Banking Crisis and Its Management Tony Latter

7/31/2019 Banking Crisis and Its Management Tony Latter

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Banking Crisis and its

Management

Causes and management of Banking

CrisisTony Latter


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Introduction

Continuous banking crisis one after another

IMF estimate: Since 1980, 130 countries facedbanking crisis and 30 to 40 are still facing it

Cost to government budgets is significant USA: 2 to 3 % of GDP

Nordic countries: 2 to 8% of GDP

Spain: 17% of GDP Hungary: 10% of GDP

Mexico: 12 to 15% of GDP


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Introduction

According to IMF estimate during 1996 bad

debts of transitional economies ranged

between 14% to 65% of total assets.

Inadequate provisioning.

Low capitalization than what is recommended

by Basle.


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Introduction

Real costs:

Direct costs incurred in resolving the crisis

Welfare losses in the economy as a whole

Administrative costs

Diversion of macroeconomic policy

Efficiency (Survival of fittest) Vs Crisis

management

Benefits of resolving crisis outweighs costs


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The structural context

Banking has evolved differently in differentcountries.

E.g. USA and Japan have fragmented banking

systems both geographically and functionally Consolidated banking systems (Geographically and

functionally) in most European countries

State owned banks in many developing countries

and former communist economies. Developing countries: Large number of small

banks due to liberalization. Many of these failed.


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The evolution process is bound to continue

Majority of the countries are committed to market

economy now.

Interference of state has reduced in affairs of

banks and would reduce further.

Rapid technological development is continuing.


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What distinguishes a bank

Is it primarily a provider of credit?

Credit is available from other sources too

Suppliers

Retailers

Capital markets

Deposit taking distinguishes a bank from otherproviders of credit


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Deposit taking by banks

Unsecured

Element of trust

Maturity transformation Credit may be for a longer period

Deposits are usually for a short period

Deposits constitute money and at maturity are

used to settle payments related to transactions

Banks therefore find themselves at the centre ofpayment system


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Central banks retain some sort of supervision

Co-location of following responsibilities

Liquidity management of banks

Money market operations

Liquidity support for a troubled bank

Role of consumer protection and systemic

stability overlaps for a central bank Private deposit insurance may exist

Banking authorization from central bank required


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Scope and structure of banking Definition of banking business

Accepting deposits

Services for payment and foreign exchange

Trade finance

Personal loans

Long term investments (Depend on ability of the bank

to procure long term deposits) Other activities:

Securities trading, brokering, underwriting, funds

management, Corporate finance, Insurance, financial advice


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Factors to be considered while allowing range

of activities to be performed by banks

Management of financial risk

Reputational risk and contagion

Competition in banking

Social policy

Industrial policy


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Management of Financial Risk

Diversification may reduce risk. It mayincrease risk if new areas are more risky

Emergence of highly sector specific banks.

Restriction on these banks to move tosecurities business or investment banking

Not allowing banks to own companies outside

banking sector. Not allowing to invest depositors money in

equities (Exception: Germany)


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Management of financial risk

Reputational Risk

Diversification beyond banking

Non banking groups establishing into banking

Transitional economies: non banking groups have tiesto banks

Central bank may like to insulate banking from these

non banking groups. Trouble in one non banking group

company may spread to related bank.


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Reputational Risk and Contagion

Additional capital may be required

Run on the bank

Any non banking group concern faces problems

Separately capitalized subsidiary

Reputation must be protected

Cause may be actual weakness or

Bad publicity Eg Deutsche Banks subsidiary Morgan Grenfell in UK.

Three of its funds were recapitalized


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Competition in Banking

Some countries prefer competition in banking

others not. Results are mixed

US

Less competition to protect local banks.

Geographical or industry specific banks e.g.

mortgage and loan associations etc.

Country wide expansion of large banks wasrestricted in US. Many small regional banks and

savings and loans associations failed in 1980s


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UK

Gains in efficiency from economies of scale andcompetition.

Europe State owned banks and sovereign guarantees may

slow progress

Developing and transition economies

Fear of too much competition resulted in barriers onentry for foreign banks. However, these restrictionshave since been reduced due to Uruguay Round


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Banking is more efficient in those countries

where there is competition

E.g. UK is a leading financial centre due to this


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Social Policy

Government may participate or intervene inthe banking sector

To provide services to whole community

Should be transparent and constitutional Undue pressure on other banks should not be

made

Govt. may provide services to all citizens which

otherwise would not be available to them.

Encroachment into other banks areas andcompetition with them should be resisted


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Industrial Policy

In some banks there is dearth of financing forlong term projects

Banks may consider such projects unviable or

poor credit risk Moreover, maturity transformation is another

problem

Government intervention may be necessary insuch case (In the form of financing suchprojects)


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Specialized banks

To solve problems stated in social andindustrial policy specialized banks may becreated.

Types of specialized banks Banks which decide on their own to concentrate

on a specific area.

May be very profitable however profitability is volatile

Banks which are created specifically for aparticular purpose

They have restricted authorization


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Specialized banks

Saving banks

Secured heaven for household savings

Created due to social policy reason

Banking failures in several advanced economies weredue to

Losses to small savers

Large call on public funds or deposit insurance

Narrow banks Limit on size of deposit

Constrained in deployment of assets

Low interest rates and strong security. Govt. backed.


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Specialized banks

Narrow banks

People may deposit in these banks during

recession and may take them away during

economic boom A more generous deposit insurance may result in

bias against other banks

Government should be cautious in this direction


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Specialized Banks

Industrial Development Banks

Formed to promote long term capital formation

Market forces and prudent banking does not allow

such financing. Therefore specialized banks areestablished for this purpose

Dangers

Unadvantageous terms for deposits

Misdirected resources

Overall losses that would eventually be borne by community

These services must be provided in a transparent way


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Causes of Banking Crisis

Macroeconomic circumstances

Collapse of asset prices (including real estate)

Inappropriate macro policy

Reckless banking decisions Sharp increase in interest rates

Fall in exchange rates

Sudden slowdown in pace of inflation Shift in prices

Removal of subsidies


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Causes of banking crisis

Macroeconomic circumstances

Banks should be able to absorb macroeconomic

shocks up to a reasonable extent

Macroeconomic conditions should generally notbe considered an scapegoat for bank failures

A sharp monetary squeeze necessitated by a

deteriorating monetary condition may result inbanking failure Mexico.


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Microeconomic Policies

Does every bank failure represent supervision

failure by Central Bank? No. Why?

A shortcoming in a bank may escape supervisionin the first place

Supervision should not be so tight to repress

banking and make it uncompetitive.


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Inadequate infrastructure

This is not the sole reason for a banks failure

Shortcoming in accounting and auditing may hide

and delay problems of insolvency and illiquidity

Shortcomings in legal infrastructure may inhibit

exercise of property rights or pledging and

realization of collateral against bank loans


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Government Interference

Directives or pressure to lend to a particular

customer at preferential interest rates

Maintain or extend uneconomic branch network

Imposition of large reserve requirement bearing

sub market interest rate

Obligation to fund state deficit at nonremunerative terms


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Moral Hazard

General expectation that banks will not beallowed to fail or financial support will readily be

available in troubled times. Banks may be tempted into morally incorrect

behaviour

Depositors will not distinguish between good and

bad banks It may prolong survival of banks but it may also

magnify the crisis when it breaks


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Banking Strategies and Operations

Failure of Strategy

In many cases problems have been brought aboutby shortcoming of its own strategy

Question: How much should supervision beallowed to interfere?

Strategies are good or bad on a post fact basis

Rush to expand in new product or geographical

areas Failure to rationalize staff, new management

culture, IT advancement


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Operational failure

Poor credit assessment

Single most common cause of banking failure

Economic growth and concentration of a bank to

expand balance sheet Rigorous credit assessment takes secound place

Subsequent problems are severe

Lesson: New business is worth booking if it is good

business

Appropriate pricing of risk


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Operational failure

Interest rate or exchange rate exposure

These may result in losses which should be limited

by internal or supervisory controls

Sharp shift in macroeconomic policies may resultin losses beyond normal tolerance level


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Operational failure

Concentration of lending

Specific customers or particular sectors

Such concentrations a source of problems for

banks and should be avoided

Ceiling on loan concentration should be defined


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Operational failure

Unauthorized trading or position taking

associated with failure of internal controls

Increasingly worrying source of banking losses

Examples: Barings, Jardine Flemming, Morgan

Grenfell, Daiwa

$ 3 Bn losses in copper market by one trader of

Sumitomo Corporation


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Operational failure

Other operational failures

Poor quality of staff or low experience due to high

turnover or too rapid expansion

Deficient management structure with insufficientclear lines of oversight and responsibility

Inability or reluctance to control cost

Reward structure that encourages excessive risk taking

Inadequate documentation, records and audit trails

Over reliance on IT system

Absence of contingency plans for emergencies


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Fraud and Corruption

Major frauds perpetrated by the management

Frauds perpetrated by one or two individuals

Lack of internal controls

Unauthorized trading or position taking


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4. ACTIONS TO PREEMPT ORRESOLVE BANKING CRISIS


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Actions to preempt or resolve banking

crisis

Solitary or Systemic

Chief concern of a central bank: Stability of the

financial system not the survival of a particular

bank. Ripple effects of failure of a bank

Credit crunch: Extreme reluctance to lend or

borrow new money may require intervention


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crisis

Interest of depositors

Duty of authorities towards retail depositors

May be covered by deposit insurance

Only banks following prudential standards may be

covered

Not recommended when

Prudential standards are not followed

Supervision by central bank is not satisfactory

l b k


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crisis Illiquidity or insolvency?

Central bank may provide support provided that therequesting bank is solvent and that the request is on atemporary basis

Illiquidity may be a sign of insolvency In case of serious illiquidity in short run a long term

view may be taken by authorities

Long term assistance may include a wind-down

Assistance without incurring credit risk: Collateralized lending

Releasing margin

Purchasing securities

l b k


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crisis

Authority; Speed:

Speed is essential

Central bank or relevant body must have the

authority to take action

Consultation with Ministry of Finance should be

done in a minimum period of time

Public should be aware of principles andconditions pertaining to such intervention

A i l b ki


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crisis

Confidentiality:

To avoid panic spreading, Central bank should

operate without publicity

Fine line between necessity and right of public forinformation

Authorities must be accountable for their actions

A i l b ki


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crisis

Clear exit:

Exit strategy must be present if central bank plans

to support a bank

Liquidation, rehabilitation or takeover

If a bank is deemed too big to fail then it may

create problem for central bank

Limitless obligation to support in such case maybe required

A i l b ki


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crisis

Limitation:

Except in extreme cases the Central Bank would

like to limit intervention in crisis to

Contain public cost Avoid limitless support and moral hazard

A ti t t l b ki


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crisis

Costs and recovery of expenditures:

Support program will have implications on the

profits of the central bank

To ensure speed, such a program must be in place

Shareholders of a failed bank should not be the

beneficiary of expenditure of public funds

A ti t t l b ki


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crisis

Minimum interference with market forces

Rescue of a bank may involve

Interference with market forces

Moral hazard

Such interference should be kept at a minimum

level

A ti t t l b ki


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crisis

Conditionality

Support may be conditional on the following:

Improving systems

Change of Management Change of strategic direction

Incentive must be given to a bank to rectify its

position and improve its performance

A ti t t l b ki


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crisis

Future of the bank

Future of an ailing bank must be considered

Closure or liquidation

Survival strategy

Rescheduling of debts

Merger

Takeover Privatization

Recapitalization or restructuring

A ti t t l b ki


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crisis

Future of the bank

If the bank is allowed to continue

It is not sufficient to deal with non performing loans

Future business must be profitable This may result in management change, cultural change

and change of strategy

New ownership

Quality of ownership to be given prime importance

Technical ability, financial resources and integrity

Private ownership does not mean effective governance


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Conclusion

Scope and organization of banking cannot bedefined by law

Banking staff must be aware of risks

associated with each activity and theirmitigants

Supervisors have significant degree ofdiscretion in their actions. Mechanism toappeal against the ruling of supervisor shouldbe present


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Conclusion

Manipulation in structure or composition ofbanking sector should be based on wellthough out economic analysis or political

decision (i.e. to help a specific region) Bank failures cannot be prevented. However, it

must be ensured that

Banks are prudently run

Interest of depositors is protected

There is systemic stability within the financialsector


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Conclusion

Depositors to be protected to a certain extent

by Deposit Insurance

Degree of protection vs moral hazard

Deposit insurance is effective only if banking

has reached a degree of stability and

supervision is effective

Depositors interest is protected if supervisors

are prompt in addressing a troubled bank


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Conclusion

Supervision cannot eliminate all risks ofbanking failure

Management of a bank should be in honest

and competent hands Risk assessment tools are properly understood

(Credit assessment / Derivatives)

System of internal controls should be in place Banks should be able to absorb economic

cycles and shocks

Documents

Banking Crisis and Its Management Tony Latter