Advanced economies take twice as long to resolve financial crises as economies in developing or emerging markets. Their macroeconomic stabilisation policies could be the culprit
Countries typically resort to a mix of policies to contain and resolve banking crises, ranging from macroeconomic stabilisation to financial sector restructuring and institutional reforms. However, despite the origins of crises have much in common, existing crisis management strategies have been met with mixed success.
Successful crisis resolutions have been characterised by transparency and resoluteness in terms of resolving insolvent institutions, thus removing uncertainty surrounding the viability of financial institutions. This requires a triage of strong and weak institutions, with full disclosure of bad assets and recognition of losses, followed by the recapitalisation of viable institutions and the removal of bad assets and unviable institutions from the system.
Sweden’s experience during its banking crisis in the early 1990s is often hailed as an example of successful crisis resolution. The Swedish government moved swiftly to liquidate failing banks, recapitalise viable institutions, and remove bad assets from the system, avoiding large-scale forbearance and ‘evergreening’ of assets. As a result, Sweden avoided the prolonged stagnation that lingering bad assets would have entailed, achieving a quick recovery from the crisis, supported by external demand.
Yet not all countries achieve Sweden’s rate of success. Japan is a case in point. Instead of acknowledging the true extent of losses at troubled banks early on, authorities allowed insolvent institutions to continue to operate as ‘zombie’ banks, evergreening bad credits, and using deferred tax accounting to bolster their regulatory capital positions. The reluctance of these banks to resolve bad assets contributed to the Japanese lost decade.
While conventional wisdom would have it that advanced economies with their stronger macroeconomic frameworks and institutional setting would have an edge in crisis resolution, the record thus far supports the opposite conclusion: advanced economies have been slow to resolve banking crises, with the average crisis lasting about twice as long as in developing and emerging market economies.
While differences in initial shocks and financial system size surely contribute to these different outcomes, in a recent working paper we suggest that the greater reliance by advanced economies on macroeconomic policies as crisis management tools may delay financial restructuring, with the risk of prolonging the crisis. We refer to this as the ‘curse’ of advanced economies.
This is not to say that macroeconomic policies should not be used to support the broader economy during a crisis. Macroeconomic policies should be the first line of defence. They stimulate aggregate demand and sustain asset prices, thus supporting output and employment, and indirectly a country’s financial system. This helps prevent a disorderly deleveraging and gives way for balance sheet repair, buying time to address solvency problems head on. However, by masking balance sheet problems of financial institutions, they may also reduce incentives for financial restructuring, with the risk of dampening growth and prolonging the crisis.
Indeed, crisis responses to date in advanced economies have favoured accommodative monetary and fiscal policy, with the increase in public debt and monetary expansion amounting to about 21% and 8% of GDP, respectively – compared with about 10% and 1% of GDP, respectively, in developing and emerging market economies. In this context, monetary expansion, measured as the percentage increase in reserve money, should not be understood narrowly as conventional monetary policy, but also as capturing central bank liquidity support and unconventional measures to the extent that they increase reserve money.
Advanced economies are generally well placed to resort to macroeconomic policies to manage crises without being overly concerned about their impact on the exchange rate, inflation, or public debt. Advanced economies benefit from well-anchored inflation expectations and reserve currencies benefit from flight to quality effects during financial crises. Emerging market economies, on the other hand, may not have the fiscal space or the access to finance to support accommodative fiscal policy, while excessive monetary expansion can quickly translate into inflation and large decreases in the value of the currency, impairing balance sheets further in the presence of currency mismatches.
Political economy considerations also favour macroeconomic policies over deep financial restructuring policies such as bank recapitalisations. The latter are generally seen by the public as enriching bankers, while accommodative monetary policy, although less targeted to the underlying problem of insufficient bank capital, is more likely to harbour broad based support: low interest rates will support asset prices for investors and house prices for home owners, and will lower the debt burden for mortgage holders and other debtors.
Moreover, initially, a country’s crisis response will be limited to tools that are readily available and do not require institutional reforms or parliamentary approval. The restructuring of financial institutions will often involve parliamentary approval for government programmes to purchase assets or recapitalise banks and the resolution of banks often faces institutional and legal challenges, such as the lack of a resolution framework or the inability to intervene in ailing institutions. For example, many countries did not have the tools in place to resolve complex financial institutions, including non-banks, prior to the crisis. Macroeconomic policies, and especially monetary policy, are the obvious first line of defence also from this perspective.
The crisis response during the on-going global financial crisis, dominated by advanced economies, has also heavily relied on monetary and fiscal policy. These countries also used a much broader range of policy measures compared to past crisis episodes, including unconventional monetary policy measures, asset purchases and guarantees, and significant fiscal stimulus packages, in part reflecting the better macroeconomic and institutional setting of the countries involved. These policies were combined with substantial government guarantees on non-deposit bank liabilities and ample liquidity support for banks, often at concessional penalty rates and at reduced collateral requirements. Liquidity support has been particularly large in the Eurozone, indicating the significant role played by the eurosystem in managing the crisis. The absence of a common fiscal authority surely also plays a role here.
Taken together, these actions have mitigated the financial turmoil and contained the crisis. But it means that the bulk of the cost of this crisis has simply been transferred to the future, in the form of higher public debt and possibly a dampened economic recovery due to residual uncertainty about the health of banks and continued high private sector indebtedness. While monetary policy has avoided an even sharper contraction in economic activity, it has also discouraged more active bank restructuring. The lingering bad assets and uncertainty about the health of financial institutions risk prolonging the crisis and depressing growth for a prolonged period of time. Macroeconomic stabilisation policies should supplement and support, not displace financial restructuring.
Luc Laeven is deputy division chief of the International Monetary Fund research department and a CEPR research fellow. Fabien Valencia is an economist in the IMF research department. These views are those of the authors and should not be attributed to the IMF. The full-length version of this blog is available on Vox the website of the Centre for Economic Policy Research
