Back to the Future: Lessons from Financial CrisesKeynote speech by Jose Viñals, Director, Monetary and Capital Markets Department, IMF
February 28, 2014
Hong Kong Monetary Authority
As prepared for deliveryI. Introduction
Good afternoon. I am delighted to be in Hong Kong among so many luminaries on Asia. I would like to sincerely thank our hosts from the Hong Kong Monetary Authority for their warm hospitality. We hope this conference will be a first step in a multi-year collaboration with country authorities and other experts in the Asia Pacific region on the future of its financial systems.
There are many lenses through which the IMF sees Asia’s growing importance.
Emerging Asia is projected to grow rapidly, increasing its share of global GDP from 22 percent in 2013 to over 30 percent in 2023.
Accompanying this growth will be an equally impressive increase in the size of Asia’s financial sectors, from 18 percent of global banking sector assets to over 30 percent over the same time period.
And, trade among Asian countries and between Asia and the rest of the world has grown rapidly, while financial interconnectedness has lagged. As Asian companies expand abroad and Asian savers look for new places to invest, Asia’s interconnectedness will also grow.
With all these changes, new risks and new challenges will arise. Asia faced and learned many lessons after the East Asia Crisis of 1997-98. Unfortunately, some of those lessons were not learned outside Asia, and history repeated itself in the Global Financial Crisis.
I will organize my talk as follows. I will first elaborate on lessons embraced by Asian authorities after the Asian Financial Crisis that helped this region weather the global crisis better than most other regions. I will then lay out new risks that emerged during the 2008 global crisis. And finally, I will suggest some ways to contain these risks in Asia, as well as in other regions.
II. Lessons from the Asian Financial Crisis
The Asian crisis of the 1990s that began with speculative attacks on the Thai baht and spread across Asia and other EMs remains vivid in our minds. The events as they unfolded are well known, so I will focus on what Asian authorities did and what the rest of the world learned or did not learn from those events.
The Asian authorities embarked on an ambitious and broad ranging program of economic and financial sector reforms following the Asian Financial Crisis. These are:
First, there was wide recognition in Asia that stock problems, such as loans gone bad, had to be dealt with early in the process. Failed institutions were closed while the remaining viable banks were recapitalized and their legacy nonperforming loans removed and sold to restore profitability. This process has been slower in Europe in the wake of the recent crisis, and while it is progressing, bank repair still needs to be fully addressed.
Second, gaps were identified in regulatory and supervisory frameworks, and new laws and institutions were introduced to fill them. A more proactive and intensive approach to bank supervision was adopted. Risk management policies, including rules on corporate governance and disclosure, were revamped with stiffer penalties for unsafe and unsound banking practices and expanded supervisory powers to intervene and conduct regular examinations. Many Asian economies also invested in modern market infrastructure to ensure that the financial sector was able to cope with the demands of a rapidly growing region. And authorities in many countries have instituted measures to encourage the development of local currency bond markets, which have the effect of reducing the double mismatch of currency and duration and to allow for further diversification of funding sources.
Third, well ahead of the rest of the world, Asian authorities realized the value of macroprudential policies to ensuring financial stability. They routinely respond to emerging systemic risks by deploying a variety of instruments, such as restrictions on loan-to-value and debt-to-income ratios, limits on currency and maturity mismatches, and adjustments in risk weights to contain excessive financial imbalances.
As I look back to the start of the Global Financial Crisis, it is striking to see how much healthier, in most cases, Asian financial systems were than the systems of many Advanced Economies. This was clear from a wide range of indicators:
• Leverage had not built up to the same extent as in advanced economies, and neither was the system as reliant on wholesale funding. Moreover, where wholesale funding had grown, such as in New Zealand and Korea, measures were taken swiftly to contain it.
• Private sector credit growth was moderate. Among five large ASEAN economies, average credit growth between 2006 and 2008 was 11 percent, while even in my home country of Spain, during the same period it was more than 17 percent.
• Before the GFC, the credit to deposit ratios of advanced Asian countries averaged around 100, while the Euro area periphery was around 131. However, these ratios have worsened in Asia while staying about the same in Europe.
• Unlike the European periphery, the banking system in Asia was well capitalized with high quality capital. In 2008, in the Euro area periphery, Tier 1 capital was 8.3 of risk-weighted assets; among advanced Asian economies, the ratio was 10.7 percent, and in ASEAN, it was11.5 percent. These disparities have persisted.
• Given tight regulatory restrictions, exposure to subprime loans or structured credit products, such as collateralized debt obligations, was minimal, with Japan the only country with some exposure. These instruments were a major source of instability in the U.S., and the materialization of these risks culminated in the global crisis.
• Banks’ net foreign asset positions were predominantly positive and they were less vulnerable to external shocks. Their exposure to short-term external liabilities, and thus rollover risk, was also low.
• Nonperforming loans remained a small share of total loans in most countries, though I should add that these numbers tend to be on the high side or not transparent in those Asian economies where banks are predominantly state-owned.
Fourth, the Asian authorities, especially in East and South East Asia, took significant steps to reduce macroeconomic and external imbalances in the wake of the East Asia crisis. These steps led to low inflation, more sustainable current account positions, and low external debt—all of which provided a sound basis for a robust economic expansion.
Fifth, exchange rate regimes were made more credible and resilient. Most significantly, many countries allowed their currencies to depreciate during the global crisis, sometimes by large amounts, cushioning the blow of capital outflows. As you know, letting the exchange rates go as a line of defense was not an easy option during the Asian crisis due to unhedged foreign borrowing and low international reserves.
Finally, Asia re-established policy credibility with clear communication of realistic policy goals and a track record of achieving them.
The reforms that followed the Asian Financial Crisis continue to help Asia today. Since mid last year, many countries have used the buffers they built in good times and deployed a mix of exchange rate depreciation, external reserves, and higher interest rates to face the tightening of global financial conditions following the Fed’s announcement of tapering its asset purchases. Of course, individual country circumstances have mattered—some countries, such as India and Indonesia, with large macroeconomic imbalances, have faced some difficulties. Importantly, though, the decisive response of the authorities has clearly helped calm financial markets.
III. Post Global Financial Crisis--New Challenges
Looking ahead, I see three new risks that have not yet been fully confronted and will remain challenges for Asia and the rest of the world:
A. New Risks
Too Big to Fail and Shadow Banking
We are all familiar with the moral hazard created by large banks in the U.S. and Europe in the aftermath of the global crisis--governments simply could not allow them to fail. Indeed, looking back, it is impressive that financial centers such as Hong Kong and Singapore with large banks but sound banking systems weathered the storm well. Nevertheless, as Asian financial systems continue to expand, Asia will face many challenges.
The global recognition of the problem has led to regulatory responses, such as higher capital charges for systemic banks under Basel III, and are being adopted by many national authorities. Despite these measures, global banks have continued to grow in size and complexity, and this process may continue. In these cases, supervisors must be able and willing to expand the perimeter to include new types of financial firms, and to intervene in their businesses if they perceive systemic risks.
Equally worrisome is the growth in shadow banking—if not well regulated, it will also likely lead to a buildup of systemic risks. This is true in some Asian countries today, as rapid innovation, often in completely novel ways, and as a response in many cases to regulatory constraints on the banking system, has led to a rapid rise in shadow banking, and made the task of assessing systemic risks even more difficult. Supervisors need to ask whether frameworks are in place to manage innovation in financial intermediation, to understand and monitor interconnectedness and systemic risk, and how to address potential failures. Finally, it is worthwhile to ask ourselves what kind of a financial sector should Asia aspire to. What are the drawbacks to a simpler, less connected system, and what are its advantages?
As Asian financial systems become more complex and interconnected, new regulatory challenges will emerge. Despite being the world’s growth and trade engine, Asia’s financial integration has lagged its integration with the rest of the world. As capital accounts open further in Asian economies, especially India and China, and regional integration in ASEAN gather pace, Asia’s large pool of savings will increasingly be invested in other countries in the region. Asian financial institutions are also increasing their presence in frontier markets such as Africa. This will tend to make Asia’s financial systems more like Europe’s, where addressing risks from cross country exposures is an integral part of financial supervision.
B. How to Deal With New Risks
Having identified these new risks, how should countries make sure their regulatory and supervisory agencies are able to contain them? Three areas where the IMF has lately been closely collaborating with country authorities around the world are improving the ability and willingness of regulatory authorities to supervise and enforce regulations, and in limiting systemic risks through macroprudential measures.
Supervisors Learning to Say No
To control risks, regulators and supervisors must have the financial and staff resources to implement and monitor compliance by financial institutions. They should also be sufficiently intrusive to assess banks’ institutional controls, and be willing to address challenges not only during crises but also when an upswing in growth or credit makes investors unwilling to curb their own risk taking.
Investors must also do their due diligence. They must understand not only the nature of their own holdings but also potential conflicts of interest or other factors that might color the assessment of other market participants.
When vulnerabilities have been detected, it is essential to take the bull by the horns and work to reduce them. Forbearance in most cases only prolongs problems. Losses at banks, insolvency in large corporates or institutional investors, or systemic problems must be addressed as soon as they are recognized—but at the same time, also ensure that the damage to the financial sector does not go too deep and too fast. To minimize the repercussions of financial uncertainty, authorities must thus thread a path between, on the one hand, forthright action and early recognition of losses, which prevent the buildup of uncertainty and lay the foundation for a recovery of growth, and on the other hand, excessive forbearance, that allows unhealthy situations to continue, postponing and undermining the eventual recovery. Rising interconnectedness increasingly demands close coordination of supervisory authorities across national borders, and will require an ability to resolve complex financial institutions that operate in multiple jurisdictions.
A key lesson of the global financial crisis is that there is no hope that a complex cross-border institution can be resolved effectively if strong resolution powers are missing at the national level. And while those economies hard hit by the East Asian financial crisis have generally reformed their system to put these powers into place, they are still lacking in many countries, including in Asia. Further efforts are needed, at the national level to ensure resolution authorities have the appropriate tools, and in cross-border cooperation, to prepare the region for a world of greater interconnectedness.
Macroprudential policy has received a great deal of attention since the onset of the GFC. Here Asia has been a world leader, with frameworks functioning in many countries across the region, and increasing empirical evidence that these policies can increase the resilience of the financial system and dampen the strength of financial cycles without leading to excessive distortion.
Macroprudential policy aims to encourage the buildup of stronger financial buffers during upswings in credit cycles. Tools aimed at curbing excessive leverage, reducing the availability of credit to high risk borrowers, and temporarily increasing capital buffers can be used to slow the risks associated with rapid expansions in credit. The current boom in household debt we see in some Asian countries is such an expansion, and some of these tools may be appropriate here. Other tools aim to mitigate systemic risk by targeting financial institutions and markets that are highly interconnected within and across national borders.
As elsewhere, Asian regulators should take the opportunity to institute regulations now that can guide the financial system towards minimizing risks associated with highly interconnected banks that have become too big to fail. While capital surcharges for systemic banks can help, other measures will be needed to ensure that Asian banks remain of manageable size. With Asia’s financial sectors expected to grow more rapidly than those of other regions, Asia has more space to address these challenges early, guiding its more rapid growth in ways that encourage more, smaller, and less systemically risky banks.
On the other hand, macroprudential policy should not be used to control or target asset prices or exchange rates: addressing domestic or external imbalances, or dealing with aggregate demand shifts, is the task of macroeconomic policy. Additionally, since the pursuit of price stability can lead to financial sector imbalances, there is a need to coordinate macroprudential and monetary policy.
As Asia’s economic growth continues to lead the world, its expansion of financial sectors will, too. Ensuring that this expansion benefits everyone requires us to learn the lessons of both the Asian as well as the Global Financial Crises.
I began today by showing how Asia’s financial sectors will grow in size and interconnectedness over the coming years. I hope that in continuing to implement their reform agenda, Asia will not only be able to claim the title of the world’s fastest growing financial system, but also it’s safest.