Resolving the financial crisis: Are the lessons of the Nordics being heeded?

by

Claudio Borio, Bent Vale and Goetz von Peter*

Norges Bank conference: Government intervention and moral hazard in the financial sector.

2 to 3 September 2010

* Claudio Borio and Goetz von Peter are, respectively, Head of Research and Policy Analysis and Economist at the BIS. Bent Vale is Assistant Director at the Norges Bank. The views expressed are those of the authors and not necessarily those of the BIS or the Norges Bank.

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Motivation and Roadmap

Two years after the current crisis started; time for preliminary evaluation of resolution methods so far

Nordic crises in the early 1990s as guide, widely regarded as best practice

ROADMAP: 3 parts: A) What are the crisis resolution principles?

Objective: minimise the present value of the losses associated with the crisis

3 principles: timeliness, comprehensiveness, balance

B) How do the two resolutions compare? Current vs Nordic resolutions against the 3

principles C) What explains the differences?

Consider possible explanations in turn 2

Norges Bank Finansiell stabilitet

The Principles

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P1: Timeliness P1: Nature and size of the problem should be

recognised early and intervention should follow quickly

Why? Stabilise situation and avoid hidden deterioration Costs increase if agents operate under distorted

incentives Bias towards inaction can be very strong (S&L, Japan) Early intervention requires supporting institutions

Is the necessary legislation in place? If not, get it in place.

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P2: Comprehensiveness

P2: Intervention and resolution should be broad-ranging and in-depth

Step 1: stabilise the system: ensure continued functioning Funding support (ELA, DI, DG, maybe blanket)

Step 2: restructure balance sheets Address losses comprehensively. Recapitalise. Deal with bad assets, internal or AMCs (“bad banks”)

Step 3: re-establish conditions for long-term profitability Reduce excess capacity (balance sheet, network) Promote operational efficiencies (business focus; cut costs) Limit competitive distortions

Requirements: Minimise cost to taxpayers Forceful approach to deal with conflicts of interest Hence, some conditionality or public control

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P3: Balance

P3: intervention should strike a balance between limiting the adverse impact on the real economy and containing moral hazard

Why? Basic tension Intervention designed to restrict unfettered market forces Shielding stakeholders distorts incentives (moral hazard)

Mechanisms to handle trade-off: Keep stakeholders (decision-takers) accountable

Managers and shareholders first Debt holders as far as possible (s.t. contagion)

Use strict conditionality for support Transfer control (with or without government ownership)

Optimal balance depends on existing institutions and market conditions.

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Norges Bank Finansiell stabilitet

How do the resolutions compare?

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P1: Timeliness

Two criteria for assessing timeliness of intervention: relative to Downleg of the financial cycle Insolvency of the institutions

In current crisis, intervention took place earlier relative to financial cycle First systemic event occurred earlier relative to

peaks Interventions followed systemic event more rapidly …by which time AP and CR had declined less

Result: institutions now further away from insolvency Then: intervention to raise capital to regulatory

minima Now: capital generally well above minima 8

99

P1: Timeliness

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Norges Bank Finansiell stabilitet

P1: Timeliness

Then: Quick targeted intervention after 1st systemic event General government capital injection, on commercial

terms 1-13 months after Asset Management Companies 4-15 months after,

Sweden and Finland only. Blanket guarantee 11-12 months after, Sweden and

Finland only. Now:

General government capital injections and debt guarantees just 1 month after 1st systemic event.

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P2: Comprehensiveness? Breadth vs depth

Step 1: stabilising the financial system Both effective, but significant differences

Then: little need for liquidity support and then only later in the crisis (together with blanket guarantees)

Now: liquidity squeeze triggered the crisis and played central role since August 2007

Blanket guarantees (then in FI and SE) vs extended DI + priced DG (today).

Implicit guarantees to systemically important institutions (G7 Plan of Action, Oct08).

Now even more (and earlier) to stabilise system (on funding side).

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Norges Bank Finansiell stabilitet

P2: Comprehensiveness? Breadth vs depth

Step 2: restructuring balance sheets Then: prompt and thorough measures,

Mainly individual targeted recapitalisations Losses fully recognized Disposal of bad assets (bank-specific AMCs FI SE after

nationalisation). Restructuring effort to eliminate excess capacity

Now: not as comprehensive Large recapitalisations largely matching past losses Loss recognition incomplete (except possibly US) Asset transfers barely started (few, stand-alone). But

AMCs may not be that crucial. Little restructuring to eliminate xs capacity Considerable uncertainty about bank balance sheets

remains

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P2: Comprehensiveness?

Now: these objectives have been far less prominent

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P3: Balance?

Nordics took a tougher stance in striking the balance between sustaining aggregate demand and containing moral hazard

Mechanism 1: treatment of stakeholders Then: shareholders wiped out, some exceptions in SE and

FI, (new legislation when required). Then: managers replaced, but debt holders made whole Now: shareholders and managers less affected (debt

holders lost in LeBr and a few FDIC handled banks). Mechanism 2: conditions for support

Then: tough restrictions; now: less so (see previous Table) Mechanism 3: less inhibited attitude towards public control or

nationalisation in Nordics went hand-in-hand with tougher stance.

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Summary evaluation and possible explanations Bottom line

Response to current crisis prompter but less comprehensive and in-depth

Funding side stabilised but less progress on asset side Cleansing of balance sheets slower Little attention to reducing excess capacity Less attention to avoiding competitive distortions

(except EC) Higher priority to sustaining demand in the short-term

than to adjustment in the financial sector and moral hazard

Why? 4 candidate explanations

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Norges Bank Finansiell stabilitet

Why the differences

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Macroeconomic conditions? Now: global and thus worse True: in hardest hit Nordic (Finland) can find at least one

parallel…. general capital injection with some attention to aggregate

demand

…But not whole story Programme in Finland was small in relation to total

interventions (tougher) even as recession was much larger than current ones

Sweden’s recession was very severe Nordics entered recession before the crisis and other

macroeconomic policies were much more restrictive Less room for manoeuvre: external crisis, procyclical

monetary policy regime (pegged exchange rates and full convertibility)

If anything, incentive to be more lenient on repair side to compensate 18

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International dimension of the crisis? Then: largely synchronous but purely domestic

Resolution has been more complicated…

No orderly resolution regime for large internationally active financial institutions in place

Huge international spillovers, desire to protect national banks and avoid putting them at a competitive disadvantage (DI horserace)

…encouraging leniency and caution, especially vis-à-vis international players

But not whole story Similar treatment of purely domestic institutions too (e.g.

Northern Rock) Pain of liquidating an international bank only partly felt at

home.

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Greater complexity?

Extensive network interlinkages Greater complexity of the assets involved today is also part of the

explanation Resolution made more complicated (information and incentive

problems) Harder to value assets, harder to price and transfer to AMCs Harder to restructure and work out bad assets (securitisation

chain) Greater opacity of system = stronger incentive to be cautious

(post LeBr)?

But not whole story Complexity an argument for nationalisation: Would have been

simpler to transfer assets if institutions nationalised, as in Nordic case (making pricing irrelevant) Reduce informational asymmetries and conflicts of interest

Fear of unpredictable responses is part and parcel of all crises Easy to overestimate specificity of current one

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Accounting and dynamics of the crisis Nature of losses and accounting is a missing piece of the

puzzle Now: first losses largely mark-to-market; Then: accrual on loan

books Appeared earlier and caused major liquidity crisis (August

2007) Given large loan books, institutions crippled but not

insolvent Two implications

Reduced ability to enforce adjustment Harder to impose strict conditionality and intervene in

depth in still solvent institutions (property rights) Reduced willingness and incentive as well

Misinterpret crisis as purely a liquidity panic for long time

Reinforced by other factors E.g. a deep-seated aversion to government ownership and

control in some countries. 21

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“Falling asset prices, deleveraging by some financial institutions and reduced risk appetite are creating illiquidity in credit markets and hampering price discovery. Prices in some credit markets have become detached from credit fundamentals due to unusually high discounts for illiquidity and uncertainty — the mirror image of the underpricing of risk during the upswing. As a result, mark-to-market losses on credit securities probably overstate the potential for future credit losses and the likely costs to the economy of the financial market disruption. This is lowering confidence and delaying the recovery of risk-taking.” (Bank of England (2008), p. 15)

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Conclusions

Compared with crisis response in Nordics case, current one has been even prompter (P1), but less comprehensive and in-depth

(P2) and less attentive to adjustment and moral hazard (P3) Reasons

International dimension and complexity of instruments Nature of losses and accounting (key and unappreciated

role) Implications

Risk of short-termism in response Need to intensify efforts to encourage adjustment May need to nuance interpretation of P1

Possible to intervene too early, unless tools and policies adjusted