No End in Sight: Early Lessons on Crisis Management

By Stijn Claessens and Ceyla Pazarbasioglu

(Version in Español)

Crises are like stories; they have a beginning, middle, and an end, and on occasion, we learn something along the way.

In times of crisis, choices must be made. In the most recent global economic crisis policymakers moved quickly to stabilize the system, providing massive financial support, which is the right response in the beginning of any crisis. But that only treated the symptoms of the global financial meltdown, and now a rare opportunity is being thrown away to tackle the underlying causes.

Without restructuring financial institutions’ balance sheets and their operations, as well as their assets ‒ loans to over-indebted households and enterprises ‒ the economic recovery will suffer, and the seeds will be sown for the next crisis. 

In our new paper we analyze the policy choices made during the crisis and compare them to a number of past ones. It turns out the phases of this crisis followed the same pattern as previous ones, but policymakers made different choices this time around. This has a lot to do with the distinct nature of this crisis; unlike those in the last 20 years, it was truly global and more complex to handle because financial institutions and markets are larger and more interconnected than ever before.

Lesson # 1All choices have a cost, some with long term effects

The complexity and severity of the recent crisis justified a rapid response to contain risks and restore confidence. While less deep restructuring early on lowered the costs in the short term, there may be higher costs in the years ahead. In particular, the policy mix chosen precluded thorough due diligence, and may reduce incentives to restructure assets. The risk is that, instead of a policy of triage, diagnosis-based resolution, and early asset restructuring, a muddling-through approach prevails. This approach, including accounting and regulatory forbearance, guarantees, and implicit public support stalls addressing nonviable banks and nonperforming assets.

Many of the structural characteristics that contributed to the build-up of systemic risks are still in place today, and moral hazard has increased. In most countries, the structure of the financial system has changed little. In fact, concentration often has increased—on average for the 12 crisis countries we examined, the assets of the five largest banks have gone from 307 to 335 percent of GDP—as large banks acquired failing institutions. This complicates resolution efforts. The large-scale public support provided to institutions and markets—a contingent liability equivalent to one-fourth of GDP at the peak of the crisis—has exacerbated perceptions of too-important-to-fail.

Lesson #2 – Find out what you don’t know and fix what you can

Diagnose the problem to learn about the viability of financial institutions and support only those that are viable, and close or restructure the nonviable ones. Stress tests were conducted and the results published in the U.S. and in Europe in May 2009, and July 2010 respectively, but only after initial government recapitalization.

While these stress tests restored short term investor confidence, their long term impact has been uneven, especially in Europe, in part due to different financial market perceptions about the credibility of assumptions used and remedial actions announced in conjunction, and subsequent events. As a result, European authorities have been compelled to engage in a new round of stress tests.

Lesson #3 – Create a global playbook

Restructuring the global financial system requires tools and policies that, just like banks, reach across country borders. It will also require policymakers to cooperate globally, just as they did at the peak of the crisis.

Since the crisis, several countries have adopted more effective resolution schemes for large financial institutions, which should allow future losses to be borne by uninsured creditors. But many countries still lag in this respect, including in how to allocate losses. The new resolution schemes remain untested to deal with failures of large cross-border institutions, and much more needs to be done to enhance the supervision of cross-border exposures and related risks.

The end of this story hasn’t been written yet, and we shouldn’t throw away the opportunity to change the way the global financial system operates for years to come.

8 Responses

  1. A great informative article looking at how to handle this nations crisis, from what we can learn from it to how to handle it and how to expect the best out of the situation this article seems to have it covered.

  2. The Basel Committee makes a shocking confession!

    The Basel Committee for Banking Supervision, speaking for all sophisticated bank regulators around the world, issued today an urgent statement regarding the discovery of a fundamental mistake committed in Basel II and which they now understand was responsible for causing the current financial crisis.

    The mistake was that though the markets and the banks were already incorporating the information about the possibilities of default that were contained in the credit ratings when calculating the corresponding risk premiums to set interest rates for their clients, the regulators based the capital requirements for banks on exactly the same credit ratings, and so, unwittingly, accounted for said credit information twice.

    The result of it was, of course, the excessive financing of everything that was officially deemed as having a low risk of default, like whatever had swell ratings like Greece and securities backed by lousily awarded mortgages to the subprime sector; and the insufficient financing of whatever was officially deemed as more risky, like the small businesses and entrepreneurs who are vital for maintaining that dynamism of the economy that creates jobs.

    The Basel Committee expresses its most sincere regrets for such a mistake and promises to take immediate corrective action.

    PS. April Fool´s joke disclaimer: Sorry, unfortunately, the Basel Committee and the sophisticated bank regulators, three years into a crisis of its own making, are still not (publicly) aware of their mistake.

    The Independent Evaluation Officer of the International Monetary Fund has recently in an Evaluation Report come to the conclusion that, for IMF at least, “the ability to correctly identify the mounting risks was hindered by a high degree of groupthink…” The reason why the truth of what happened does not come out must probably now be attributed to group-interests.

  3. “Diagnose the problem”!!!

    At this moment the best way to tackle the lack of capital that a bank faces is for it to collect the loans given to small businesses and entrepreneurs and which generate high capital requirements, and lend it to, for instance, Spain–something which even after Spain´s credit rating downgrading, as a good rated sovereign generates minimum capital requirements, if any at all.

    Banks are now also building up monstrous exposure to interest rate risk, but the monothematic regulations from Basel base the capital requirements only on the perceived default risk… of the clients of the banks.

    Clearly shamefully little has been learned from this crisis as that requires acknowledging the problems, and when the main source of the problems are the regulations, that unfortunately makes for a very uncomfortable learning process for the regulators.

  4. [...] citadel of that second-guessing is at the International Monetary Fund, where researchers this week concluded that the rescues “only treated the symptoms of the global financial [...]

  5. [...] citadel of that second-guessing is at the International Monetary Fund, where researchers this week concluded that the rescues “only treated the symptoms of the global financial [...]

  6. Sir / Madam

    With regards to reply at 21.32 March 9, all I can say to u is, Rubbish; For far too long these banks have being doing whatever they like. And here we are in 2011 and the banks are sill in the same mess as they where in 2008, with no end in sight. And as for these ‘so-called’ stress test what a load of bull. I said it before and I will keep on saying until the day Ii die, someone within the IMF/EU/ECB has a vested interest. These bank have no interest, nor do they care what everyone is saying. YET 2.5 years on, these bankers are still ripping the people off, and what is the ECB/IMF/EU doing? Nothing. Sorry, they are holding their meetings; and with regards to the German prime minister, maybe it’s time she shut up and stopped telling the ECB and Ireland what to do. It looks to me like Germany / France seem to be telling everyone what to do /say. Ireland has every right to say that the interest being paid is too high, and as a member of the E.U has the right to complain. And noone has the right to tell Ireland anything about our 12.5 tax. It has nothing to do with Germany or France.
    Note: I, P.J. Carroll, call on the people of all EU counties to take to the streets and DEMAND that the IMF/EU gets off it’s fat behind and STOPS giving these banks tax-payers money, and DEMANDS these banks sort out their mess.
    Philip j Carroll
    Dublin

  7. Sir / Madam

    With regards to the two named persons regarding this paper, all I would say to them is “Waken Up.” Two senior executives enjoyed earnings above the €500,000 banking cap, with their perks pushing them above the €500,000 mark. So with regards to this paper on the banking mess, What a load of bull; These banks DO NOT give a toss about the likes of these reports/paper ‘etc.’ Remember these bank are the ones in control,

    Philip j Carroll

  8. On stress testing of banks, there are more questions than answers……..Is there a wider correlation of the perception of investors to the credibility of the stress tests undertaken by the European bank regulator and the remedial actions supposedly taken in June 2009 and July 2010 by the different European banks and governments? Also, why did the Irish banks need a government bail-out after stress-tests were conducted and a good health check certificate issued? And why have the EBA felt it necessary to embark on a new round of stress tests now? What does it hope to achieve? The other question that I would like to ask is whether stress testing is best left to the national regulator of each country in the EU rather than a centralized authority like the EBA? Would that improve investor confidence in the markets in the individual countries? The historical evidence suggests that trying to achieve a certain level of banking regulatory harmonization in a monetary union through a centralized regulator has not been very successful till date.

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