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How to contain banking crises

Governments in emerging markets have spent $250 billion bailing out banks in the past decade. How can the industrial countries help stop the haemorrhage and any knock-on into their own markets? By imposing worldwide rules for better supervision, building markets and institutions in their own image, or by letting free markets do their work? James Smalhout reports.

Lax financial supervision in emerging markets can cost lives. "They're killing people in Albania right now because of a failure in financial regulation," says deputy US treasury secretary Larry Summers. Less dramatic than the Albanian pyramid savings debacle but equally troubling to the financial world and overstretched national budgets have been such events as the Mexican peso crisis, the collapse of Barings and lesser fiascos involving emerging market banks.

The IMF reported last year that more than 130 countries had experienced significant banking problems since 1980. Cleaning up the mess has cost more than 20% of GDP in some Latin American countries. It's estimated that emerging market governments have paid out more than $250 billion bailing out banks during the past 10 years. These problems seem bound to last for at least another decade. "The financial sectors, particularly the banking systems, in developing countries today are quite fragile," says Jonathan Fiechter, the World Bank's director of financial sector development. "I worry that development agendas will come to a screeching halt, particularly in countries that depend on capital inflows from abroad."

Local banking systems in emerging economies - a key link in cross-border capital flows - remain insular and backward, in many cases having been protected from foreign competition until recently. The arrival of strong foreign competitors and macroeconomic volatility - external and domestic - is expected to produce a stream of insolvencies.

It took the Mexican crisis to make G-7 officials take much note of banking problems outside their own countries. They first discussed them at the Halifax summit two years ago. Then in Lyons, last year, they directed finance ministries and central banks to come up with proposals for emerging market banking supervision in time for this month's Denver summit.

The G-7's own domestic regulatory systems are not without blemish - the Barings crisis, for example, may have involved developing-country markets but it was developed country supervision that ultimately was at fault. Nevertheless, three big studies that appeared in April - from the Basle Committee on Banking Supervision, the G-10 deputies (deputy finance ministers and senior central bank officials) and US academic Morris Goldstein - pick up on the call for closer supervision of developing-world financial systems. Issues raised in these reports are likely to be given serious attention in September at the World Bank and IMF annual meetings in Hong Kong.

Goldstein, a scholar at the Institute for International Economics in Washington, is reckoned to have prodded the international community towards considering a common approach. According to IMF deputy managing director Stanley Fischer: "The Basle committee [on banking supervision] initially told the IMF representative that a standard applicable beyond the G-10 [the largest industrial countries] would take about 10 years to develop and adopt." Fischer credits Goldstein with "mobilizing immobilizable institutions with a speed not seen in recorded history".

The Basle committee managed by April to produce a consultative draft entitled "Core principles of effective bank supervision". It should be finalized by September. Patrick Honohan, research professor at Dublin's National Economic and Social Research Institute, explains the initial hesitation, pointing out that "industrial-country bank regulators - who made up the Basle committee until recently - had put together a very complex package, politically speaking".

The current Basle capital standards balanced various national traditions and approaches to bank supervision. They set out a number of rules that did little violence to any of the traditions but provided a workable set of formulas for supervising international banks on a common basis. Were that model to be revised and extended to emerging markets there would be a risk of unpredictable problems being raised. The committee feared the earlier Basle agreement would be destabilized.

But there were also compelling reasons for the committee to act. The Bank for International Settlements - which provides a secretariat for the Basle committee - was interested in preserving its role after the creation of a European central bank. Meanwhile Bank supervisors worldwide were looking to the Basle committee for guidance. Then there was also a lot of pressure from the G-7 and the IMF. According to one official: "Members of the committee were told in no uncertain terms that if they wanted to become the pre-eminent body for bank supervisors worldwide they had to get going."

Universal agreement

The mix of caution and urgency meant the Basle committee produced another delicately balanced and politically complex report - on which there could be near universal agreement. Some observers describe it as mild. Others dismiss it as platitudinous. Others are puzzled by it. Roger Taillon, managing director for financial institutions ratings at rating agency Standard & Poor's, says: "It's a good start. But I wonder whether all of the supervisors who were involved in drafting the Basle report really subscribe to the overriding principles at the very beginning." (These set preconditions for effective supervision including clear responsibility, legal authority to address safety and soundness concerns, and operational independence.)

Goldstein is urging the Basle committee to strengthen the "core principles". He wants mechanisms built into them that reduce government involvement in the banking system. He also thinks American-style rule-based corrective action that is promptly applied needs emphasis. And he wants more specific guidelines for accounting, disclosure and provisioning. Finally, Goldstein faults the initial proposals on monitoring compliance - he is sceptical about the Basle committee's intention to conduct a survey by mail every two years that will rely on bank supervisors to rate their own systems.

Hard on the heels of the Basle committee report, the G-10 deputies released a broader study of principles for strengthening emerging market financial systems. These two projects are linked for one simple reason: the Basle committee is officially a G-10 group. Hal Scott, Nomura professor of international financial systems at the Harvard Law School, praises the G-10 report. "It focused on financial systems rather than just on banks," he says. "This is particularly important when everybody tells us that the world is moving from banking to capital markets. Another aspect of crisis prevention involves the payments system. The G-10 report gives some attention to that. It's promoting good practices. It's not an international banking standard. I have no problem with it because I don't think that it's coercive."

That places Scott at odds with Goldstein. Goldstein helped get the debate going, first with his papers and then with his recent book, The case for an international banking standard. A Goldstein-style international banking standard would cover a long list of activities including deposit insurance, bank licensing, internal controls and money-laundering. Goldstein's standard would be voluntary, but countries would formally sign up if they intended to comply with it. In that sense, it goes much further than the Basle committee and the G-10. These propose only to preach sound practice. Market observers who hold to Scott's view think the minute the first country signed up to a Goldstein-style standard, it would become coercive for every other country.

Liliana Rojas-Suarez, an economist and banking specialist at the Inter-American Development Bank, takes a different tack. "The most important contribution of these reports," she says, "is that they validate the role of supervisors in emerging markets." She complains: "Supervisors there do not have enough independence in many cases. These reports bring emerging markets to the forefront of discussion and will allow supervisors to have more autonomy. That will be extremely welcome."

But Rojas-Suarez also points to the difficulty of applying regulations, for example in Latin America. "There are features of developing countries that are not taken into account," she says. "A key difference between industrialized and developing countries is that the markets for bank stocks work in industrialized countries. They support the regulators by pushing the banks into self-correction. You need to understand that property is very concentrated in Latin America. Wealth is in the hands of a small number of people. That by itself is a constraint for the development of capital markets. There is not enough in these reports that would lead to improving the effectiveness of regulations."

Other observers point to the difficulty of creating an environment in which banks will behave responsibly. Charles Calomiris, a professor at Columbia University and previously a Federal Reserve economist, argues that successful handling of the moral hazard of deposit insurance needs either close regulation or a laissez-faire approach that relies on market forces to control aberrant behaviour.

The first approach involves regulators limiting the risks banks can assume. In theory, formulas like the Basle capital standards will then work - in theory, because this demands that regulators behave honestly.

Calomiris leans to the second approach - allowing banks flexibility in what they can do. "The world is a globalized universal banking system," he says. "There's lots of synergies and efficiency gains from allowing that globalization, from allowing activities across products, and from allowing banks to conduct highly sophisticated hard-to-penetrate operations in derivatives and in other areas."

But with that approach it's hard to set regulatory benchmarks, such as capital ratios, that will provide effective discipline. Calomiris therefore thinks banks must issue subordinated debt to guarantee that market forces are brought to bear by those most likely to lose out if banks get into difficulties. "There is no alternative to bringing in someone with money on the line and who doesn't gain from the upside of taking risk the way a stockholder does," he argues. He persuaded the Argentine government to this way of thinking. It passed a law that required banks to issue subordinated debt late last year. Chile, by contrast, has attempted a rigorous application of the conventional model of regulation.

Wrong turn

Calomiris thinks the Basle committee, the G-10, Chile and the US FDICIA and FIRREA laws took a wrong turn. His experience tells him regulators can't be trusted. Second, he points out, it's no longer smart to restrict banks.

Rumblings against deposit insurance and moral hazard are also coming from the World Bank. As Gerard Caprio, a senior economist there, sees it: "The real challenge for developing countries is that they're rushing to adopt safety nets of one sort or another. How do you deal with this where the institutions aren't quite ready?" Banking losses in developed economies have been smaller - relative to their size - than in developing countries because many developing countries don't yet have the necessary rules, laws, regulations and human skills. These take some time to acquire.

Caprio notes that the Basle committee, G-7, G-10 and Goldstein reports "say that we should go full speed ahead at changing the institutions in developing countries in order to limit the losses involved with the safety net". They don't, he says, question whether there should be a safety net and don't analyze how long it will take to improve the institutions. Implicitly they assume significant institutional reform can be made in a relatively short time, say, five or 10 years. Caprio believes more attention should be given to markets and less to safety nets.

Ernest Leung, president of the Philippine Deposit Insurance Corporation, says: "I think the best system is the current one in New Zealand. They don't have a deposit insurance safety net. Instead, the high standard of audited financial statements and quality of disclosure make factual verification by regulators redundant. I was riding around Auckland in a bus and ended up talking to the driver about monetary policy and the financial statements of banks. Here was an ordinary New Zealander who actually looks at the financial condition of banks. So you have a situation where you have empowered people with knowledge to protect themselves."

Leung stresses that regulation by the market can work only if there is institutional backing for it, and this is as unlikely to develop quickly as is the institutional backing required by a safety-net system. "It can work only if you have an audit industry whose professionalism and integrity is unquestionable," he says. "Our accounting profession try their best, but they're not yet there. Our regulators are trying as well. So, you must compensate with a safety net for those people who have no way to know better." When market information is no longer so deficient, he argues, a move away from the safety net can be made.

But studies prepared for the World Bank warn that it's easier to adopt a deposit insurance system than it is to set up a regulatory and incentive environment in which only small losses occur. Pressure can also build to expand small-scale deposit insurance programmes into large-scale systems. There's a down-side to this - researchers at the World Bank and elsewhere have found unambiguous evidence that explicit deposit insurance systems raise the probability of banking crises.

Despite this tendency, the G-10 report urges countries to set up deposit insurance for small depositors and to include an element of co-insurance. "There is always a problem when you get people from major institutions doing reports of this sort," notes one observer. "They're not going to goof and recommend something that's out of the mainstream. That can be dangerous when it's not clear that the mainstream is all that good."

Summers at the US treasury recognizes the problem: "Both globally and within countries the most difficult dilemmas involve moral hazard... I think that the best available experience points toward the desirability of controlling safety nets combined with increased reliance on market discipline. Industrial country bank regulation has increasingly moved in these directions. But I think that mantra takes you only so far when commitments have been made in the past or when institutions are involved that are central to the economies of particular countries."

Such commitments include governments using state funds to recapitalize troubled banks, a temptation that's hard to resist. A better approach to such problems, many bankers would argue, is globalization and open entry, which can provide useful role models. "I think that international banks and other private market participants from abroad can play a very important role by establishing themselves in developing countries," says Tom de Swaan, a director of the Dutch central bank and chairman of the Basle committee. "They can show that living by the core principles - which are used effectively in their home countries - improves their financial health and raises their international standing. Their presence can serve as proof that supervision is there to help banks."

Governments also need to let some banks fail, as the Basle committee points out. Estonia decided to let depositors bear losses in order to reduce the burden on the state. In some cases, new owners can inject capital into institutions that survive, but they may have limited ability to create the conditions that will enable banks to retain and expand that capital. Many countries therefore need to restructure their economies far beyond the banking sector. Otherwise, recapitalizing the banks can become the equivalent of flushing money down the drain.

Development issue

"We're not in Kansas any more. Developing countries are underdeveloped," says Caprio "It's not a matter of a policy trick or two. It's a development issue. The institutional settings are very different from industrial countries. The measures that will work to improve the safety and soundness of the banking system really must be tailored to the circumstances found in those countries."

Summers is impressed with the "three-pillar architecture" for monitoring and surveillance that is emerging - involving the Basle committee or comparable international regulatory bodies, the IMF, and the World Bank and regional multilaterals.

De Swaan expects that "the Basle committee will remain deeply involved for the foreseeable future. We will keep looking at possibilities to refine the core principles. We will assist by interpreting the principles, particularly when countries that did not participate in setting them up come to us with specific questions. And we will commit time and money in order to improve the skills of people employed by bank supervisors in developing countries. Finally, there will be presentations of the core principles at the annual meetings in Hong Kong and at various regional gatherings of supervisors during the next year or so."

And the IMF? Summers says it should play a role in monitoring financial policies because international financial stability is its central mission. The IMF has a unique ability to keep tabs on these situations as part of its annual Article IV consultations with member countries. Meanwhile, the World Bank and the regional development banks will emphasize technical help and financial sector lending.

The World Bank's Fiechter doubts the process will be so clear-cut. He says: "I'm not certain how much success we'll have in terms of assigning one institution or another a specific obligation that would apply to all emerging markets."

Harvard's Scott - Summers' former colleague - worries that international agencies that are "not that expert in bank supervision" could one day assume a role that relied on threats and sanctions. "If we're going to have standards," he says, "the people who are formulating them should enforce them. They are the people who are going to know what they mean and they are the people who can enforce them with some feel for how they should operate in particular circumstances."

Caprio sums up the prevailing view at the World Bank. "Financial reform is a process, not an event," he says. "This is not a matter of coming up with a way to reform the financial systems in developing countries. It's a matter of developing those financial systems. That doesn't happen with the stroke of a pen or the publication of a book."

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