Mr. Ferguson discusses the role of banking in the global market-place  (Central Bank Articles and Speeches, 16 Apr 98)
Central bank: fed | Type: speech | Date: 1998-05-17

Mr.

Ferguson discusses the role of banking in the global market-place Remarks by Mr.

Roger W.

Ferguson, Jr., a member of the Board of Governors of US Federal Reserve System, before the Urban Bankers Coalition, Inc., in New York on 4/1

## Are Banks Safe for the World and Is the World Safe for Banks?Thank

you for your kind invitation to speak to you this evening.

Your banking in the global market-place, is obviously timely.

Given the role of internati flows, I expect that this is a topic that will continue to be the focus of a great de The current crisis in Asia, which is both a banking crisis and a macroeconomic cris starting point of my talk this evening.

As I considered the Asian crisis, I became know whether it is a unique problem due to a unique set of circumstances, or an acci happened in a few Asian countries this time, but could occur in other countries at a time.

I would like to share with you the results of my inquiries.

## Banks Continue To Be Important in a Global ContextThe starting point of my research was to confirm the critical role banks c to

play in global finance, particularly for countries with relatively underdevelop markets.

For example, the Bank for International Settlements estimates that the international bank loans had grown to $8.5 trillion at the end of September 1997 30 times the level 25 years earlier.

Importantly, loans to developing countries now $1 trillion.

While it is true that international bond and equity flows have grown period, new issues of bonds only exceeded bank lending 10 years ago, and the st outstanding loans is still considerably greater.This flow of capital has been critical in increasing the standard of livi the globe.

Funds have flowed internationally from savers to borrowers, who generally t entrepreneurs and others in business who need capital to build businesses and serve c both in their home countries and overseas.

This international flow moves capital towar productive use, in principle, from the higher saving industrialized world to the h capital-short developing nations.Are there issues that should give us concern in this benign pic Unfortunately, there are many.

I would like to turn now to the question of whether safe for the world economy and if the world economy is safe for banking.

## Are Banks Safe for the Global Economy?The

current crisis in Asia led me to ask how many other countries experienced banking crises, either domestic or cross-border?

The answer I found may s you.

Research done by economists of the International Monetary Fund indicates that 13 181 countries who are members of the Fund, more than two-thirds, have experienced sign banking problems at some time since 1980 1 .

Thirty-six of those instances would be described banking 'crises' in that there were runs or other portfolio shifts, collapses of finan massive government intervention.

Several countries experienced multiple banking Banking crises have affected developed countries, such as the United States, Sweden,1 See 'Bank Soundness and Macroeconomic Policy', C.

J.

Lindgren, G.

Garcia, and M.I.

Saal, International Monetary Fund, 1996.BIS Review 33/1998and Norway, as well as rapidly developing or 'transitional' countries, including now Indonesia and Malaysia, but earlier Mexico, Argentina, and Chile.Banks fail for a number of reasons, including poor management, excessive taking, fraud and a poor operating environment.

Individual bankers too often fo fundamental tenets of banking, which are universal and apply to internationally active Amsterdam as well as to community banks here in New Amsterdam.

These tenets inclu Know your customer; understand the legal framework in which you are working; thoroug understand the sources of repayment and the risk of nonperformance; and price your s accordingly.

We know that in Asia banks violated some of these rules.

Banks often en directed lending, either directed by government bureaucrats or commercial enterprise shared ownership with the bank.

Because of government intervention in the lending p Asian banks had not developed the necessary credit risk skills, and bank superviso incapable of enforcing reasonable standards of behavior on the part of local banks.In the international context, the interbank lending problem that emerged arose in part because of a lack of transparency in the financial system, making it d foreign bank lenders to know the quality of the ultimate credit.

More importantly, foreign banks that funded Asian banks may have assumed an implicit government guarante inter-bank counter-parties because a history of supporting troubled institutions may ha impression.What is the impact of a banking crisis?

First, the financial cost of f insolvent banking system is high, and that cost is ultimately borne by the taxpayer.

F in Australia's banking crisis of 1989-1992, the IMF estimates the cost of rescuing st banks to be nearly 2% of GDP.

In Mexico, the overall cost of several programs to sup banking system is estimated (in present value) at 6.5% of GDP.

Currently in Jap government has announced an intention to spend as much as 30 trillion yen, 6% of GD support its banking system.

For Finland, Chile, and Argentina, the IMF estimated t impact of banking crises to have been between 4% and 8% of GDP.

Finally, in the U States, resolution of the S&L crisis is estimated to have cost $150 billion, approxima GDP in 1990.In addition to the cost imposed upon society, an unsound banking system ca carry out its credit-creation function and can distort macroeconomic performance. banks, ones with sufficient liquidity but a high percentage of nonperforming loan deteriorating capital base, act on a different set of incentives than do sound banks. to declare loans in default unless they admit their own insolvency, such banks may co lend to nonperforming borrowers or, alternatively, capitalize unpaid - and uncollectibl That is, they may act to defer recognition of their problems.

At the same time, they riskier investments to try to offset their problems with higher earnings.

In addition may attempt to attract depositors by paying higher interest rates than their solvent A high percentage of nonperforming loans may also lead to a contraction of credit, crunch,' as banks turn away sound borrowers in order to continue to support unsound o unduly raise underwriting standards in fear of making more weak loans.

Finally, a system that is unsound cannot perform its role as a transmitter of monetary policy.

P in emerging economies, in which other financial markets are not well developed, banks monetary policy by expanding or contracting their balance sheets, i.e., engaging in mo lending.

An economy which is relatively stagnant cannot easily recover using monetary it is saddled with an unsound banking system, because efforts to stimulate growth by interest rates may not lead to a sufficient expansion of lending.˝In an international context with cross-border lending, the same issues may Banks that are saddled with a large number of nonperforming loans from another country, private or public debt, will have a need to work out those loans, and continue to su borrowers rather than engage in new lending, either domestic or cross-border.

Simila banks are unlikely to be as efficient as they otherwise would be in transmitting the policy of their home country central bank into their home country macroeconomy.So it is clear that an insolvent banking system is bad for a local, and i global economy.

The costs to fix such as system can be substantial, the credit functio carried out properly by such a system, and monetary policy may be hampered.

## Is the Global Economy Safe for Banking?Obviously, however, the record of banking crises around the globe does not that

banking is the source of all problems.

Macroeconomic policy and the performa policymakers also have the potential to create systemic problems.

Macroeconomic condit policies that undergo sufficiently significant and unexpected changes impact all ba managed and poorly managed alike.

Unfortunately, the current Asian crisis and previo crises, including our own, indicate that a range of macroeconomic mistakes can lea unsound banking system.

Put another way, there are many macroeconomic roads to ruin.First, let's start with Asia.

The countries currently in crisis followed macroeconomic policies that in the main were sound.

They avoided fiscal deficits, and cases ran surpluses.

In addition, they avoided a general inflation in the prices o services.

However, notwithstanding responsible macroeconomic policies, strong incre private spending, much of it financed by bank credit and capital inflows, turned out have been unwarranted.

Much of the increased investment spending was concentrated in and real estate, and asset price bubbles emerged.

Moreover, exchange rates were in so allowed to get out of line with fundamental forces in the economy, leading to sharp in imports and a widening of trade deficits.

To some extent this effect was a result exchange rates to the U.S. dollar, or to a basket of currencies in which the dollar weight, at a time when the value of the dollar was rising against the yen.Exchange rate and capital flow problems could similarly be assigned blam several earlier banking crises, as well.

For example, in the late 1970s, the Chilean followed a policy of rapid exchange rate appreciation, culminating in a fixed exchang 1979.

Credit to the private sector rose sharply as massive capital inflows foll international slowdown in the early 1980s resulted in a collapse in the price of copp major export, an increase in the country's trade deficit, and a sudden reversal of its Recession followed and banks were left with unserviceable, foreign-currency-denomi debts.However, exchange rate problems are only one type of macroeconomic concern Other countries, such as Finland, Sweden and Norway, experienced banking crises foll explosions in central bank credit and bubbles in asset prices or in credit creatio Fiscal and monetary policy, and the need to reverse policy unexpectedly, can also banking crises if bubbles arise in asset markets and banks are heavily exposed to a inflated values through their lending practices or balance sheets.˝Other countries, particularly those that rely heavily on a single inte commodity export, such as oil, have experienced banking crises following rapid adjust the prices for those commodities.

Often in these cases, the government attempts to us monetary stimulus to offset the loss of standard of living that results from a commodity prices.

This policy generally only succeeds in inducing a cycle of strong perhaps accompanied by pressures on exchange rates, followed by a steep correction.Finally, here in the United States, the S&L crisis was due in part to dere of interest rates on deposits, that left S&Ls with low returns on assets but a high c In a scramble for new sources of revenues and an effort to generate earnings, S&Ls greater and greater risk.

## Potential SolutionsGiven this history of banking crises throughout the world - some the result banking practices, some tied to the rapid ebb and flow of cross-border capital, and so internal macroeconomic policies - what should one recommend?

I would like to focus on sets of solutions designed to minimize the risk of future cross-border banking (1) improvements in supervision and basic banking skills; (2) international tran including sound accounting standards; and (3) ways to avoid potential problems in capit This analysis also points to a responsible policy for countries faced with unsound systems.First, with respect to banking supervision, the faster pace and inc complexity of financial services mean that banking supervision has had to change its me rely more heavily on market forces as a means of regulating banks.

For example, the Reserve has become more focused on how individual institutions, including community b manage the risks of banking.In the international arena, the Federal Reserve is working with the Committee on Banking Supervision, which was established by the central banks of the industrial countries, to increase outreach to emerging-market countries.

The Basle C has recently published a set of core principles for effective banking supervisi implementation of these core principles should aid many countries in making their sup more effective.

I believe that adopting these principles, or something like them, is first step as countries move to participate more actively in global financial markets. probably near when we have to determine how to encourage more countries to adopt and comply with these principles, or their equivalents.

The world should not be subject to supervision in any country.Having sound banking practices may also be a necessary condition for hav fully open capital markets.

In general, the skill building and training problem f transitional countries is immense.

I believe that governments should probably spend time determining how to transfer solid banking skills into domestic banks as they spend determine whether to open capital markets.

To date debate has probably centered a bit on the latter and not enough on the former.Second, with respect to transparency, the Basle Committee is now exploring possibility of setting benchmarks for information about individual financial instit should be available to both supervisors and markets.˝More broadly, the time may be appropriate to hasten the adoption of wi accepted international accounting and disclosure principles that raise the standard for treatments in all countries.

These standards might focus on four key areas:

(1) financial statements; (2) management disclosure about risk profiles, risk management and performance; (3) timeliness of disclosure and (4) control and audit environment. would be three-fold.

First, any international accounting principles should provide th depicting a clear and fair picture of the condition of the bank and of corporate credit any principles should provide a means by which firms identify and disclose their maj such as funding, foreign exchange or concentrations.

Finally, compliance with these p should be sufficient to support market confidence in the basic integrity of a firm's financial statements and other disclosures.Such transparency is important because, ultimately, the market is the regulator.

However, adequate market discipline can be brought to bear only if inves information that is sufficient in quantity, reliability and timeliness.

As my coll Phillips has said:

'Well-managed firms can benefit if better disclosure enables them funds at risk premiums that accurately reflect lower risk profiles.

Inadequate disclosures, on the other hand, could penalize well-managed firms, or even countries, participants do not trust their ability to assess firms' or countries' fundament strength.'I indicated that historical experience teaches that volatile short-term cap particularly those involving banks, are often at the heart of banking crises.

A challenge, therefore, is how to minimize the impact of these flows without attempting them altogether, which is neither beneficial nor feasible.

One approach advocated by the so-called Chilean model.

This includes a system in which firms and banks that borr from abroad maintain a non-interest-bearing cash reserve at the central bank for one one-year term of the reserve deposit makes the requirement most onerous for shor positions, which is of course the intent.

Proponents argue that these controls longer-term, more stable investments.

However, there are downsides.

Over time, contr and almost certainly will, be circumvented, which might encourage even more controls. controls, if successful, tend to perpetuate or create distortions and inefficiencies protection of weak and poorly managed domestic financial institutions.

On balance recognizing these potential problems, I believe that short-term capital controls appropriate, if they are a temporary part of an orderly entry by a small country into capital market.All of the above initiatives and approaches are aimed at avoiding an ins banking system.

Nevertheless, since we know that banking accidents will happen in the market place, what is the best solution for countries that face an insolvent banking s best solution to emerge from these crises and significant banking problems appears remove the nonperforming loans from the bank system, even if only through governm (or quasi-governmental) purchases, and then resell them to private market participants prices available.

To the extent that the government is involved, a number of questi First, should nonperforming loans be purchased at par to help recapitalize banks?

This has been followed in some countries, but providing such a subsidy to banks does not d the issue of removing excess banking capacity nor does it discourage the repetition mistakes.

Second, what process should be used to determine which banks need to be clo merged, and which can continue to operate on a recapitalized basis, probably with new and managers?

Third, how much support should the government provide, through guarantee example, to purchasers of nonperforming loans?

Our experience in the United States i˝that the scale of such support, however structured, must be commensurate to the p Finally, and by no means least important, we must consider how official assistance structured, if at all, to minimize moral hazard.

Do we understand how to achieve burde with the private sector?

A critical point, though, is to act decisively to re mechanisms and place nonperforming assets in the hands of those capable of putting t greatest use.

Allowing a serious problem to languish can be a great and costly mistake

## ConclusionIn conclusion, we know that the banking industry plays and will continue t an important role in the global market place.

Unfortunately, a combination of poor practice, weak supervision and a number of macroeconomic shocks can destabilize a ba system.

The solutions might include bank supervision at the best international leve transparency, and, perhaps, some interference with capital flows.

When a banking becomes insolvent, however, there is no substitute for stripping away the bad assets allow banks to once again perform their special role in society.

Who bears the costs ensure market discipline may be the most important issues to be addressed in that solutUnfortunately, given changes in technology and global economic forces, I am that we will not stop discussing the issue of banking crises.

I appreciate the cha these thoughts with you this evening.˝