Lessons from Financial Crises Crises

1
Lessons from Financial Crises Crises

• Stefan Ingves
• Moscow
• March 2009

2
Content of Presentation

• Structure of Crises - in general
• Crisis Management
• Crisis Resolution
• How to get out of the crisis? What have we
  learnt?
• Some Practical Solutions
• Conclusion

3
Structure of Crises

• The general structure of financial crises does
  not vary much.
• Types of crises
• Banking
• Currency
• Sovereign
• Political

4
Structure of crises

• Weak credit granting risk concentration excess
  liquidity low risk premiums regulatory gaps
• Property and other bubbles burst macro economic
  downturn risk aversion increases
• Loss of confidence leads to dried-up markets,
  interbank lending and household deposits.
• Private and public measures to reduce extent of
  crisis and to reduce costs to participants incl.
  society at large.

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Similarities between Crises

• Many similarities on all components of the crises
  structure Weak credit granting excess
  liquidity excessive risk appetite regulatory
  gaps property bubbles which burst in an economic
  downturn.
• Recognized ex post
• Moral hazard vs Had no idea!

6
New Features in Present Crisis

• The interlinkages of markets (credit,
  securities, liquidity etc.).
• The increasingly global character of the
  financial system.
• The opacity of certain instruments and
  organisational structures.
• The new business model of banks.

7
Crisis Management Generally Valid Principles

• - Swift and forceful actions by authorities,
  often based on insufficient information.
• Transparent and predictable solutions.
• Openness and active communication to explain the
  situation.
• Close coordination between authorities and
  between political parties.
• Provide incentives (sticks and carrots) for
  private sector to act,the common good.
• State financial support to banks non-trivial.

8
Crisis Management - Differences

• Liquidity squeeze across markets and countries.
  Need to restore confidence (State guarantees) and
  to infuse liquidity (central bank facilities in
  local currency and in USD).
• Coordinated actions between countries both for
  liquidity and solvency support.
• Stigma when using certain facilities so this
  must be taken into account when constructing
  them.

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Crisis Resolution - Similarities

• All the basic alternatives are still valid and
  are being used
• Private solutions Lloyds bought HBOS
• Facilitated solutions Bear Stearns
• Bridge bank IndyMac
• P A Bradford
  Bingley
• Open bank assistance IKB (Germany)
• Nationalisation Northern Rock
• However, crisis resolution have now been expanded
  to new categories of institutions such as
  invextment banks, insurance, Govt sponsored
  agencies.

10
Current Plans

• Intensive international activity now going on
  May reduce risk for future crises but not for the
  current one.
• More urgent Focus must be on restoring
  confidence so banks may fund themselves and
  expand lending again. Some of the national and
  international measures so far have not led to
  expected results since they are misconstrued
  (e.g. incorrect pricing policies for guarantees).

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What have we learnt?

• Basic mistakes led again to a crisis Lax
  lending flawed risk assessments concentration
  risk inadequately explored instruments and
  models. Lending based on optimistic assumptions
  on property prices.
• Crisis resolution Tough decisions by banks and
  authorities cannot be avoided. The challenge is
  to distribute the losses so that the overall cost
  (not only financial) is minimized.

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What have we learnt ?

• Restoring confidence is paramount. Transparency
  is crucial Proper valuation of assets Clear
  rules and incentives for dealing with distressed
  institutions.

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How to get out of this crisis?

• Full transparency about balance sheets set
  realistic values.
• More equity is needed but not enough.
• Homeopatic palliatives should be avoided.
  (Changing accounting or prudential regulations).

14
The Swedish Model

• Structured framework for bank resolution
• High degree of transparency
• Political consensus
• Rescuing banks, not owners
• Govt interventions in banks as needed
• Govt upside
• Active use of AMCs

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Practical Solutions in Present Crisis

• The Problem Lack of confidence
• The Cure Restore confidence by transparency
  bank-by-bank
• - Identify all toxic or otherwise weak assets
  and transfer them at conservative values to AMCs,
  which could be free-standing or within the bank.
• Recapitalise the good bank and the AMC.
• Work with outside and neutral experts on true
  valuation of toxic/weak assets. Publish the
  results.

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Practical Solutions

• Should the Govt buy assets or recapitalise?
• Both. Asset transfers at conservative prices
  leads to need for recap. Bank must be adequately
  capitalized to dare to lend.
• A tempting but unworkable method is to transfer
  assets at overly optimistic values. This may
  stifle asset markets for many years.

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Practical Solutions

• Choice of method for restructuring a bank
• - Each bank needs a customized solution, but
  there should be a general framework to ensure
  fairness and predictability.
• - Perform due diligence to assess the situation
  and needs of each bank.
• - Use a triage method to assess a banks
  viability and restructuring alternative.

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A Non- Solution

• Experience has shown that some methods do not
  work, for instance
• Cuddling shareholders or management by letting
  them hold on to a failed bank (or buying it back
  at a low price) in spite of States capital
  infusion. The banks weaknesses will not be
  rectified. This does not mean that the State as a
  major shareholder should run a bank on other than
  commercial terms and by professional staff.

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Conclusions

• The present crisis is different global, across
  markets, complex instruments and opaque
  valuations,
• but proven principles for crisis resolution are
  still valid,
• and the crisis cannot be resolved until there is
  full transparency at the micro level.
• Bank restructuring is essentially corporate
  finance