paper.) Additional macro prudential regulatory triggers that increase regulatory requirements for capital, liquidity, or provisioning as a function of credit growth, asset price growth, and possibly other macroeconomic risk measures. (Borio Drehman paper.)

83. Case Study: Colombia 2006-2008 Financial system loans annual growth rose from 10% in December 2005 to 27% by December 2006. Financial system loans annual growth rose from 10% in December 2005 to 27% by December 2006. Core CPI rose gradually relative to credit (from 3.5% in April 2006 to 4.8% in April 2007). Core CPI rose gradually relative to credit (from 3.5% in April 2006 to 4.8% in April 2007). Real GDP growth in 2007 was 8%. Real GDP growth in 2007 was 8%. Current account deficit rose from 1.8% GDP in second half of 2006 to 3.6% GDP in first half of 2007. Current account deficit rose from 1.8% GDP in second half of 2006 to 3.6% GDP in first half of 2007. Monetary authority reacted directly to credit growth in real time: Interest rates were increased 400 bps from April 2006 to July 2008. Monetary authority reacted directly to credit growth in real time: Interest rates were increased 400 bps from April 2006 to July 2008. But central bank saw too small a market response to this, so it But central bank saw too small a market response to this, so it increased reserve requirements for banks and increased reserve requirements for banks and convinced superintendency to raise provisioning for credit, convinced superintendency to raise provisioning for credit, imposed measures to raise costs of borrowing short-term from abroad (deposit requirement reactivated), and imposed measures to raise costs of borrowing short-term from abroad (deposit requirement reactivated), and limited not only currency mismatches of banks and other FX exposure in the system, but also gross currency positions (to avoid counterparty risks). limited not only currency mismatches of banks and other FX exposure in the system, but also gross currency positions (to avoid counterparty risks). Credit growth is now “only” 13%; risk-weighted capital ratio for banks is 13.9%, and first half 2008 is 4.9% above first half of 2007, expected to fall to about 3.5% for 2008 as a whole. Credit growth is now “only” 13%; risk-weighted capital ratio for banks is 13.9%, and first half 2008 is 4.9% above first half of 2007, expected to fall to about 3.5% for 2008 as a whole.

84. Fix Too Big To Fail CoCos for large banks probably will take care of much of the problem. CoCos for large banks probably will take care of much of the problem. Regulatory surcharge (which takes the form of higher required capital, higher required liquidity, or more aggressive provisioning) on large, complex banks. Regulatory surcharge (which takes the form of higher required capital, higher required liquidity, or more aggressive provisioning) on large, complex banks. Detailed regularly updated plans for intervention and resolution of large, complex institutions prepared by them, which specify how control the bank’s operations when transferred to a prepackaged bridge bank if the bank became severely undercapitalized. Detailed regularly updated plans for intervention and resolution of large, complex institutions prepared by them, which specify how control the bank’s operations when transferred to a prepackaged bridge bank if the bank became severely undercapitalized. Hybrid reliance on bankruptcy with special resolution authority triggered by credible determination of real systemic risk. Key problem: how to keep unwarranted resolutions from happening? Hybrid reliance on bankruptcy with special resolution authority triggered by credible determination of real systemic risk. Key problem: how to keep unwarranted resolutions from happening?

85. Aftermath of crises Does crisis tend to lay groundwork for more or less liberalization? Does crisis tend to lay groundwork for more or less liberalization? It can go either way, depending on domestic political environment (Mexico, East Asia and Brazil vs. Argentina) It can go either way, depending on domestic political environment (Mexico, East Asia and Brazil vs. Argentina) How to deal with massive insolvencies? How to deal with massive insolvencies? There are many possible mechanisms There are many possible mechanisms Liquidation via market (but adverse selection problems, legal system and information limits) Liquidation via market (but adverse selection problems, legal system and information limits) AMCs a solution? No, since they also must liquidate, and same problems plague them; also corruption plagues them, much more than in U.S. or Scandinavia. AMCs a solution? No, since they also must liquidate, and same problems plague them; also corruption plagues them, much more than in U.S. or Scandinavia. Creative solutions that work with market incentives (Punto Final program in Mexico) Creative solutions that work with market incentives (Punto Final program in Mexico) Assistance to recapitalize banks (RFC vs. Japan) Assistance to recapitalize banks (RFC vs. Japan) Foreign entry of banks to speed reestablishment of credit. Foreign entry of banks to speed reestablishment of credit. Debt moratorium (cultura de no pago in Mexico) Debt moratorium (cultura de no pago in Mexico) Debt redenomination (Argentina; U.S. precedents) Debt redenomination (Argentina; U.S. precedents)

86. US Bank Assistance in 1930s vs. Japan ’ s in 1990s (w/ Mason) US Banking problems US Banking problems Real shocks, not runs (until 1933) (Calomiris- Mason 2003a) Real shocks, not runs (until 1933) (Calomiris- Mason 2003a) Market discipline  Capital crunch (Calomiris- Wilson 2004) Market discipline  Capital crunch (Calomiris- Wilson 2004) Depositor preferences (active vs. passive) Depositor preferences (active vs. passive) Loan supply contracts Loan supply contracts Dividends cut Dividends cut Large adverse macroeconomic consequences of credit contraction (Calomiris-Mason 2003b) Large adverse macroeconomic consequences of credit contraction (Calomiris-Mason 2003b) Asset market illiquidity problems, too, from liquidation of bank assets, which slowed resolution Asset market illiquidity problems, too, from liquidation of bank assets, which slowed resolution

87. US in 1930s (Cont ’ d) Policy Response Policy Response RFC lending (inadequate) RFC lending (inadequate) RFC preferred stock begins in 1933 RFC preferred stock begins in 1933 Selective: Targeting marginal banks, field office autonomy seems to have limited abuse Selective: Targeting marginal banks, field office autonomy seems to have limited abuse Limits behavior: Dividends, capital, voting on management issues; Regression evidence suggests that RFC conditionality mattered Limits behavior: Dividends, capital, voting on management issues; Regression evidence suggests that RFC conditionality mattered Seems to be effective, reduces failure risk Seems to be effective, reduces failure risk

88. Comparison RFC Recipients Non-Recipients Fail Prob ’ 310.1470.096 Fail Prob ’ 340.0110.004 Div Pay ’ 340.0010.008

89. Japan in the 1990s Little deposit market discipline Little deposit market discipline Convoy system spreads assistance Convoy system spreads assistance Dividend payments to common stock remain large (liquidity for Keiretsu firms) Dividend payments to common stock remain large (liquidity for Keiretsu firms) Banks do not have to accumulate additional capital to get assistance Banks do not have to accumulate additional capital to get assistance Assistance seems to have had no effect on failure risk or lending, and NPLs have grown over time Assistance seems to have had no effect on failure risk or lending, and NPLs have grown over time

90. What might have worked better? Conditional Assistance Conditional Assistance Dividend limits Dividend limits Capital plan with matching requirement (note that this is self-selecting) Capital plan with matching requirement (note that this is self-selecting) Introduce Market Discipline in Regulation Introduce Market Discipline in Regulation Minimum sub debt or other uninsured debts Minimum sub debt or other uninsured debts Interest rate-sensitive capital requirements Interest rate-sensitive capital requirements High reserve requirements, but allow offshore SLOCs in lieu of reserve requirements High reserve requirements, but allow offshore SLOCs in lieu of reserve requirements

91. Debt redenomination: US in 1860s, US in 1930s In both cases, this was a convenient way of using the change in numeraire of debt to restore net worth of banks and borrowers. In both cases, this was a convenient way of using the change in numeraire of debt to restore net worth of banks and borrowers. Civil War: legal tender acts saved banks after shock of December 1861 by making bank liabilities decline with bank assets (govt. bonds). Civil War: legal tender acts saved banks after shock of December 1861 by making bank liabilities decline with bank assets (govt. bonds). Great Depression: elimination of gold clauses actually increased values of bonds, implying that effect on default premium outweighed effect on face value. Great Depression: elimination of gold clauses actually increased values of bonds, implying that effect on default premium outweighed effect on face value. Key advantages: speed, no reliance on institutional quality. Key advantages: speed, no reliance on institutional quality.

92. Argentina ’ s Redenomination 2002 Does same logic apply to Argentina 2002? Does same logic apply to Argentina 2002? Fiscal crisis leads to arm twisting of banks to buy bonds, then eventual collapse of banks and exchange rate. Fiscal crisis leads to arm twisting of banks to buy bonds, then eventual collapse of banks and exchange rate. “ Pesification ” of debt could provide relief to borrowers, especially high dollar debt firms in non-tradables sector. “ Pesification ” of debt could provide relief to borrowers, especially high dollar debt firms in non-tradables sector. Asymmetric aspect of pesification hurt banks and had clear political element, but we can conceptually separate it from pesification. Asymmetric aspect of pesification hurt banks and had clear political element, but we can conceptually separate it from pesification.

93. Argentina (Cont ’ d) Argentina ’ s peculiar vulnerability to devaluation Argentina ’ s peculiar vulnerability to devaluation Investment evidence Investment evidence Stock market reactions Stock market reactions Conclusion: There seems to have been a significant positive effect on market and on non-tradable producers with high dollar debt exposures. Conclusion: There seems to have been a significant positive effect on market and on non-tradable producers with high dollar debt exposures. Net benefit? Net benefit?

94. Figure 1C: Reinhart-Rogoff-Savastano Composite Dollarization Index Level vs. Exports-to-GDP Ratio for Reinhart-Rogoff-Savastano’s Fifty Highest Dollarized Countries

95. Non-Tradable Firms Tradable Firms Mexico Mexico MeanFirms Std. Dev MeanFirms High- Dollar Debt Firms 0.071170.06690.1460230.1460 Low- Dollar Debt Firms 0.1625280.21410.1224250.0893 Dif-0.0914 0.0236 T-Stat-1.9155 0.6695 Pr(Dif ≥ 0) 0.0324 0.7463

96. Non-Tradable Firms Tradable Firms ArgentinaMeanFirms Std. Dev MeanFirms High- Dollar Debt Firms 0.072460.09590.181770.1579 Low- Dollar Debt Firms 0.064450.03970.215570.1537 Dif0.0080 -0.0339 T-Stat0.1862 -0.4069 Pr(Dif ≥0) 0.5712 0.3456

97. DDA t-1 -0.1449-1.79 (0.0809)0.076 DDA t-1 x ARG 0.21921.63 (0.1346)0.106 TR x DDA t-1 0.12421.21 (0.1029)0.230 TR x DDA t-1 x ARG -0.2684-1.64 (0.1638)0.104

98. EVENT STUDY Dependent Variable Cumulative Raw Returns Cumulative Abnormal Returns Independent Variables Coefficient (Std. Error) T-StatP>|t|Coefficient T-StatP>|t| TR0.15613.820.12492.37 (0.0409)0.001(0.0528)0.026 DDA t-1 0.24472.330.34732.56 (0.1051)0.028(0.1356)0.017 Constant-0.0255-0.49-0.0959-1.42 (0.0524)0.631(0.0676)0.168 Regression Statistics Observations2929 R2R2R2R20.40700.2912 Adjusted R 2 0.36130.2367 Root MSE 0.1009 0.1301