Publications on: Banking Crises Other Titles in the Occasional Paper Series

O C C A S I O N A L   P A P E R       224             Managing Systemic Banking Crises By a Staff Team Led by David S. Hoelscher and Marc Quintyn ©2003 International Monetary Fund August 28, 2003 Order Information Contents Preface I   Overview II   Systemic Crises: Causes, Cost, and Resolution The Emergence of a Systemic Crisis The Cost of Banking Crises Macroeconomic Context for Bank Restructuring A Strategy for Managing a Systemic Banking Crisis Implementation of Restructuring Strategies III   Crisis Containment Overview of Strategy Policies for Stabilization Burden Sharing and Depositor Protection IV   Bank Restructuring Overview of Strategy Legal and Institutional Framework Burden Sharing and Loss Allocation Bank Restructuring Options Returning the Banking System to Normal V   Asset Management and Corporate Debt Restructuring Overview of Strategy Managing Nonperforming Assets Corporate Debt Restructuring VI   Bank Restructuring and Macroeconomic Policies Issues in Monetary and Exchange Rate Policies Systemic Crises and Economic Growth Postcrisis Reintermediation The Impact of Sovereign Debt Restructuring Appendices I   Costs of Banking Crises II   Case Studies of Banking Crises References Boxes 1.   Bank Resolution Terminology 2.   Typology of Banking Crises 3.   Guiding Principles from Recent Systemic Banking Crises 4.   Dealing with Bank Runs in Dollarized Economies 5.   Indonesian Bank Closures--Doing It Wrong and Doing It Right 6.   Deposit Freeze: The Case of Ecuador 7.   Difficulties in the Identification of Bank Solvency 8.   How to Assess the Financial Condition of Banks: The Case of Turkey 9.   Elements of the Public Recapitalization Program in Turkey 10.   Appropriate Design Features of a Centralized Asset Management Company 11.   Good Practices for Corporate Debt Restructuring 12.   Best Practices in Corporate Workouts 13.   Depositor Reactions to Contract Changes Figures 1.   Fiscal Costs of Selected Crisis Countries 2.   Options for Asset Management 3.   Estimated Output Losses in Selected Crisis Countries 4.   Evolution of Bank Deposits and Loans in Selected Crisis Countries 1990­2001 Text Tables 1.   Liquidity Support During Selected Systemic Banking Crises 2.   Blanket Guarantees: Overview of Their Implementation Appendix Tables AI.1.   Fiscal Costs of Selected Banking Crises AI.2.   Fiscal Costs of Selected Banking Crises: Sources and Country-Specific Information AII.1.   Description of the System Before and After the Crisis AII.2.   Crisis Outbreak and Containment: Financial and Monetary Measures AII.3.   The Restructuring Phase: Judicial and Institutional Measures AII.4.   The Restructuring Phase: Financial and Corporate Measures AII.5.   Management of Impaired Assets AII.6.   Exit from the Crisis

I. Overview This paper draws lessons on the general principles, strategies and techniques for the effective management of systemic banking crises.1 Lessons outlined in this paper derive from the accumulated experiences of IMF staff. Principles and practices of crisis management derived from earlier crises have already been discussed by the IMF Executive Board and subsequently published.2 Recent financial sector crises and their resolution have raised new issues and provided additional experiences. Specifically, banking crises in Argentina, Ecuador, Russia, Turkey, and Uruguay have occurred within the context of highly dollarized economies, high levels of sovereign debt, and/or severely limited fiscal resources. These factors have introduced new challenges as the effectiveness of many of the typical tools for bank resolution has been affected. Banks' unique features—their key role in intermediation and growth, price stability, and the payment system—makes the management of banking problems markedly different from the management of other corporate failures. This paper focuses, however, on issues raised in systemic crises and not on the resolution of individual bank problems. Resolution of individual bank problems in normal times is the subject of a recent report by the Working Group of the Basel Committee on Banking Supervision.3 This paper draws on the conclusions of that report and should be seen as a complement to it. In the same vein, in-depth discussions of legal issues are being addressed by a joint IMF/World Bank project.4 Managing a systemic banking crisis is a complex, multiyear process. Whereas defusing an initial li- quidity crisis may be accomplished in a few weeks, resolving a systemic banking crisis and the related corporate debt restructuring can take many years. While many of the initial measures are macroeconomic in nature—meant to restore confidence—the medium-term restructuring is largely a microeconomic exercise. The key to successful banking crisis management is coordination of the banking strategy with the overall policy framework. Management of such crises often requires adjustments in most aspects of economic policy implementation. While this paper concentrates on the specifics of bank restructuring, policymakers need to be aware of the broader policy context within which bank restructuring must take place. Banking resolution has to take place in a supportive macroeconomic environment. Over the full cycle of a crisis, this often requires the authorities to deal with various combinations of monetary and exchange policies (including the possible introduction of capital controls), and fiscal and debt management policies. Macroeconomic constraints must be consistent with the framework for addressing banking sector problems. Banking crises are often costly to society. The costs of banking crises can be minimized if appropriate policies are followed. The banking strategy must be rapidly designed and efficiently implemented. A delay in addressing the emerging crisis increases the costs and prolongs the crisis. Modifications in the legal framework may become necessary if bank shareholders and creditors have excessive powers that allow them to pass eventual costs to the government. The process of bank diagnosis must be quickly implemented. The banking strategy, together with the policies concerning depositor protection, should be designed to avoid the presumption that banks cannot fail. Rather, the strategy should aim for an efficient banking system that is viable over the medium term. In an effort to limit the public costs of a crisis, private funds should be the first source for bank recapitalization. To that end, it may be helpful to maximize private sector participation in bank restructuring. This latter effort may involve reducing legal impediments to foreign investment in the banking system. The provision of public resources, in turn, should be subject to clear and transparent rules. Moreover, the policy on the provision of public resources should be made within the context of the medium-term sustainability of the public sector finances. Finally, the eventual costs of a banking crisis will be eased by the adoption of appropriate techniques to maximize asset recovery and reprivatization of intervened banks (see Box 1 for bank resolution terminology). Box 1. Bank Resolution Terminology Some terms related to bank resolution have a range of meanings. The following terminology is used in this paper:Intervention or takeover of insolvent or nonviable institutions by the authorities refers to the assumption of control of a bank, i.e., taking over the powers of management and shareholders. The term "intervened bank" is used to indicate a bank where such actions have taken place. Such a bank may be closed or may stay open under the control of the authorities while its financial condition is better defined and decisions are made on an appropriate resolution strategy. Such strategies include liquidation, merger or sale, transfer to a bridge bank, recapitalization by the government, and sales or transfers of blocks of assets or liabilities. A bank undergoing this process is termed a "resolved bank."Closure means that the bank ceases to carry on the business of banking as a legal entity. A closure may be part of a legal process of achieving the orderly exit of a weak bank through a range of resolution options, including liquidation or a complete or partial transfer of its assets and liabilities to other institutions. A bank may be left with a rump of bad assets to be worked out. Withdrawal of the banking license typically accompanies a closure.Liquidation is the legal process whereby the assets of an institution are sold and its liabilities are settled to the extent possible. Bank liquidation can be voluntary or forced, within or outside general bankruptcy procedures, and with or without court involvement. In liquidation, assets are sold to pay off the creditors in the order prescribed by the law. In a systemic crisis with several institutions to be liquidated simultaneously and quickly, special procedures or institutions may be needed for the liquidation because existing structures cannot carry out the job in a timely manner.A merger (or sale) of an institution means that all the assets and liabilities of the firm are transferred to and absorbed into another institution. Mergers can be voluntary or government assisted. A key issue is to avoid mergers of weak banks that result in a much larger weak bank, or the weakening of an initially strong bank.In a purchase and assumption operation, a solvent bank purchases all or a portion of the assets of a failing bank, including its customer base and goodwill, together with all or part of its liabilities. In such a supported purchase and assumption operation, the government typically will pay with securities to the purchasing bank the difference between the value of the assets and liabilities. Purchase and assumption operations could include some form of put option, entitling the acquiring bank to return certain assets within a specified time period, or a contractual profit or loss­sharing agreement related to some or all of the assets.A bridge bank involves the use of a temporary financial institution to receive and manage the good assets of one or several failed institutions. A bridge bank may be allowed to undertake some banking business, such as providing new credit and restructuring existing credits. A full crisis-management cycle represents a sequence of interdependent events. To present and discuss such a sequence poses a challenge, yet can look deceptively orderly. It is important to keep in mind that no presentation represents a one-size-fits-all model for dealing with systemic banking crises. There are common threads and similarities among countries but, in the end, all countries have to deal with their own special economic, legal, institutional, and political conditions. The intention here is modest—to present and discuss tools that are available and how they can be used. The structure of the paper is as follows: Section II provides a brief discussion of causes of a systemic banking crisis, its costs, and the crisis management strategy. Section III describes the initial crisis containment stage. Section IV deals with the second component, bank restructuring, while Section V covers the third component, management of nonperforming loans and corporate debt restructuring. Section VI discusses linkages between bank restructuring and macroeconomic policies. Appendix I discusses the methodology for measuring fiscal costs associated with major systemic crises. Finally, Appendix II provides case studies of key systemic banking crises that have emerged since the early 1990s. 1There is some debate about the definition of a systemic crisis. Systemic crisis is generally considered one in which the stability of the banking system and, as a consequence, the payments system and real sector, are threatened. 2Lindgren, Garcia, and Saal (1996); IMF (1997); and Lindgren and others (1999). See also Bank for International Settlements (1999) and Dziobek and Pazarbas,ig(breve)lu (1997). 3Basel Committee on Banking Supervision (2002). 4A joint IMF/World Bank project is developing guidelines for the legal and institutional aspects of dealing with bank insolvencies (forthcoming IMF/WB paper). On this topic, see also Asser (2001).