Speech

Promoting Safe and Sound Banking Systems: An IMF Perspective -- Address by Michel Camdessus

September 28, 1996

President Iglesias, ladies and gentlemen. It is a great pleasure to join you here at the Inter-American Development Bank and to participate in your discussions on "Safe and Sound Financial Systems." The topic is a critical one—for Latin America and the world—and I am very happy to have this opportunity to provide the IMF's perspective.

Banks form the core of financial systems. Thus, whether a country's financial system is "safe and sound" or not depends in large part on the soundness of its banking system. Since the late 1970s, virtually every country in Latin America has experienced banking sector problems. And so have more than two-thirds of all Fund members—industrial, developing, and transition economies alike. These problems can be quite costly to the country concerned—in both financial and economic terms. But they can also involve high costs for the international community, since, as you know from your experiences last year, banking problems in individual countries can easily spill over into other markets. The soundness of banking systems is, therefore, a matter of great concern for the IMF, the IDB, and all of our member countries.

Transparency is a cardinal virtue in this domain, so let me be very candid with you, and tell you the following. I am frequently asked: Where will we have the next international economic crisis—the next Mexico? My answer is: I don't know, but I suspect it will begin with a banking crisis. And even if such a crisis does not start in the banking sector, it will almost certainly be worsened by a banking crisis. This is all the more reason why we must do our best to understand the causes of banking sector problems and find effective ways to address them, preferably before crises occur. So let me tell you how we at the Fund see the problem, how we believe banking systems could be strengthened, and how the IMF can contribute to the process.

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Causes of banking sector problems:

The first order of business is to consider the factors that lead to unsound banking systems. Through our surveillance activities in 181 member countries, we have had many opportunities to observe the causes of banking system problems. And for the most part, what we see are variations on a few common themes.

In most cases, banking sector problems begin with lax management within individual banks. Of course, this problem is by no means confined to developing countries; indeed, the front pages of the financial press have chronicled a number of stunning bank management failures in industrial countries. But lapses in sound banking practices appear to be pervasive in developing countries—in large part because bank owners and managers often lack strong enough incentives to act prudently. There is also often a lack of legal and judicial infrastructure that tends to lead to a breakdown in the credit discipline without which banks cannot perform properly.

One of the principal reasons why incentives are weak is lack of transparency about banks' operations and financial condition, which makes it difficult for market participants—or even bank supervisors—to distinguish the weak institutions from the strong. In many developing countries—as in many industrialized countries—loan valuation and provisioning standards are not rigorous enough to prevent banks from concealing the full extent of non-performing loans. The lack of reliable data and uniform disclosure rules make it difficult for the market—including deposit holders—to compare relative performance. In these circumstances, the market is not in the position to perform the essential role it plays in countries where bank operations are more transparent—that is, rewarding good performers and sanctioning the poor ones.

The problem is compounded when domestic banking supervision is also weak—either because laws and regulations are not comprehensive enough, or because bank supervisors are not free from political interference, or indeed, because the supervisory authority does not have the necessary human and financial resources to carry out its responsibilities effectively. Government involvement in the banking sector also distorts incentives, especially when the normal profit-making objectives of banks take a back seat to political goals, such as channeling financial support to ailing industries. Government involvement in the form of creating strong expectations of public bail-out of owners and creditors, often combined with weak exit policy and over-generous lending of last resort can further distort incentives, work against market forces, and shortchange the work of supervisors.

An aggravating factor is the fact that banks in developing countries typically operate in a more volatile economic and financial climate than institutions in industrial countries. Larger swings in real exchange and interest rates, private capital flows, and terms of trade, among other variables, at least in relation to the size of their economies, expose developing country banks to greater risks. Regrettably, however, for the most part, banks in developing countries have not responded with appropriate prudence, and supervisory authorities have not required sufficiently high capital cushions against the higher risks. Adding to these risks is the fact that many countries, which have recently liberalized and/or privatized their financial systems, have done so without simultaneously taking the necessary precautions to ensure that banks and supervisors have the expertise and resources needed to cope in the new environment. Under these circumstances, many institutions are assuming inappropriate levels of credit, exchange rate, interest rate, and other market risks.

For many countries, including a number in Latin America, increased international capital flows have put new strains on unsound banking systems. In particular, a rapid expansion of credit fueled by capital inflows tends to lead to poor credit decisions and eventual loan portfolio problems. Such situations cannot be prevented by prudential policy alone; they also require monetary and fiscal policy action. It is important to take such action promptly, before the situation deteriorates to the point where policymakers are reluctant to tighten policies for fear of exacerbating banking sector problems. Otherwise, delays in policy action can set the stage for a loss of market confidence in domestic economic policy which, in turn, can trigger capital outflows and put further pressure on weak banks.

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So, you see, banking sector weakness can be traced to a variety of sources. It stands to reason, therefore, that a successful attack on the problem of unsound banking systems must be launched on several fronts. In fact, a number of constructive steps are already under way.

At the national level, many countries, including a number in Latin America, have taken, or are taking, steps to strengthen their banking systems. Banking laws have been updated throughout the region and many countries have made efforts to upgrade their supervision of banks. In particular, Chile considerably strengthened its banking supervision following its banking crisis in the early 1980s—a terrible one, indeed—and is often used as a model for reforms in the region, and beyond. The region also has begun to see a wave of bank consolidations, as is typical in the rest of the world—for example, there have been extensive bank restructurings, mergers, and privatizations in Argentina and, to some extent, in Brazil.

Most of the countries in the region have adopted the standards and guidelines developed by the Basle Committee for the G-10 countries. But, recognition should also be given to the work of regional supervisory bodies in developing regional standards beyond those originating in Basle. For example, the Association of Bank Supervisory Agencies in Latin America and the Caribbean has developed regional standards on loan classification and provisioning and on the role of external auditors; and the Caribbean Supervisors Group is working to harmonize the regulatory framework and supervisory practices within the CARICOM.

The Fund, for its part, helps to promote bank soundness through its surveillance, lending and technical assistance activities. In surveillance, we are striving to improve the macroeconomic environment and structural framework in which banks operate. In our discussions with member countries, the Fund calls attention to emerging macroeconomic problems and structural deficiencies and recommends appropriate policy action. Our efforts to strengthen member countries' banking systems are also reflected in the design of Fund-supported lending programs and technical assistance, which in recent years has focused increasingly on banking legislation, regulation, and supervision. In response to the Mexican crisis, we have strengthened our surveillance, making our discussions with country authorities more continuous and probing, and paying greater attention to banking sector issues, the sustainability of capital flows, and countries where crises could spill over into other markets. Recently, the Fund's Executive Board has put the importance of bank soundness for macroeconomic stability and policymaking high on our agenda, and thus we intend to continue with, and build upon, these efforts.

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At the national level, many of the fundamental causes of unsound banking systems persist, including poor internal governance and a lack of transparency about banks' operations and financial condition, inadequate supervision, and excessive official complacency about problem banks. Moreover, all too often efforts to strengthen domestic banking systems, though welcome, are undertaken only after crisis has struck. I hate to have to recognize that this may be the only time when there is sufficient momentum for real reform, as this is an awfully high price to pay. With all their indirect costs, the crisis in Chile exceeded 30 percent of GDP and the recent one in Venezuela, 20 percent. We must be able to do better than this and avoid such exorbitant costs. No quisiera nunca ver esto de nuevo. Nunca más!

At the international level, existing standards for international banking are not as comprehensive as they should be. In some areas, such as accounting, there is still debate even among industrial countries. And in some crucial areas, such as loan valuation, provisioning rules, and especially exit policies, there is no consensus among G-10 countries—or even the EU.

Standards adopted by the Basle Committee are typically also used in non-G-10 countries, but the question remains how well adapted they are for the circumstances of developing countries. Many standards, such as the Basle Capital Accord, tend to assume conditions that are not always present in developing and some industrial countries. For example, without proper loan provisioning a capital adequacy measure may be meaningless. Moreover, given the greater volatility of macroeconomic conditions and private capital flows in emerging markets, developing countries may require more stringent standards than industrial countries apply. Indeed, some Latin American countries seem to have taken this view in setting more demanding capital ratios and risk weights for calculating capital adequacy than the Basle Capital Accord suggests. And, despite all of these initiatives, we are not yet at the point where it is possible to consider that the situation is under control. Far from it, to say the least!

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Where do we go from here? The Fund, with its responsibility for surveillance over the macroeconomic and financial stability of its 181 members and the soundness of the international monetary system as a whole, has a keen interest in seeing that these lacunae are filled and that domestic banking and financial systems are strengthened. From our perspective, the principal emphasis should be on strengthening internal bank governance and reinforcing market discipline in banking practices. But there is also a clear need to improve external oversight and support, at least until internal governance and market discipline become more effective.

One promising avenue is to look for standards and practices that have served particular groups of countries well, whether industrial or developing, and to consider how they can be adapted and applied in other countries. Such an effort to search out and agree on "best practices" and disseminate them to a wider group of countries is, indeed, the philosophy that lies behind the valuable work of the Basle Committee. This is also the spirit that has recently animated the Fund's successful initiative to develop standards to guide members in the dissemination of economic and financial data to the public.

I believe there are advantages in this approach. International guidelines should help national authorities to make improvements in domestic regulation and supervision that they might not otherwise be able to carry out—whether for lack of information, for competitive reasons, or because of domestic opposition. Moreover, by reinforcing market discipline over banks' behavior, and facilitating supervisory oversight, such standards would provide strong incentives to improve internal bank governance, which, as I noted earlier, lies at the heart of most banking sector problems. Although these international banking guidelines would be voluntary, the prospect of a positive market reaction for countries that implement them should provide strong incentives for reform.

Beyond developing international guidelines, we also need to find ways to deal with other difficult and even more pressing issues, such as: how to help countries to take corrective action against problem banks preferably early, while distortions are small; how to close down insolvent banks; how to design payments systems so as to limit contagion; and how to ensure that lender of last resort facilities do not prolong the lives of unsound banks, or lead to moral hazard.

The Fund stands ready to help with these tasks in the following ways: by contributing with its universal experience to the development of internationally agreed standards and making sure that such standards meet the circumstances of developing countries; by helping to disseminate those standards; by monitoring progress in their implementation and/or in the implementation of national policies aiming at the same objectives; and in helping to restructure banking and financial systems. Needless to say, all of this will need to be done in close collaboration with other international, regional, and national organizations involved in this work—and here I have in mind our very close collaboration with all those who have expertise or support to provide. In this business, as in many others, all must be in; for when the challenge is of such dimension, we all must hang together, if we don't want to hang separately.

I must tell you here that what we have done so far in Latin America, in close cooperation in particular with the IDB and the World Bank, is for us a source of encouragement. The extent of our cooperation would be a long story to tell you, so let me only mention some recent developments.

Following the financial sector crisis in Venezuela, a coordinated approach taken by the IDB, the World Bank, and the Fund in providing technical assistance has contributed to an important strengthening of banking supervision.

In Costa Rica and Nicaragua, the IDB and the Fund have worked together on programs to modernize and restructure state-owned banks;

In Argentina, our three institutions cooperated with the authorities in privatizing a number of provincial banks;

In Ecuador and Guyana, the IMF and the IDB have been assisting with the drafting of modern banking legislation;

Finally, in Nicaragua, the authorities' program of structural reform and macroeconomic stabilization, which is being supported by the Fund through ESAF, has been greatly reinforced by an IDB technical assistance project to modernize the central bank and to develop core financial and economic statistics, for which the Fund serves as executing agent.

Learning from experience, we are more determined than ever to give a very high priority to these operations, which allow us in some way to pool our surveillance, financing, and technical assistance resources with our two sister organizations, while drawing on the expertise and technical assistance capabilities of our friends from Basle and from the central banking community.

I think you will agree that there is an enormous amount of work ahead—not just in Latin America, but around the world. So let us join forces and bring together our collective experience and insight into these problems. Surely, there is plenty for all of us to do. In this way, we can be sure that this work, which is so essential for domestic prosperity and global stability, goes forward.