Slide1: (
Financial and Banking Crises, Contagion Effects and Lessons for Developing Countries:
An Economist’s Perspective Leadership Breakfast Forum
6th Annual Conference of the International Association of Deposit Insurers (IADI) The Westin Langkawi
4 November 2007 Yeah, Kim Leng
Group Chief Economist
RAM Holdings Berhad
Presentation Outline: Presentation Outline Overview of Financial and Banking Crises
Transmission Channels of Economic and Financial Shocks and Contagion
Policy Responses and Lessons for Developing Countries
Concluding Remarks
I. Overview of Financial and Banking Crises Defining Financial Crisis: I. Overview of Financial and Banking Crises Defining Financial Crisis Currency or foreign exchange crisis – large deviation in an index of currency market pressures, typically a weighted average of changes in nominal exchange rates and in international reserves
Banking crisis – NPLs reached at least 10% of total bank assets or cost of rescue operations at least 2% of GDP; emergency rescue operations mounted (deposit freezes, blanket guarantees to depositor or creditors; bank holidays)
Debt crisis – classified by a global credit rating agency as being in default on any of its obligations; access to non-concessional finance from IMF in excess of a 100% of its quota A disturbance to financial markets that disrupts the market’s capacity to allocate capital – financial intermediation and hence investment comes to a halt. What is a financial crisis? Types of Financial Crises
I. Overview of Financial and Banking Crises Frequency and Costs of Financial Crises: I. Overview of Financial and Banking Crises Frequency and Costs of Financial Crises I. Frequency II. Costs Currency crises – 4-7 % of output
Banking crises – 12 % of output
Twin crises of currency and banking – 15 % of output
(Chile & Argentina – banking crises estimated to cost 40% of output) Period since the 1970s has been the most turbulent in world monetary history – more than 100 national banking systems collapse
Asset price bubbles in Japan, Nordic states, Southeast Asian countries and US.
I. Overview of Financial and Banking Crises Typology of Financial Crisis Models: I. Overview of Financial and Banking Crises Typology of Financial Crisis Models First Generation: Excessive government fiscal deficit leads to collapse of fixed exchange rate due to speculative attacks or panic runs as forex reserves fall below a critical level. Eg. Latin American debt problems in the 1970s. Second Generation: Caused by pursuit of incompatible expansionary monetary policy under a fixed exchange rate, resulting in overvalued currency and eventual break as government is unable to defend parity or require sharp rise in interest rates to stem capital outflow. Besides weak fundamentals, the causes include self-fulfilling currency crisis and speculative attacks. Eg. Mexican peso crisis of the 1990s. Third Generation: (a) Moral-hazard-driven bank lending; implicit government guarantee leads to ‘reckless lending’ by banks and ‘over-borrowing’ by the private sector; (b) bank runs due to self-fulfilling loss of confidence that forces financial intermediaries to liquidate investments prematurely; (c) contagion effects; (d) loss of confidence transfers problem from capital outflows to current account surpluses through currency depreciation; (e) deterioration in firms’ balance sheets due to combination of declining sales, high interest rates and a depreciated currency. Eg. 1997/98 Asian financial crisis
I. Overview of Financial and Banking Crises Typology of Financial Crisis Models (cont’d): I. Overview of Financial and Banking Crises Typology of Financial Crisis Models (cont’d) Fourth Generation?: Deterioration in sub-prime mortgage market leads to losses in CDOs and CLOs, risk repricing and liquidity tightening in short term CP markets that funded leveraged investment vehicles
I. Overview of Financial and Banking Crises Causes of Firm Distress and Crisis: I. Overview of Financial and Banking Crises Causes of Firm Distress and Crisis External
demand contraction
profit margin squeeze
falling asset prices
escalation in import costs
rise in debt servicing burden
credit squeeze
increased working capital needs Company financial distress arise from various internal or external causes or combinations thereof….. Internal
over-optimistic forecasts and plans
over-leveraging
funding mismatch – maturity and currency
sectoral over-exposure/ over-concentration
poor management In a market-based economy, firm failures are common even under normal economic conditions as inefficient or uncompetitive ones are forced to exit.
In a crisis situation, we are concerned with systemic or industry-wide failures where even ‘good’ firms fail, resulting in loss of productive capacity and jobs.
I. Overview of Financial and Banking Crises Causes of Economy-wide Crisis: I. Overview of Financial and Banking Crises Causes of Economy-wide Crisis Financial fragility or vulnerability is increased by: External
Deterioration in terms of trade
Volatile international interest rates
Abrupt changes in capital flows
Volatile exchange rates
Speculative currency attacks
Investor panic
Foreign capital pull-out Internal
Slowdown in growth
High inflation
Excessive “connected lending”
Excessive growth of domestic assets
Real estate lending boom
Term mismatch between bank liabilities and assets
Currency mismatch in banks’ balance sheets
Excessive external borrowings by banks
Inadequate prudential supervision and regulation
II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers: II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers Capital Flight and
Credit Withdrawal TRIGGERS Asset price deflation FINANCIAL DISTRESS AT FIRM LEVEL Credit Squeeze Escalating Debt Service Liquidity Problem Insolvency Currency Runs and
Speculative Attacks TRANSMISSION CHANNELS Interest - rate hikes Credit tightening Higher input cost Excess capacity/inventories Demand Contraction DEMAND SHOCKS SUPPLY SHOCKS FINANCIAL SHOCKS Reduced Cashflow Generating Capacity Exchange rate depreciation Loss of Confidence and Investor Panic
II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers: II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers Financial linkages – a Malaysian example Corporate bond defaults indemnified by Malaysian Banks during the 1997/98 Asian Financial Crisis Issuer Instrument Value (RM million) Kelanamas Industries Bhd Bond+Warrants 55,000 Capitalcorp Securities Sdn Bhd RUF 100,000 Seng Hup Corporation Bhd NIF 25,000 Omega Securities Sdn Bhd RUF 100,000 Arab-Malaysian Corp Bhd RUF 210,000 Arab-Malaysian Corp Bhd RUF 250,000 Timbermaster Industries Bhd Bond+Warrants 75,000 Pembinaan YCS Bhd Bond+Warrants 60,000 Tajo Bhd Bond+Warrants 33,000 Jupiter Securities Sdn Bhd RUF 50,000 Renong Bhd Bonds 450,000 Ho Wah Genting Bhd Bond+Warrants 40,000 Wing Tiek Holdings Bhd Bonds 30,000 Associated Kaolin Industries Bhd Bonds 40,000 Pengkalen Securities Sdn Bhd GRUF 100,000 TOTAL 1,618,000
II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers: II. Transmission Channels of Economic and Financial Shocks and Contagion Transmission Channels, Linkages & Spillovers Real–financial sector linkages – Malaysian experience Distressed Companies Financially Sound Companies Core No. Exposed % Exposed No. Exposed % Exposed Industry Companies to Property to Property Companies to Property to Property Industrial 9 5 55.6% 10 0 0.0% Infrastructure 2 1 50.0% 7 0 0.0% Property 9 9 100.0% 4 4 100.0% Mining 0 0 na 4 0 0.0% Plantation 0 0 na 3 0 0.0% Construction 6 6 100.0% 2 2 100.0% Others* 5 1 20.0% 10 6 60.0% Total 31 22 71.0% 40 12 30.0% Non-Property 22 13 59.1% 36 8 22.2% Companies ... distressed companies show a higher percentage of exposure to the property sector than financially sound companies
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries Practice sound macroeconomic management
Pursue fiscal and monetary policies that do not result in excess liquidity and high inflation
Adopt viable exchange rate regime that does not result in overvaluation, unsustainable peg and high currency volatility
Build adequate foreign reserves to insulate against sudden reversals in capital flows A. Preventing Crisis
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries Prepare adequately for financial liberalisation
When pursuing financial sector liberalisation, watch for excessive credit creation in liberalized sectors such as real estate and securities
Reduce connected lending and state involvement in banking sector
Strengthen domestic financial institutions particularly in the area of risk management
Develop bond markets to reduce concentration risk and maturity mismatches in banking system
Strengthen corporate accounting and disclosure standards
Enhance informational efficiency across all markets A. Preventing Crisis (cont’d)
III. Policy Responses and Lessons for Developing Countrie: III. Policy Responses and Lessons for Developing Countrie
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries Appropriate policy responses
Loosen fiscal discipline to ease crisis-induced recession
Allow exchange rate flexibility and save foreign reserves if currency is attacked
Provide assistance to private sector – assist entrepreneurs to raise capital and encourage new set of entrepreneurs including FDIs.
Institutionalise or promote orderly debt work-outs
Voluntary rescheduling and restructuring
Lengthening of maturities
Part conversion of debt into equity
Write-off of bad loans by creditors
Avoid nationalization of private debt B. Managing Crisis
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries Address illiquidity issues to restore credit flows and business confidence – Malaysian experience during the Asian crisis:
Money market operations
Placement of deposits
Reduction in SRR (from a peak of 13.5% to 4%)
New liquidity framework
Lowering of interest rates
Administration of lending margins B. Managing Crisis (cont’d)
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries B. Managing Crisis (cont’d) Address insolvency problems – Malaysian experience:
Banks
Specially constituted entity to inject capital into distressed banks; funded by issuance of bonds (Danamodal)
Special purpose vehicle to carve out non-performing loans from banking system (Danaharta)
Encourage bank mergers and acquisition of ailing banks by stronger ones
Corporates
Special body to facilitate voluntary debt workouts for large borrowers with multiple creditors (Corporate Debt Restructuring Committee)
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries B. Managing Crisis (cont’d) Assistance rendered to distressed borrowers through voluntary debt workouts arbitrated by Corporate Debt Restructuring Committee: Actual amount injected to recapitalize the banking system was far below the initial estimate Malaysian experience during the 1997 Asian financial crisis
III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries: III. Policy Responses and Lessons for Developing Countries Lessons for Developing Countries Every crisis is different – the current US sub-prime mortgage crisis
Too much liquidity and extended period of very low interest rates resulted in excessive risk taking and risky lending (lowering of credit standards) that fueled housing market boom and caused huge compression of credit spreads in US short term capital markets (versus Asian banks during the 1998 financial crisis).
Combination of liquidity and insolvency/debt crisis among a variety of borrowers that overborrowed excessively during the boom phase of the latest Minsky credit bubble (“hundreds of thousands of US households are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime – no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had these toxic waste characteristics”…Roubini).
Subprime mortgage problems took time to surface because of information gaps, use of derivatives (‘slicing and dicing of risks’) and rising number and size of leveraged hedge funds and special investment vehicles.
Combination of risks (global economic slowdown, US current account and fiscal deficits, oil and commodity price shocks, Asian currency appreciation, terrorism) will accentuate fall-out in any particular financial market segment.
IV. Concluding Remarks Concluding Remarks: IV. Concluding Remarks Concluding Remarks We still do not fully understand the causes, triggers and timing of financial crises, contagion and transmission channels. Continuing vigilance and sharing of information by all parties – regulatory agencies, industry players, market intermediaries and rating agencies – are needed. Regional cooperation framework for liquidity support and coordinated response mechanisms to manage currency and capital market volatility.
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