Responses to financial crises typically involve three phases (see Reinhart and Rogoff 2009, Ingves et al. 2009, Honohan and Laeven 2005, Hoelscher and Quintyn 2003, Dziobek and Pazarbasioglu 1998).
- • First, containment, to deal with acute liquidity stress and to stabilise financial liabilities.
- • Second, resolution and balance-sheet restructuring, which involves removing insolvent financial institutions from the system and recapitalising viable ones.
- • And third, operational restructuring to restore the financial soundness and profitability of viable institutions and asset management to rehabilitate non-performing loans.
How do the policy choices in the current crisis compare to those made in past crises? And what does it mean for the recovery prospects going forward? This is obviously a much debated issue (e.g. Eichengreen and O’Rourke 2010). To shed light on the issue, in a paper with a team of colleagues at the IMF (Claessens et al. 2010), we compare the policy choices in a number of recent crisis countries with those made in past crises. We show that the recent crises followed the usual pattern through the first phase, but subsequent policy responses have been less forceful, at least for the major countries. Acknowledging the unique and global nature of the recent crisis and varying country circumstances, our analysis suggests that the diagnosis and repair of financial institutions and overall asset restructuring are much less advanced than they should be at this stage.
In term of overall approaches and the timing of policy interventions, Figure 1 depicts the evolution of liquidity support and the timing of guarantees and recapitalisations by governments around the onset of crises. As in past crises, liquidity support and guarantees were deployed in the early stages, although more extensively relative to GDP. Compared to the past crises, however, these interventions were soon followed by across the board recapitalisation of financial institutions in many countries.
Figure 1. Change in claims of central banks on deposit taking institutions (in % of GDP)
Furthermore, expansionary and unorthodox monetary policies were used much more intensively and broadly during the recent crises to support banks and markets (Figure 2). And accommodative fiscal policies were important in maintaining aggregate demand and asset values, thus indirectly supporting financial institutions.
Figure 2. Monetary and fiscal policies during crises
After these general and accommodative interventions, our analysis shows that policy approaches in the recent crises became less forceful than those typically followed in the past. In particular, progress with comprehensive operational restructuring of financial institutions and assets has been much slower. Comparing the frequency of policies used shows that in particular asset-management companies, used to take non-performing assets from banks’ balance sheets, were much less used, while asset guarantees, which leave assets on banks’ balance sheets, were used much more. Together, this means that the necessary asset restructuring is left much more to the banks than in past cases.
So far, the direct fiscal support of the various interventions has been lower than in past crises, averaging about 5% of GDP as of end-2009, against 15% for past crises (see Figure 3). In greater part due to large fiscal expansions, however, the broader fiscal costs have been larger than in past crises, with projected increases in debt for the four-year period after the onset of the crisis higher for the recent crises (about 25% of GDP) than for past crises. These increases come on top of the already large public debt burdens in many advanced countries. And while output losses have been lower than in the past, they are still very significant, and have been shared globally.
Figure 3. Cost of recent and past crises (medians, in % of GDP)
The risk of things to come
Assessing the current state of financial and operational restructuring and institutional reforms, our analysis suggests that there may be higher costs in the years ahead and that moral hazard has increased. While the complexity and severity of the recent crisis justified the rapid and unprecedented response to contain risks and restore confidence, and mitigated the real effects of the crises, it did not lead to the deep restructuring needed. In particular, the policy mix chosen precluded thorough due diligence of financial institutions, and reduced incentives to restructure assets. The risk is that, instead of a policy of triage, diagnosis-based resolution, and early asset restructuring, a muddling-through approach prevails.
This approach, including accounting and regulatory forbearance, guarantees, and implicit public support stalls addressing nonviable banks and non-performing assets. Consequently, vulnerabilities in the global financial system remain considerable and continue to threaten the sustainability of the recovery. This points to a number of steps to finish the business of financial sector repair and reform.
- Establishing the long-term viability of the financial system requires recognising non-performing assets at financial institutions and a deeper operational restructuring of debts of enterprises and households. Regarding the persistent weaknesses in bank balance sheets, in-depth diagnoses still need to be conducted, including through strict and transparent stress tests. When the diagnoses call for credible recapitalisation plans or restructuring of liabilities, they should be carried out swiftly in ways that do not worsen sovereign debt burdens. Conditions in some countries require government interventions, including targeted programmes to alleviate debt overhangs in the household and commercial real-estate sectors. More broadly, asset restructuring needs to be driven by market forces, supported by tighter regulations –including in the areas of loan-loss classification, provisioning, and disclosure – and enhanced supervision.
- In most countries, more effective resolution tools are required to preserve financial stability in an increasingly complex and interconnected global system. Since the crisis, several countries have adopted more effective resolution schemes for large financial institutions, which should allow future losses to be borne by uninsured creditors rather than by taxpayers. But many countries still lag in this respect, including in how to allocate losses. The new resolution schemes remain untested to deal with failures of nonbank financial institutions that are of systemic importance and of large cross-border institutions, and much more needs to be done to enhance the supervision of cross-border exposures and related risks.
- The policy mix applied in the recent crisis has greatly intensified moral hazard. Confidence in financial systems is still highly dependent on explicit and implicit central bank and government support. Moral hazard has increased, in part as sectors have become more concentrated, while financial systems are still prone to stress and turmoil. Measures are needed to restore proper incentives and market discipline. Governments need to rethink how to reduce the threat that large financial institutions pose to systemic stability, including through reduced complexity, better capital structures, and, possibly, restrictions on their scope and activities.
- The policy mix applied in the recent crisis is unlikely to be repeated in response to a future crisis. It would be too costly economically and too controversial politically. In preparing for a future crisis, therefore, policymakers must consider how to apply the constructive aspects of the recent response – early stabilisation through accommodative policies – and improve the areas in which it was weakest – the limited conditionality of public support and the gradual restructuring of assets.
This column represents the views of the authors and does not necessarily represent IMF views or IMF policy. The view expressed herein should be attributed to the authors and not to the IMF, its Executive Board, or its management.
Claessens, Stijn, Ceyla Pazarbasioglu, Luc Laeven, Marc Dobler, Fabian Valencia, Oana Nedelescu, and Katharine Seal (2011), “Crisis Management and Resolution Policies: Early Lessons from the Financial Crisis”, Staff Discussion Note 11/05, IMF.
Eichengreen, Barry and Kevin H O’Rourke (2010), “A tale of two depressions: What do the new data tell us?”, VoxEU.org, 8 March.
Dziobek, C and C Pazarbasioglu (1998), “Lessons from Systemic Bank Restructuring”, Economic Issues Paper, 14, IMF.
Hoelscher, D, and M Quintyn (2003), “Managing Systemic Banking Crises”, IMF Occasional Paper 224.
Honohan, P, and L Laeven (eds.), 2005, Systemic Financial Crises: Containment and Resolution, Cambridge University Press.
Ingves, S, G Lind, M Shirakawa, J Caruana, GO Martinez (2009), “Lessons Learned from Previous Banking Crises: Sweden, Japan, Spain and Mexico”, Group of Thirty, Occasional Paper 79, Washington DC.
Reinhart, C, and K Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press.