## _0598ch4pdf ## Source details **Canonical URL:** [_0598ch4pdf](https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/weo0598/pdf/_0598ch4pdf.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/weo0598/pdf/_0598ch4pdf.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/weo0598/pdf/_0598ch4pdf.pdf.json) --- ### Box 6. Resolving Banking Sector Problems — Origins and macroeconomic drivers - Overly expansionary monetary and fiscal policies can spur lending booms, excessive debt accumulation, and overinvestment in real assets, driving up equity and real estate prices to unsustainable levels. - Tightening of policies and correction of asset prices can lead to: - slowdown in economic activity, - debt-servicing difficulties, - declining collateral values and net worth, - rising levels of nonperforming loans that threaten banks’ solvency. - Macroeconomic factors, especially lending booms, have been found to play an important role in creating financial sector vulnerability in many Latin American countries and in other emerging market economies. - External conditions contributing to crises include sudden, large shifts in the terms of trade and in world interest rates; an abrupt rise in industrial country interest rates can curb foreign financing and increase fragility of the domestic financial system. - Currency mismatches in private sector balance sheets are particularly problematic in countries with inflexible exchange rates; pegs can encourage borrowers to ignore exchange rate risk. - Countries with high levels of short-term debt, variable-rate debt, foreign-currency-denominated debt, or foreign debt intermediated through domestic financial institutions are especially vulnerable to shocks. ### Box 6 — Timing and speed of restructuring actions - Countries that made substantial progress in restructuring their banking sectors began to take measures, on average, in less than 10 months after banking problems surfaced. - Countries that made slow progress waited over 40 months. ### Box 6 — Role of central banks and government agencies in restructuring - Direct central bank involvement can create conflicts with monetary policy objectives; experience suggests that, generally, the smaller the role of the central bank, the more progress the country makes in bank restructuring. - Where the central bank did not take a direct role, countries often used an independent agency to lead restructuring efforts. Such agencies: - implemented firm exit policies, - closed or merged insolvent banks, - facilitated loss-sharing between the state, the banks, and the public, - helped solvent banks to sell bonds or equity in exchange for nonperforming loans. - Agencies can be crisis-specific (example: Resolution Trust Corporation in the United States) or ongoing (role similar to the Federal Deposit Insurance Corporation in the United States). ### Box 6 — Managing nonperforming assets and workout strategies - Failing to actively manage nonperforming assets of all banks, and remaining assets of failed banks, increases the total cost of restructuring and creates inequitable loss distribution. - Liquidation may be necessary in some cases, but loan or debt restructuring can be the least costly alternative under certain conditions; mass liquidation could cause asset price deflation and worsen macroeconomic difficulties. - Loan workout units, whether decentralized or centralized and actively managed to maximize returns and maintain asset values, can help recover restructuring costs and send appropriate signals to delinquent borrowers. - Example outcome: in Sweden, the net fiscal cost of bank restructuring has been diminishing over time mainly because of success in loan recovery by asset management companies. ### Box 6 — Privatization and ownership issues - When difficulties are concentrated in state-owned banks, privatization has sometimes been used—but the design of privatization programs is critical. - Poorly designed privatizations can seed subsequent crises: problems include preferences given to certain bidders, overpriced bank assets, and weak legislation allowing nonbank conglomerates to acquire large portions of the financial system. ### Box 6 — Corporate governance, supervision, and disclosure reforms - Once recapitalization has commenced, operational performance must be improved by creating appropriate incentives for bank owners, managers, supervisors, and the market to monitor banks and ensure prudent corporate governance and profitability. - Shortcomings to address include supervisory, regulatory, legal, and accounting frameworks and excessive/distorted taxation schemes. - Country examples: - Chile: managers dismissed, shareholders bore losses, fraud prosecuted, accounting rules and supervision brought up to international standards; banks barred from lending to borrowers in default and required to be rated by private credit agencies at least twice a year. - Malaysia: a credit bureau was established to improve information on potential borrowers. - New Zealand: market-oriented approach emphasizing disclosure and incentives; banks required to disclose quarterly asset quality and provisioning, risk management systems, loan concentration, and credit ratings; abbreviated disclosure statements must be posted in all banks and full statements available on demand; bank managers must attest to absence of misleading information and can face criminal penalties and unlimited liability. ### Box 6 — Financial sector distortions, capital flows, and contagion - Financial sector distortions (weak supervision, government intervention in credit allocation/pricing, connected or politically motivated lending, fraud) combined with macroeconomic volatility underpin many banking crises. - Composition and maturity of capital inflows matter: reliance on short-term borrowing to finance large current account deficits was crucial in recent crises (Thailand; 1994–95 Mexican crisis). - Foreign direct investment is often viewed as safer than debt-creating inflows, but data reliability distinguishing FDI from other flows can be questioned; net FDI flows can be quite volatile. - Changes in maturity structure and interest arrangements in recent decades have altered vulnerability to shocks; crises demonstrate dangers of high levels of short-term, foreign-currency-denominated debt. - Currency crises can be clustered due to: - common external causes (“monsoonal effects”), - spillovers through trade and capital market linkages or creditor portfolio interdependence, - contagion from investors’ reassessment of fundamentals or herding behavior. ### Box 6 — Preconditions and core principles for effective banking supervision (Basle Core Principles summary) - The Basle Committee on Banking Supervision formulated 25 basic principles that need to be in place for a supervisory system to be effective. Key summarized principles include: 1. Clear responsibilities and objectives for each supervisory agency; operational independence and adequate resources; suitable legal framework including authorization, ongoing supervision, powers to address compliance and safety, legal protection for supervisors, and arrangements for confidential information sharing. 2. Clear definition of permissible activities for licensed banks; control of the use of the word “bank” in names. 3. Licensing authority must have the right to set criteria and reject establishments that do not meet standards; licensing should assess ownership, directors, senior management, operating plan, internal controls, and projected financial condition, including capital base; prior consent of home supervisor required for foreign parent banks. 4. Supervisors must have authority to review and reject proposals to transfer significant ownership or controlling interests in existing banks. 5. Supervisors must have authority to establish criteria for reviewing major acquisitions or investments by a bank and to ensure corporate affiliations/structures do not expose the bank to undue risks or hinder effective supervision. 6. Supervisors must set prudent and appropriate minimum capital adequacy requirements reflecting banks’ risks and defining capital components; for internationally active banks, requirements should not be less than those established in the Basle Capital Accord and its amendments. 7. Supervisory evaluation of a bank’s policies, practices, and procedures related to granting loans, making investments, and ongoing portfolio management is essential. 8. Supervisors must be satisfied that banks establish and adhere to adequate policies, practices, and procedures for evaluating asset quality and the adequacy of loan-loss provisions and loan-loss reserves. --- ### Box 7. Effective Banking Prudential Regulations and Requirements — Basle Committee and context - The Basle Committee on Banking Supervision was established by the central bank Governors of the Group of Ten countries in 1975 and consists of senior representatives of banking supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. - For details see David Folkerts-Landau and Carl-Johan Lindgren, Toward a Framework for Financial Stability (Washington: IMF, January 1998). - A comprehensive summary of these principles is provided in Folkerts-Landau and Lindgren, Toward a Framework for Financial Stability. See also Basle Committee on Banking Supervision, Core Principles for Effective Banking Supervision (Basle, Switzerland: Bank for International Settlements, 1996). ### Box 7 — Core prudential rules and supervisory expectations (findings and requirements) - 9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio, and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. - 10. To prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. - 11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring, and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks. - 12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor, and adequately control market risks; supervisors should have powers to impose specific limits or a specific capital charge (or both) on market risk exposures, if warranted. - 13. Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior management oversight) to identify, measure, monitor, and control all other material risks and, where appropriate, to hold capital against these risks. - 14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations. - 15. Banking supervisors must determine that banks have adequate policies, practices, and procedures in place, including strict “know-your-customer” rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements. ### Box 7 — Methods of ongoing banking supervision (operational requirements) - 16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision. - 17. Banking supervisors must have regular contact with bank management and thorough understanding of the institution’s operations. - 18. Banking supervisors must have a means of collecting, reviewing, and analyzing prudential reports and statistical returns from banks on a solo and consolidated basis. - 19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors. - 20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis. ### Box 7 — Information requirements - 21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition. ### Box 7 — Formal powers of supervisors (enforcement) - 22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking license or recommend its revocation. ### Box 7 — Cross-border banking and consolidated supervision - 23. Banking supervisors must practice global consolidated supervision over their internationally active banking organizations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organizations worldwide, primarily at their foreign branches, joint ventures, and subsidiaries. - 24. A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host-country supervisory authorities. - 25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home-country supervisors of those banks for the purpose of carrying out consolidated supervision. --- ### Box 8. The Current Account and External Sustainability — Limitations of solvency-based benchmarks - The trade (surplus) required to keep the ratio of external liabilities to GDP constant has been used as a simple measure of solvency but has serious shortcomings: - No presumption that a stable ratio of external liabilities to GDP (or to exports) is “optimal” or appropriate. - Protracted current account imbalances in developing countries may reflect transition toward higher output; steady-state benchmarks may be inappropriate. - Calculations presuppose continued willingness of foreign investors to lend on current terms; in a world of high capital mobility this may be inappropriate. - Simple solvency tests would have failed to signal problems for most fast-growing Asian economies, including Indonesia and Korea. - Conclusion: stock imbalances and capital market factors can precipitate crises even when flow variables like the current account appear sustainable. This argues for monitoring a broader set of capital account and financial indicators. ### Box 8 — Broader set of indicators to assess external sustainability - Categories of indicators proposed and their rationale: - Growth, investment rate, export performance, and openness to trade: related to ability to generate future trade surpluses to repay external liabilities. - Rate of growth in private credit, stock market performance, and banking-system health indicators (nonperforming loans, quality of prudential supervision): gauge whether private behavior violates intertemporal budget constraints or reflects asset-price bubbles or implicit bailout guarantees. - Volatility of terms of trade: measures vulnerability to external shocks. - Composition of external liabilities, ratio of M2 to reserves, size of short-term external debt relative to short-term external assets (reserves): indicators of vulnerability to sudden swings in investor sentiment. - Level of the real exchange rate: can indicate misalignment or reflect supply-side productivity gains; complex to interpret. - Need: rank and translate multiple indicators into an overall measure of external sustainability or vulnerability; research is ongoing. ### Box 8 — Stylized behavior of macroeconomic variables around crises (overview and methodology) - Sample and methodology: - Analysis of currency crises over the period 1975–97 for a group of 50 advanced and emerging market countries. - For currency crises, constructed 49-month windows (t–24 to t+24) and compared monthly averages in the window with tranquil-period averages. - For banking crises, constructed seven-year windows (t–3 to t+3) using annual data and compared with tranquil-period averages. - Typical precrisis pattern (currency and banking crises): the economy is overheated—real exchange rate appreciated, inflation relatively high, current account deficits widened, domestic credit grew rapidly, and asset prices were often inflated. ### Box 8 — Key empirical findings: currency crises (selected statistics) - Real exchange rate: - Around 24 months before a crisis the real exchange rate was, on average, about 7 percent higher than its normal level. - Around three months before a crisis the real exchange rate began to decline toward the tranquil-period mean. - In the second year after a crisis the real exchange rate was about 7 percent on average below the tranquil-period average. - Exceptions: reserve-loss crises and crises associated with banking sector problems did not show the same precrisis real-appreciation pattern. - Exports, imports, trade balance: - Precrisis: deterioration in export performance accompanied real appreciation. - Postcrisis: exports rose significantly; imports contracted sharply. - International reserves: - Measured in months of imports, reserves failed to display a pronounced pattern; in absolute dollar value they declined precipitously as the crisis broke. - Inflation and monetary aggregates: - Inflation in the two-year period around a crisis was significantly higher than in tranquil periods. - From around 15 months prior to a crisis inflation moderated somewhat; with onset of crisis inflation surged over the next 12 to 18 months, then began to slow around 18 months after the crisis date. - Narrow and broad money growth showed pronounced increases almost two years prior to a currency crisis, peaking around 18 months before the outbreak. - Banking-sector liquidity indicator (M2-to-reserves ratio): - Rose throughout the 24-month period prior to a crisis, with growth increasing close to the crisis. - A few months after the crisis the ratio plummeted sharply; two years later it was below tranquil-period average. - In crises associated with banking sector problems the ratio did not rise appreciably beforehand. - Asset prices: - Equity-price growth typically began to decline sharply around 6 to 12 months before a crisis, turned negative at around the sixth month, and then plummeted to around 25 percentage points below the tranquil-period average soon after the crisis. - Recovery in equity prices typically began about a year after the crisis peak. - Real activity: - Twelve-month change in industrial production did not show a distinctive precrisis pattern, but fell sharply in the aftermath and usually began to recover within a year; 18 months after outbreak it was above the tranquil-period level. - Fiscal and current account balances (annual data): - Fiscal deficit in percent of GDP increases in the year prior to a crisis but is not significantly different from tranquil periods. - Current account deficit in percent of GDP is significantly larger than during tranquil periods. ### Box 8 — Key empirical findings: banking crises (selected dynamics) - Precrisis indicators (annual data, t–3 to t+3): - Domestic credit grows rapidly prior to banking crises. - Financial liberalization indicators (rising ratio of M2 to M1) often precede banking crises. - Growing deposits and high real interest rates tend to peak around the crisis point. - Larger inflows of short-term capital often precede banking crises. - Starting around a year before a banking crisis, stock markets begin to decline; real activity displays a downward trend. - Institutional/regulatory weaknesses: - Banking crises often accompanied by excessive government influence or liberalization before adequate prudential regulation/supervision. - Country examples cited: Sri Lanka (state-owned banks with nonperforming loans ~35 percent of loan portfolio); Costa Rica (public banks accounting for 90 percent of total credit had ~30 percent uncollectible loans); liberalization-related crises in Colombia, Venezuela, Spain, Thailand, and Malaysia. ### Box 8 — Early warning indicators and their performance - Variables consistently informative about vulnerability to currency crises: - Real exchange rate appreciation. - Credit growth (domestic credit expansion). - M2-to-reserves expansion (growth in the ratio of broad money to reserves). - Other indicators with conditional usefulness: - Stock price declines: significant signals mainly for industrial countries. - Low domestic real interest rates (easy monetary conditions): useful indicator. - Terms of trade deterioration: strong signal for emerging market countries at around eight months prior to crisis. - World real interest rate increase: not significant except very close to a crisis. - Caveats: - Indicators may fail for countries experiencing contagion/spillovers where a crisis elsewhere is the more informative signal. - Many variables do not signal until a crisis is near, and some data arrive too late to be actionable. - Indicators can give false signals and cannot predict crises with certainty. ### Box 8 — Index of macroeconomic vulnerability and East Asian example - Construction of vulnerability index: - Weighted average of deviations of (i) the real exchange rate, (ii) the 12-month percent change in real domestic credit, and (iii) the ratio of M2 to foreign reserves from their respective three-year means. - Weights are the inverse of the three-year, country-specific standard deviation. - Empirical application to six Asian and four Latin American countries: - Beginning in early 1997 vulnerability increased in almost all east Asian economies most affected by the turmoil. - Thailand, Malaysia, and to a lesser extent Indonesia and Korea were vulnerable according to the index. - A sustained buildup in macroeconomic imbalances is often followed by a sudden jump in an index of foreign exchange market pressure that identifies the eruption of a currency crisis (clear in Thailand and Malaysia; also present in the 1994–95 Mexican crisis). - Major emerging market countries that resisted contagion showed little sign of vulnerability in mid-1997 (Argentina, Brazil, Chile, Mexico, Singapore). - Limitations: - Index did not perform as well for many industrial countries—other factors (e.g., labor market conditions) may matter more. - Availability and timeliness of data limit usefulness; index may mainly summarize vulnerability after the event if data are delayed. - No single index captures the full complexity of crisis precursors; indicators need to be supplemented with country-specific information. ### Box 8 — Policy-relevant implications and recommended monitoring - Use a broad set of indicators—macroeconomic, financial, and external—to assess vulnerability, not just solvency tests based on current account flows. - Monitor in particular: - Real exchange rate movements (look for sustained overvaluation). - Rapid domestic credit growth and monetary expansion. - The ratio of broad money (M2) to international reserves. - Asset-price booms (equity, real estate) and indicators of banking-sector health (nonperforming loans, prudential supervision quality). - Composition and maturity structure of external liabilities and short-term external debt measures. - Recognize that: - Early warning systems cannot reliably predict all crises; indicators can give false signals. - Contagion/spillover risks mean that crises elsewhere may be the most informative signals for some countries. - Timely data and comprehensive country-specific analysis are essential for credible vulnerability assessments. - IMF practice: staff do not rely on any single indicator; assessments are based on comprehensive analysis and consultations with country authorities. *Source: Box 6. Resolving Banking Sector Problems; Box 7. Effective Banking Prudential Regulations and Requirements; Box 8. The Current Account and External Sustainability (excerpts).* ### Box 6.Resolving Banking SectorProblems ### Box 6.Resolving Banking SectorProblems ### Origins and macroeconomic drivers of banking problems - Overly expansionary monetary and fiscal policies can spur lending booms, excessive debt accumulation, and overinvestment in real assets, driving up equity and real estate prices to unsustainable levels. - The eventual tightening of policies and correction of asset prices can lead to: - slowdown in economic activity, - debt-servicing difficulties, - declining collateral values and net worth, - rising levels of nonperforming loans that threaten banks’ solvency. - Macroeconomic factors, especially lending booms, have been found to play an important role in creating financial sector vulnerability in many Latin American countries and in other emerging market economies as well. - External conditions that have contributed to crises include sudden, large shifts in the terms of trade and in world interest rates; an abrupt rise in industrial country interest rates can curb foreign financing and increase fragility of the domestic financial system. - Currency mismatches in private sector balance sheets are particularly problematic in countries with inflexible exchange rates, as pegs can encourage borrowers to ignore exchange rate risk. - Countries with high levels of short-term debt, variable-rate debt, foreign-currency-denominated debt, or foreign debt intermediated through domestic financial institutions are especially vulnerable to shocks. ### Timing and speed of restructuring actions - Evidence shows that countries that made substantial progress in restructuring their banking sectors began to take measures, on average, in less than 10 months after banking problems surfaced, while countries that made slow progress waited over 40 months. ### Role of central banks and government agencies in restructuring - Direct central bank involvement can create conflicts with monetary policy objectives; experience suggests that, generally, the smaller the role of the central bank, the more progress the country makes in bank restructuring. - Where the central bank did not take a direct role, countries often used an independent agency to lead restructuring efforts. Such agencies: - implemented firm exit policies, - closed or merged insolvent banks, - facilitated loss-sharing between the state, the banks, and the public, - helped solvent banks to sell bonds or equity in exchange for nonperforming loans. - Agencies can be crisis-specific (example provided: Resolution Trust Corporation in the United States) or ongoing (role similar to the Federal Deposit Insurance Corporation in the United States). ### Managing nonperforming assets and workout strategies - Failing to actively manage nonperforming assets of all banks, and remaining assets of failed banks, increases the total cost of restructuring and creates inequitable loss distribution. - Liquidation may be necessary in some cases, but loan or debt restructuring can be the least costly alternative under certain conditions; mass liquidation could cause asset price deflation and worsen macroeconomic difficulties. - Loan workout units, whether decentralized or centralized and actively managed to maximize returns and maintain asset values, can help recover restructuring costs and send appropriate signals to delinquent borrowers. - Example outcome: in Sweden, the net fiscal cost of bank restructuring has been diminishing over time mainly because of success in loan recovery by asset management companies. ### Privatization and ownership issues - When difficulties are concentrated in state-owned banks, privatization has sometimes been used—but the design of privatization programs is critical. - Poorly designed privatizations can seed subsequent crises: examples of problems include preferences given to certain bidders, overpriced bank assets, and weak legislation allowing nonbank conglomerates to acquire large portions of the financial system. ### Corporate governance, supervision, and disclosure reforms - Once recapitalization has commenced, operational performance must be improved by creating appropriate incentives for bank owners, managers, supervisors, and the market to monitor banks and ensure prudent corporate governance and profitability. - Shortcomings to address include supervisory, regulatory, legal, and accounting frameworks and excessive/distorted taxation schemes. - Country examples: - Chile: managers dismissed, shareholders bore losses, fraud prosecuted, accounting rules and supervision brought up to international standards; banks barred from lending to borrowers in default and required to be rated by private credit agencies at least twice a year. - Malaysia: a credit bureau was established to improve information on potential borrowers. - New Zealand: market-oriented approach emphasizing disclosure and incentives; banks required to disclose quarterly asset quality and provisioning, risk management systems, loan concentration, and credit ratings; abbreviated disclosure statements must be posted in all banks and full statements available on demand; bank managers must attest to absence of misleading information and can face criminal penalties and unlimited liability. ### Financial sector distortions, capital flows, and contagion - Financial sector distortions (weak supervision, government intervention in credit allocation/pricing, connected or politically motivated lending, fraud) combined with macroeconomic volatility underpin many banking crises. - Composition and maturity of capital inflows matter: reliance on short-term borrowing to finance large current account deficits was crucial in recent crises (Thailand; 1994–95 Mexican crisis). - Foreign direct investment is often viewed as safer than debt-creating inflows, but data reliability distinguishing FDI from other flows can be questioned; net FDI flows can be quite volatile. - Changes in maturity structure and interest arrangements in recent decades have altered vulnerability to shocks; crises demonstrate dangers of high levels of short-term, foreign-currency-denominated debt. - Currency crises can be clustered due to: - common external causes (“monsoonal effects”), - spillovers through trade and capital market linkages or creditor portfolio interdependence, - contagion from investors’ reassessment of fundamentals or herding behavior. ### Preconditions and core principles for effective banking supervision (Basle Core Principles summary) - The Basle Committee on Banking Supervision formulated 25 basic principles that need to be in place for a supervisory system to be effective. Key summarized principles include: 1. Clear responsibilities and objectives for each supervisory agency; operational independence and adequate resources; suitable legal framework including authorization, ongoing supervision, powers to address compliance and safety, legal protection for supervisors, and arrangements for confidential information sharing. 2. Clear definition of permissible activities for licensed banks; control of the use of the word “bank” in names. 3. Licensing authority must have the right to set criteria and reject establishments that do not meet standards; licensing should assess ownership, directors, senior management, operating plan, internal controls, and projected financial condition, including capital base; prior consent of home supervisor required for foreign parent banks. 4. Supervisors must have authority to review and reject proposals to transfer significant ownership or controlling interests in existing banks. 5. Supervisors must have authority to establish criteria for reviewing major acquisitions or investments by a bank and to ensure corporate affiliations/structures do not expose the bank to undue risks or hinder effective supervision. 6. Supervisors must set prudent and appropriate minimum capital adequacy requirements reflecting banks’ risks and defining capital components; for internationally active banks, requirements should not be less than those established in the Basle Capital Accord and its amendments. 7. Supervisory evaluation of a bank’s policies, practices, and procedures related to granting loans, making investments, and ongoing portfolio management is essential. 8. Supervisors must be satisfied that banks establish and adhere to adequate policies, practices, and procedures for evaluating asset quality and the adequacy of loan-loss provisions and loan-loss reserves. *Source: Box 6. Resolving Banking Sector Problems, IV FINANCIAL CRISES: CHARACTERISTICS AND INDICATORS OF VULNERABILITY* ### Box 7.Effective Banking Prudential Regulations and Requirements ### Box 7.Effective Banking Prudential Regulations and Requirements ### Basle Committee and context - The Basle Committee on Banking Supervision was established by the central bank Governors of the Group of Ten countries in 1975 and consists of senior representatives of banking supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. - For details see David Folkerts-Landau and Carl-Johan Lindgren, Toward a Framework for Financial Stability (Washington: IMF, January 1998). - A comprehensive summary of these principles is provided in Folkerts-Landau and Lindgren, Toward a Framework for Financial Stability. See also Basle Committee on Banking Supervision, Core Principles for Effective Banking Supervision (Basle, Switzerland: Bank for International Settlements, 1996). ### Core prudential rules and supervisory expectations (findings and requirements) - 9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio, and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. - 10. To prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. - 11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring, and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks. - 12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor, and adequately control market risks; supervisors should have powers to impose specific limits or a specific capital charge (or both) on market risk exposures, if warranted. - 13. Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior management oversight) to identify, measure, monitor, and control all other material risks and, where appropriate, to hold capital against these risks. - 14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations. - 15. Banking supervisors must determine that banks have adequate policies, practices, and procedures in place, including strict “know-your-customer” rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements. ### Methods of ongoing banking supervision (operational requirements) - 16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision. - 17. Banking supervisors must have regular contact with bank management and thorough understanding of the institution’s operations. - 18. Banking supervisors must have a means of collecting, reviewing, and analyzing prudential reports and statistical returns from banks on a solo and consolidated basis. - 19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors. - 20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis. ### Information requirements - 21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition. ### Formal powers of supervisors (enforcement) - 22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking license or recommend its revocation. ### Cross-border banking and consolidated supervision - 23. Banking supervisors must practice global consolidated supervision over their internationally active banking organizations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organizations worldwide, primarily at their foreign branches, joint ventures, and subsidiaries. - 24. A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host-country supervisory authorities. - 25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home-country supervisors of those banks for the purpose of carrying out consolidated supervision. *Source: Box 7, "Effective Banking Prudential Regulations and Requirements" from the provided IMF chapter excerpt.* ### Box 8.The Current Account and External Sustainability ### Box 8.The Current Account and External Sustainability ### Limitations of solvency-based benchmarks - The trade (surplus) required to keep the ratio of external liabilities to GDP constant has been used as a simple measure of solvency but has serious shortcomings: - No presumption that a stable ratio of external liabilities to GDP (or to exports) is “optimal” or appropriate. - Protracted current account imbalances in developing countries may reflect transition toward higher output; steady-state benchmarks may be inappropriate. - Calculations presuppose continued willingness of foreign investors to lend on current terms; in a world of high capital mobility this may be inappropriate. - Simple solvency tests would have failed to signal problems for most fast-growing Asian economies, including Indonesia and Korea. - Conclusion: stock imbalances and capital market factors can precipitate crises even when flow variables like the current account appear sustainable. This argues for monitoring a broader set of capital account and financial indicators. ### Broader set of indicators to assess external sustainability - Categories of indicators proposed and their rationale: - Growth, investment rate, export performance, and openness to trade: related to ability to generate future trade surpluses to repay external liabilities. - Rate of growth in private credit, stock market performance, and banking-system health indicators (nonperforming loans, quality of prudential supervision): gauge whether private behavior violates intertemporal budget constraints or reflects asset-price bubbles or implicit bailout guarantees. - Volatility of terms of trade: measures vulnerability to external shocks. - Composition of external liabilities, ratio of M2 to reserves, size of short-term external debt relative to short-term external assets (reserves): indicators of vulnerability to sudden swings in investor sentiment. - Level of the real exchange rate: can indicate misalignment or reflect supply-side productivity gains; complex to interpret. - Need: rank and translate multiple indicators into an overall measure of external sustainability or vulnerability; research is ongoing. ### Stylized behavior of macroeconomic variables around crises (overview) - Sample and methodology: - Analysis of currency crises over the period 1975–97 for a group of 50 advanced and emerging market countries. - For currency crises, constructed 49-month windows (t–24 to t+24) and compared monthly averages in the window with tranquil-period averages. - For banking crises, constructed seven-year windows (t–3 to t+3) using annual data and compared with tranquil-period averages. - Typical precrisis pattern (currency and banking crises): the economy is overheated—real exchange rate appreciated, inflation relatively high, current account deficits widened, domestic credit grew rapidly, and asset prices were often inflated. ### Key empirical findings — currency crises - Real exchange rate - Around 24 months before a crisis the real exchange rate was, on average, about 7 percent higher than its normal level. - Around three months before a crisis the real exchange rate began to decline toward the tranquil-period mean. - In the second year after a crisis the real exchange rate was about 7 percent on average below the tranquil-period average. - Exceptions: reserve-loss crises and crises associated with banking sector problems did not show the same precrisis real-appreciation pattern. - Exports, imports, trade balance - Precrisis: deterioration in export performance accompanied real appreciation. - Postcrisis: exports rose significantly; imports contracted sharply. - Trade balance: deterioration near outbreak but not distinctive earlier. - International reserves - Measured in months of imports, reserves failed to display a pronounced pattern; in absolute dollar value they declined precipitously as the crisis broke. - Inflation and monetary aggregates - Inflation in the two-year period around a crisis was significantly higher than in tranquil periods. - From around 15 months prior to a crisis inflation moderated somewhat; with onset of crisis inflation surged over the next 12 to 18 months, then began to slow around 18 months after the crisis date. - Narrow and broad money growth showed pronounced increases almost two years prior to a currency crisis, peaking around 18 months before the outbreak. - Banking-sector liquidity indicator (M2-to-reserves ratio) - Rose throughout the 24-month period prior to a crisis, with growth increasing close to the crisis. - A few months after the crisis the ratio plummeted sharply; two years later it was below tranquil-period average. - In crises associated with banking sector problems the ratio did not rise appreciably beforehand. - Asset prices - Equity-price growth typically began to decline sharply around 6 to 12 months before a crisis, turned negative at around the sixth month, and then plummeted to around 25 percentage points below the tranquil-period average soon after the crisis. - Recovery in equity prices typically began about a year after the crisis peak. - Real activity - Twelve-month change in industrial production did not show a distinctive precrisis pattern, but fell sharply in the aftermath and usually began to recover within a year; 18 months after outbreak it was above the tranquil-period level. - Fiscal and current account balances (annual data) - Fiscal deficit in percent of GDP increases in the year prior to a crisis but is not significantly different from tranquil periods. - Current account deficit in percent of GDP is significantly larger than during tranquil periods. ### Key empirical findings — banking crises - Precrisis indicators (annual data, t–3 to t+3) - Domestic credit grows rapidly prior to banking crises. - Financial liberalization indicators (rising ratio of M2 to M1) often precede banking crises. - Growing deposits and high real interest rates tend to peak around the crisis point. - Larger inflows of short-term capital often precede banking crises. - Starting around a year before a banking crisis, stock markets begin to decline; real activity displays a downward trend. - Institutional/regulatory weaknesses - Banking crises often accompanied by excessive government influence or liberalization before adequate prudential regulation/supervision. - Country examples cited: Sri Lanka (state-owned banks with nonperforming loans ~35 percent of loan portfolio); Costa Rica (public banks accounting for 90 percent of total credit had ~30 percent uncollectible loans); liberalization-related crises in Colombia, Venezuela, Spain, Thailand, and Malaysia. ### Early warning indicators and their performance - Variables found to consistently provide information about vulnerability to currency crises (correctly signaled crises many times, not too many false alarms, provided early signals): - Real exchange rate appreciation. - Credit growth (domestic credit expansion). - M2-to-reserves expansion (growth in the ratio of broad money to reserves). - Other indicators with conditional usefulness: - Stock price declines: significant signals mainly for industrial countries. - Low domestic real interest rates (easy monetary conditions): useful indicator. - Terms of trade deterioration: strong signal for emerging market countries at around eight months prior to crisis. - World real interest rate increase: not significant except very close to a crisis. - Caveats: - Indicators may fail for countries experiencing contagion/spillovers where a crisis elsewhere is the more informative signal. - Statistical significance and timeliness matter: many variables do not signal until a crisis is near, and some data arrive too late to be actionable. - Indicators can give false signals and cannot predict crises with certainty. ### Index of macroeconomic vulnerability and East Asian example - Construction of vulnerability index: - Weighted average of deviations of (i) the real exchange rate, (ii) the 12-month percent change in real domestic credit, and (iii) the ratio of M2 to foreign reserves from their respective three-year means. - Weights are the inverse of the three-year, country-specific standard deviation. - Purpose: identify macroeconomic vulnerabilities that raise substantial risk of a currency crisis (not to predict crises). - Empirical application to six Asian and four Latin American countries: - Beginning in early 1997 vulnerability increased in almost all east Asian economies most affected by the turmoil. - Thailand, Malaysia, and to a lesser extent Indonesia and Korea were vulnerable according to the index. - A sustained buildup in macroeconomic imbalances is often followed by a sudden jump in an index of foreign exchange market pressure that identifies the eruption of a currency crisis (clear in Thailand and Malaysia; also present in the 1994–95 Mexican crisis). - Major emerging market countries that resisted contagion showed little sign of vulnerability in mid-1997 (Argentina, Brazil, Chile, Mexico, Singapore). - Limitations: - Index did not perform as well for many industrial countries—other factors (e.g., labor market conditions) may matter more. - Availability and timeliness of data limit usefulness; index may mainly summarize vulnerability after the event if data are delayed. - No single index captures the full complexity of crisis precursors; indicators need to be supplemented with country-specific information. ### Policy-relevant implications and recommended monitoring - Use a broad set of indicators—macroeconomic, financial, and external—to assess vulnerability, not just solvency tests based on current account flows. - Monitor in particular: - Real exchange rate movements (look for sustained overvaluation). - Rapid domestic credit growth and monetary expansion. - The ratio of broad money (M2) to international reserves. - Asset-price booms (equity, real estate) and indicators of banking-sector health (nonperforming loans, prudential supervision quality). - Composition and maturity structure of external liabilities and short-term external debt measures. - Recognize that: - Early warning systems cannot reliably predict all crises; indicators can give false signals. - Contagion/spillover risks mean that crises elsewhere may be the most informative signals for some countries. - Timely data and comprehensive country-specific analysis are essential for credible vulnerability assessments. - IMF practice: staff do not rely on any single indicator; assessments are based on comprehensive analysis and consultations with country authorities. *Source: Box 8. The Current Account and External Sustainability (excerpts).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/weo0598/pdf/_0598ch4pdf.pdf_