Financial System Soundness--A Factsheet

Surveillance--A Factsheet

artwork from the cover of this publication   Building Strong Banks

Editors: Charles Enoch, David Marston, and Michael Taylor

©2002 International Monetary Fund
September 12, 2002

Ordering Information

   Charles Enoch, David Marston, and Michael Taylor
Part I: Issues in Surveillance
Loan Review, Provisioning, and Macroeconomic Linkages
   Luis Cortavarria, Claudia Dziobek, Akihiro Kanaya, and    Inwon Song
Domestic Lending in Foreign Currency
   Fernando L. Delgado, Daniel S. Kanda, Greta Mitchell    Casselle, and R. Armando Morales
Toward a Framework for Systemic Liquidity Policy
   Claudia Dziobek, J. Kim Hobbs, and David Marston
Emergency Liquidity Support Facilities
   Dong He
Issues in the Unification of Financial Sector Supervision
   Richard Abrams and Michael Taylor
The Financial Sector—The Responsibilities of the Public Agencies
   Peter Hayward
Part II: Resolution Strategies
Addressing the Prudential and Antitrust Aspects of Financial Sector Mergers and Acquisitions
   Michael Andrews
Guidelines for Bank Resolution
   David S. Hoelscher
Two Approaches to Resolving Nonperforming Assets During Financial Crises
   David Woo
Recapitalizing Banks with Public Funds:Selected Issues
   Charles Enoch, Gillian Garcia, and V. Sundararajan
An Operational Framework for Addressing the Public Costs of Systemic Bank Restructuring
   Priya Basu
List of Authors

Charles Enoch, David Marston, and Michael Taylor
The twin themes of this book—surveillance and resolution--involve issues that are at the core of the IMF's recent work on the financial sector. Although the intensity of this work is relatively new, the IMF has long recognized that an appropriate macroeconomic policy stance alone is not sufficient to maintain balance in an economy; sound underlying microeconomic conditions are also vital. In no area is this more important than in monetary policy. Maintaining a monetary policy stance geared to price level stability requires a sound and competitive banking system to transmit policy signals and to ensure the efficient allocation of financial resources. Moreover, maintaining openness to international capital markets requires a sound and well-regulated banking system through which these flows can be intermediated. The IMF helps to promote bank soundness through its surveillance, lending, and technical assistance activities. In its surveillance activities, the IMF aims to improve the macroeconomic environment and structural framework in which banks operate.

In its discussions with member countries, the IMF calls attention to emerging macroeconomic problems and structural deficiencies and recommends appropriate policy actions. The IMF's efforts to strengthen member countries' banking systems are also reflected in the design of IMF-supported lending programs and technical assistance, which in recent years has focused increasingly on banking legislation, regulation, and supervision and on the design of bank safety nets, including lender-of-last-resort facilities and deposit insurance schemes.

Since the mid-1990s, partly in response to the Mexican and Asian crises, the IMF has kept a watchful eye on financial sector issues, paying greater attention to the banking sector, the sustainability of capital flows, and situations where crises could spill over into other markets. At its April 1998 meeting, the IMF's governing body, the Interim Committee (now the International Monetary and Financial Committee), set a demanding agenda for the IMF's work, including the central role to be played by the IMF in crisis prevention through its surveillance and its role in encouraging members to strengthen their macroeconomic policies and financial sectors. The Interim Committee also called upon the IMF to help members strengthen their domestic financial systems by encouraging them to develop supervisory and regulatory frameworks that are consistent with internationally accepted best practices, as well as strengthened standards for bank and nonbank institutions. Subsequently, the IMF has enhanced its surveillance of the financial sector through the Financial Sector Assessment Program (FSAP) conducted jointly with the World Bank.

In addition to its surveillance and institutional development work, the IMF has also provided extensive technical assistance to member countries in banking system restructuring—the management and resolution of banking sector problems. IMF staff has been actively engaged in assisting member countries in reestablishing their banking and financial sectors on a sound basis both during and immediately after financial crisis, frequently in the context of IMF-supported programs. Given the relatively high number of the IMF's 184 member countries that have experienced significant banking sector problems during the last decade, this has provided IMF staff with a unique vantage point from which to consider the issues involved in bank system restructuring and to gain a comparative perspective on the effectiveness of crisis management and resolution arrangements.

In recent years the IMF has spent a good deal of time developing "best practice" standards that allow it to judge the strength of banking systems and of the related bank safety net. Moreover, the IMF staff has also sought to reflect upon the expertise it has developed in assisting member countries to resolve their banking sector problems in the aftermath of financial crises. The present volume can be viewed as one outcome of this ongoing effort, in that it is concerned primarily with the practical lessons that can be drawn in building a sound financial sector and in both the prevention and management of banking system instability. It represents a distillation of the collective experience of the staff of the Monetary and Exchange Affairs Department (MAE), which has primary responsibility within the IMF for these areas. Given the breadth of the subjects considered, the present volume can inevitably only deal with selected issues.

The first part of this volume examines IMF surveillance and the best practice standards that serve as a benchmark for judging financial systems. Key prerequisites for banking system soundness are high standards of prudential supervision and regulation. The IMF's work, through the FSAP process and through its technical assistance program, which is increasingly shaped by the outcome of the resulting Financial Sector Stability Assessments, aims to help member countries raise their standards of supervision. In this way, member countries enjoy both improved access to international capital markets and an improved ability to manage the resulting capital flows. The IMF's work in this area is supported by the now well-established body of international best practice standards for banking supervision, with the work of the Basel Committee at its center. The key document of these standards is the Committee's Core Principles for Effective Banking Supervision, although the work of other financial organizations also has a direct bearing on the development of these best practice standards.

One important issue highlighted by the IMF's experience is that the existing body of international capital standards for banks presuppose adequate and comprehensive rules on the recognition and valuation of assets and liabilities, as well as the adequacy of rules for making provisions for impaired assets. Although a number of crisis-hit countries appeared to include banks that were well-capitalized according to international standards, their capital adequacy was overstated by the failure to recognize adequately (and hence provision for) nonperforming loans. Hence a robust system of loan classification and provisioning must be at the center of any system of banking supervision. The second chapter by Luis Cortavarria, Claudia Dziobek, Akihiro Kanaya, and Inwon Song reviews this important issue.

Foreign currency­denominated lending lies as the heart of the linkage between currency vulnerabilities and financial sector weakness. As a number of recent financial crises have demonstrated, foreign currency lending to domestic residents by domestic financial institutions can destabilize the banking system if such lending is not properly monitored and controlled. In the third chapter, Fernando Delgado, Daniel Kanda, Greta Mitchell Casselle, and R. Armando Morales argue against placing too much emphasis on outright restrictions on this type of lending. Instead, bank regulators and firm management need to pay close attention to developing internal control systems to ensure that banks are able to identify and control their risks.

Another form of risk at the micro-institutional level that can rapidly be translated into banking system instability at a macro level is the risk of illiquidity. Indeed, one of the primary reasons why special regulation of banks is necessary is because they engage in a process of maturity transformation, turning short-term liabilities into long-term assets. The robustness of banking systems, and of the financial sector more generally, can be enhanced if banks have access to deep and liquid money markets. Although the conditions for the existence of these markets are often taken for granted, they form an essential component of financial sector soundness. The fourth chapter by Claudia Dziobek, J. Kim Hobbs, and David Marston reviews some of the issues in establishing a sound infrastructure for liquidity management.

The framework for a systemic liquidity policy should be supplemented by emergency liquidity support, both for individually distressed institutions and for systemic disruptions. Emergency lending to one or a few nonsystemic institutions will necessarily differ from the support given to systemically important institutions, whose troubles could threaten serious banking sector instability. But in Chapter 5, Dong He argues that properly designed lending procedures, together with clearly laid out authority and accountability and disclosure rules, are all central to a well-functioning lender-of-last-resort function.

The final two chapters of Part I focus on the institutional structure of regulation. The lack of comprehensive consolidated supervision has been at the root of a number of banking sector problems. Some have argued that some of these problems might have been avoided if a single integrated regulatory agency had existed that could have surveyed the entire financial sector. Many IMF member countries have recently taken steps to create this very kind of integrated agency, thus attracting widespread international interest. In the sixth chapter, Richard Abrams and Michael Taylor review this trend and consider the circumstances in which the integrated approach might be adopted. They argue that the decision will rest on a complex matrix of factors that will vary according to the circumstances of particular countries.

In addition to the regulatory function itself, many countries distribute the responsibility for ensuring the soundness of the financial system among a variety of bodies. These include the government (usually the ministry of finance), the central bank, the supervisory agency (or agencies), and sometimes a deposit insurance agency as well. In times of crisis, a dedicated crisis resolution body is also often established. The extent to which these institutions are allocated clearly defined responsibilities and how they coordinate their activities can have important implications for the soundness of the financial system as a whole. In Chapter 7, Peter Hayward seeks to set out some guiding principles concerning the respective roles of these different bodies, so as to achieve the efficient allocation of their responsibilities and to ensure effective coordination.

Part II is concerned with banking system "restructuring." This term does not necessarily refer to the bank consolidation that is being observed in many countries around the world, but with the management and resolution of banking sector instability. Since in most countries serious banking sector problems are a rare event, the expertise and specialist knowledge concerning the most efficient mechanisms for resolving banking crises can rarely be found within a single country. A sense of what constitutes "best practices" in bank crisis resolution requires the degree of specialization and cross-country experience that the IMF is perhaps uniquely placed to provide.

Even the best-regulated and managed banking system can be overwhelmed by a sufficiently severe macroeconomic shock such as a sudden drop in currency values. In managing and resolving banking sector instability, one needs to bear in mind that the best practice in normal times may not represent the best practice in a crisis. This distinction runs through many of the chapters contained in Part II. Nonetheless, all the papers have as an overarching concern the need to minimize moral hazard, the notion that "bailouts" (or a promise of support) prompt recklessness among investors.

Countries whose banking systems have suffered only modest damage can cope by encouraging bank mergers and the acquisition of weaker banks by stronger ones. This technique raises important antitrust issues that exist in a particularly acute form in banking, especially because there is a prudential dimension to mergers and acquisitions in the financial sector that does not exist in mergers in other sectors of the economy. Thus, in considering mergers in the banking sector, there is a need to consider the interaction between competition law and prudential supervision. Michael Andrews examines in Chapter 8 some of the issues that arise in this comparatively neglected area and attempts to provide an overview of the principles and best practices that should be applied to financial sector mergers and acquisitions.

Where attempts to rehabilitate insolvent banks fail or are not feasible, then the banks should be liquidated. As insolvency laws differ among countries, universally applicable procedures for bank liquidation cannot be developed. However, there are a number of issues that must be addressed, irrespective of the legal environment, including the treatment of shareholders, the respective responsibilities of the central bank and the supervisory agency (where these are different), and the role and responsibilities of the bank liquidator. These issues are considered by David Hoelscher in Chapter 9, which also seeks to lay out specific procedures to be followed at each stage of the liquidation process.

Where the financial crisis has led to a collapse of asset values, a dislocation of secondary markets, and widespread real sector insolvency, a range of different techniques for banking sector restructuring and resolution is required. Chapter 10 by David Woo reviews two further possible approaches to resolving a systemic crisis--the creation of asset management companies and the creation of out-of-court centralized corporate debt workout frameworks--that have come to define the core asset management infrastructure of countries most seriously affected by recent financial crises. In addition to investigating their respective roles and evaluating their strengths and weaknesses, his chapter also seeks to develop benchmarks for assessing best practice in their design.

In several recent cases, the resolution of banking sector problems has involved the use of substantial amounts of public funds to permit banks to write off bad debts and to be returned to capital adequacy. Recapitalizing banks is a complex process that requires significant government intervention and careful management at both the strategic and individual bank levels. Chapter 11 by Charles Enoch, Gillian Garcia, and V. Sundararajan highlights the range of operational and strategic issues to be addressed and the institutional arrangements needed to foster an effective banking system restructuring and to maximize the return on the government's investment. The approaches to recapitalization have varied, with different countries choosing different mixes of capital injections and asset purchase and rehabilitation. The choice of an appropriate mix is critical to minimizing the expected present value of government outlays net of recoveries.

Where banking system restructuring has involved public funds, it will have often required the issuance of vast quantities of public debt. While government support to bank restructuring through the issuance of public debt can help address the immediate crisis, it can result in escalating costs to the government, raising significant--and often unanticipated--medium-term risks related to fiscal and debt sustainability and financial stability. Priya Basu in Chapter 12 concludes this volume by presenting a simple operational framework for quantifying, analyzing, and reducing such costs on an ex post basis.

As already noted, this volume has a strong practical flavor with most chapters growing out of the authors' close involvement in dealing with these issues in the context of IMF programs or technical assistance. Many of the chapters have appeared as Operational Papers of MAE or Working Papers of the IMF. As their name suggests, Operational Papers are intended to provide practical advice to experts working in the field, and are authored by MAE staff based on their own extensive practical experience of the subject under review. By including these papers as chapters of the present volume we hope to make this important body of work available to a wider audience.