David Clementi: Crisis prevention and resolution
two aspects of financial stability
Speech by Mr David Clementi, Deputy Governor of the Bank of England, at the Inaugural Lecture at
the South Bank University Centre for Monetary and Financial Economics, London, on 6 September
2000.
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Introduction
Ladies and Gentlemen,
When I was invited to give the inaugural lecture at the Centre for Monetary and Financial Stability, I
was pleased to accept. It is obviously an honour to be asked to inaugurate any academic institute but
supporting the foundation of a centre dedicated to the pursuit of monetary and financial stability is, for
a central banker, a particular pleasure! After all, monetary and financial stability and the interaction of
the financial system with monetary policy are at the heart of the Bank's mission. The first of the
Bank's core purposes is maintaining the integrity and value of the currency or, in other words,
monetary stability; the second is maintaining the stability of the financial system.
I intend to focus my remarks on this second core purpose. Financial stability has always been an
integral concern for central banks. We have been reminded of its importance by the events of recent
years. The Asian Crisis in particular set in train a programme of international work and discussions,
looking at ways to prevent a recurrence and to handle one if it did. One concrete result was the
creation of the Financial Stability Forum, which meets semi-annually, bringing together central banks,
finance ministries and regulators to discuss issues of common concern and to develop policies for
controlling risks to the international financial system.
The work broadly falls into three categories: crisis prevention, surveillance and crisis resolution. It is
my intention today to concentrate on crisis prevention and crisis resolution and to discuss in some
detail two issues currently under debate. The first relates, in the context of the revision of the Basel
Accord, to the aggregate capital in the banking system and the optimal level of bank capital. The
second concerns the international financial architecture and the respective roles of the private and
official sector in dealing with liquidity crises.
But before I turn to these I would like to say something about surveillance. This responsibility is
shared in the UK between the Bank, FSA and HMT. Following the creation of FSA, the respective
roles of the three parties were set out in a Memorandum of Understanding between them. While HMT
is responsible for the structure of financial legislation and the FSA is responsible for the regulation of
individual firms, the Bank is responsible for the stability of the financial system as whole. To this end,
the Bank dedicates significant time and resources to tracking developments in the global economy and
financial markets with a view to identifying potential threats to financial stability. Major developments
are discussed each month in the Bank's Financial Stability Committee. Within the Bank, the Financial
Stability Committee occupies a similar position in relation to financial stability as the MPC does for
monetary stability. Bank staff present papers to the Financial Stability Committee evaluating the
overall conjunctural position and reviewing issues of specific concern. The staff assessment of
financial stability is shared with the Treasury and FSA and discussed with them in the Standing
Committee, set up under the MoU, that meets each month to monitor financial stability and to consider
issues of common concern. The objective is to identify sources of instability before problems emerge,
to be in a position to take preventative action or to respond quickly in the event of trouble.
The Bank sets out to articulate publicly its financial stability role and to communicate current concerns
by the publication semi-annually of the Financial Stability Review. Each edition includes an overview
of financial stability providing an assessment of current threats to the system, ranging from imbalances
in the major industrialised economies or debt structures in EMEs, to sectoral issues such as equity
market volatility or gearing in the telecoms industry. While other commentators may talk of economic
miracles, you can rely on central banks to find disaster waiting in the wings! But if surveillance feeds
off central bankers' capacity to worry, then crisis prevention and crisis resolution, working on rules to
minimise the risk or the cost of a financial crisis, may be the only prospect for us to get a decent
night's sleep.
Crisis prevention: bank capital requirements
I would like to discuss one particular weapon in the crisis prevention armoury, which is bank capital.
This is, of course, a very topical subject at the moment, with the revision by the Basel Committee on
Banking Supervision of the 1988 Capital Accord.
Importance of capital
Why does bank capital have a crucial role in crisis prevention? This question has two aspects: first, the
importance of capital itself; and second, the special role that banks play in the economic system.
Capital has a vital two-fold role. First, capital - or rather equity capital - acts as a buffer against
insolvency. It therefore helps to protect the system and limit calls on the safety net. And second, equity
capital helps to align the objectives of the firm's owners with the objectives of the authorities. Where
the owners of firms invest only pinpoint capital, or see their investment erode to the point where the
firm is only marginally solvent, owners have an incentive to "gamble for resurrection", because with
limited liability, taking on extra risk has substantial potential upside but no extra downside for owners.
But with a higher cushion of capital, owners do have something to lose.
That said, we should not overstate the role of capital in ensuring the health of the banking system. If
other fundamentals are shaky - such as the macroeconomic environment, the legal system, or the
framework for asset valuation and auditing - capital is likely to produce only limited comfort. And
capital adequacy is of course only one aspect of prudential regulation, with other aspects of risk
management such as liquidity management and systems and controls also being vitally important.
The Basel Committee has now of course explicitly recognised that the formal regulatory minimum
capital framework is only one pillar in the edifice of bank soundness. It has to be complemented by
supervisors individually reviewing the capital adequacy of banks in the light of a wide range of risk
factors - the second pillar of the proposed new Accord - and by market discipline on banks, the third
pillar.
On the question of why we focus on banks, it would be difficult to overstate the importance of a stable
banking system to economic health and growth. Banks play a crucial role in intermediating savings
and credit and they are at the heart of the payments system. Most firms in most economies remain
heavily reliant on banks for finance, and even in economies where a significant number of firms can
turn to the capital markets for finance, banks retain important roles as providers of payment facilities,
short-term credit, and backup liquidity. In less advanced economies, their role is even more dominant,
to the extent that a number of full-blown macro-economic crises have had their roots in weak banking
systems.
Changes to the Basel Accord
As I have said, the capital framework for banks is currently under review by the Basel Committee. It is
worth reminding ourselves what this framework consists of. First, it sets out a method for measuring
the riskiness of assets. Second, it sets out a definition of capital. And third, it lays down a minimum
ratio between capital, the numerator, and risk assets, the denominator, namely that capital should be at
least 8% of risk-adjusted assets, with at least 4% of this consisting of Tier 1 capital.
What changes will the new Accord make to these elements?
The work has to date been heavily focused on the first element of the framework, the method for
measuring risk. There will be substantial changes here, with the aim of introducing more risk
sensitivity to the existing crude measures and to widen the coverage of the measures beyond just credit
risk and market risk which was addressed in the previous review of the Accord. The direction of the
changes was laid out in the Committee's consultative paper of June last year and I do not intend to go
into a description here.
On the second aspect, the Committee has stated that "With respect to the definition of regulatory
capital, the Committee will maintain at this stage the existing rules set out in the 1988 Accord." In
other words, they will not at this stage be revising their definition of capital. Just to remind you, this
definition of capital broadly divided capital into two tiers, of which Tier 1 mainly consists of
shareholders equity and reserves and Tier 2 of certain subordinated debt instruments and an element of
general provisions. There have been some modifications to the definition since 1988, for instance to
introduce another layer of less permanent capital to back short term trading risks, and more recently to
accommodate some more innovative types of issues which can be aligned with Tier 1 for capital
purposes (but with debt for tax purposes - an outcome which I believe is technically described as
"having one's cake and eating it"!).
It would of course be intellectually more satisfying to be reviewing the whole framework together, but
the Committee's decision not to revisit this definition at this time is, I believe, a defensible pragmatic
one: modernising the denominator is proving quite difficult and contentious enough without involving
the numerator as well. That said, there is a discussion which needs to take place at some point as to
whether the definition has achieved the right composition of elements and emphasis on those
elements.
How much capital does the system need
It is on the third aspect of the framework that I mainly wish to offer some thoughts today, that is, on
the level of capital that should come out of the framework. Here again, the Committee has signalled a
"no change" or at least a "no change in aggregate" intention, by saying that "The Committee believes
that the new framework should at least maintain the overall level of capital currently in the banking
system."
We should of course be under no illusion that the ratios chosen in 1988 were arrived through a
scientific process. If I may digress briefly into anecdote, I recall that Bill McDonough once related that
he had asked his staff why, under the market risk amendment to the capital accord, it had been decided
to apply a three-times multiplier to the outcome of VAR models. Why three times? The answer came
back that three times was selected because "two times was too low and four times was too high". I
imagine that the process of selecting 4% minimum equity was very similar to this. The selection of a
capital ratio ought, ideally, to depend upon answers to the following questions: what is the risk we are
trying to limit? What is a good measure of that risk? What residual level of risk are we willing to
tolerate? And how do we fix a capital level so as to achieve that residual level? These questions were
not explicitly addressed back in 1988, although possibly we can infer some of the implicit answers
from the regime that was established. However, although neither 1988's Accord's measure of risk nor
its selection of the minimum capital ratio may have been scientifically derived, the Committee's
statement that we will at least maintain the overall level of capital in the system indicates that, ex post,
they are reasonably happy with what the 1988 Accord achieved.
But what exactly do they mean by this statement? And how do we go about achieving their intended
outcome? Is it, indeed, a reasonable outcome to strive for? I will try to address these questions.
One way of thinking about the 1988 Accord is that, aimed principally at internationally active G10
banks, and using crude measures of risk that assumed some sort of average portfolio and profile of risk
for such banks, it set a "confidence level" for the soundness of individual banks and hence the system.
Looked at in this light, the Committee's statement means that the authorities do not intend to tolerate a
different - ie lower - level of confidence following the introduction of the new Accord. In other words,
under the new regime, the average internationally-active G10 bank will not be more likely to fail than
it would be under the old regime.
This seems a fairly sensible way to view the relationship of the old Accord with the new version. It
leaves plenty of scope to see redistribution of required capital, from less-than-averagely risky banks to
more risky ones. It also leaves scope for overall capital to reduce over time, if better risk measurement
or other techniques lead to a reduction in the risk taken.
That said, looking at the appropriate level of capital in this way still means that we have to be able to
measure the current confidence level for G10 bank insolvency which is established by the existing
Accord. This is not an entirely straightforward task. One starting point could be the ratings of G10
banks. The median rating of banks, taking the entire rated G10 population of more than 300 banks, is
A1 on the Moody's scale, or A+ on the Standard and Poor's scale. This would indicate a near-invisible
insolvency probability for such banks over a 1 year horizon. However, this very small insolvency
probability does reflect two factors which ideally we would wish to discount. First, the ratings reflect
the bank's actual capital level which will in most cases be significantly above the regulatory
minimum. And second, in some cases the rating also reflects the agency's expectation that public
support would be forthcoming for the bank, which of course we would wish to strip out. A more
accurate measure of the confidence level established by the Basel 8% would be the "standalone"
ratings produced by some agencies, for those banks whose capital is at or close to the Basel minimum.
Even on this basis, nearly all such banks are rated above investment grade. The message therefore
from this view of the matter is that under the new Accord we should be targeting a minimum level of
regulatory capital for our G10 internationally active banks that is at least consistent with an investment
grade rating.
An alternative way of assessing the regulatory soundness standard would be on a "bottom up" basis,
that is by modelling the probability of default arising from a typical credit portfolio if the bank held
only the Basel minimum capital. The advent of credit risk modelling techniques such as CreditMetrics
allow such an exercise to be attempted. Any results under this sort of approach need to be treated with
a fair amount of caution, given the number of assumptions involved. The work we have done at the
Bank, experimenting with these models and using different parameters, at least supports the
proposition that G10 international banks (the target constituency for the Accord) should have capital
on the basis of a one-year default probability that is consistent with an investment grade rating.
Assuming that we can somehow identify the current confidence level implicit in the existing capital
Accord, we may, as I suggested above, nevertheless want to debate the question of whether the
Committee would be right in aiming to replicate this under the new Accord. Is this a reasonable
objective? Or are we being too conservative?
Clearly there are types of banking exposures for which too much capital is being demanded, such as
lending to very high quality corporates. This has led to some exposures being moved outside the
banking system, through disintermediation or regulatory arbitrage. This problem is one of the main
drivers behind the Basel Committee's current review of risk measures. However, there are equally
transactions for which the Basel minimum is severely inadequate, such as lending to some OECD
countries. But the question is really whether on average the regulatory requirement produces the right
level of protection.
Given the Bank of England's general concern for systemic risk, we would tend to evaluate this
question in terms of whether the existing cushion of capital has given the right level of protection to
the system, ie have we established the right level of tolerance towards banking crises. Individual bank
failures do not prove inadequacy of the framework - although a complete absence of bank failures
would suggest severe overprotectionism.
It is very difficult to answer this question definitively, given that bank failures and banking crises tend
to have their roots in a number of different causes, not just inadequate capital. It is difficult to say
therefore how much difference extra capital would have made, or how many more crises would have
resulted had the regulatory capital demand been lower. Nevertheless the frequency of crises, even in
developed countries since the Basel Accord was implemented, is not so low as to make us feel that the
regulatory demand for capital is overstated. Using IMF data on banking crises, we find that during the
1990s four out of 11 G10 countries have suffered a banking crisis - a statistic which I do not find
particularly comforting. And, although developed countries tend to escape the twin plague of a
banking crisis combined with a currency crisis, we should not suppose that this rather high incidence
of crisis in developed countries is mitigated by the costs of the so called crises being noticeably low. I
hesitate to put precise numbers on costs, because they do vary quite considerably. However, as Bank
of England research which is to be presented later to this conference indicates, both the fiscal and
welfare costs on all the measures used are very significant indeed. On some measures, in fact, the
output costs of banking crises in developed countries tend to be higher than in emerging markets,
largely because the length of crises is longer in developed countries. Overall, therefore, in the light of
past experience, I think we would be taking an unjustified risk if we deliberately set out to lower the
existing regulatory demand for capital.
Crisis management and payments
Standstills: I want to turn now from crisis prevention to crisis resolution and from domestic banking to
more general international liquidity crises. While the banking system was a source of instability in
many countries during the Asian crisis, a more immediate problem was the liquidity crisis triggered by
the sudden outflow of capital from the region. It is the free movement of capital that I would like to
discuss and, in such a regime, the need for arrangements that would deal with a liquidity crisis where
developing countries get into payment difficulties.
The international capital market
Global capital flows have exploded since the 1970s. Between 1970 and 1996, real GDP in the G7
economies more than doubled. Over the same period, world trade volumes rose by roughly twice this
amount. But since 1970, real gross private capital flows have risen by a factor of more than eight
double the growth in world trade and four times the growth in world income.
Rising capital flows have delivered huge benefits to the developing countries. Capital liberalisation,
like trade liberalisation, has facilitated "catch-up" in the levels of income of these countries. It delivers
a permanent, and potentially huge, welfare gain. The experience of the Asian tigers from the 1970s
onwards, and before that of Germany and Japan during the 1950s and 1960s, is testimony to that.
But large-scale capital flows also bring risks. Capital flows are not just large, but volatile too. The
financial crises in Mexico in 1994, across South-East Asia in 1997, in Russia in 1998 and in Brazil last
year are the most recent and visible examples. But the incidence of financial crisis has in fact been
rising since the early 1980s. And the cost of financial crises are considerable. In the stricken
South-East Asian countries, capital flow reversals and output losses were anywhere between 5% and
20% of GDP. In many of these cases, there has been encouraging evidence of a V-shaped recovery in
output and asset prices following crisis. But the depth of the V is clear evidence of the potential cost of
volatile capital movements.
Capital markets have of course been prone to "panics, manias and crashes" for as long as they have
existed. It would be naïve to think we can ever entirely prevent crises - and indeed it may be
undesirable to attempt to do so. But it is realistic to think that the incidence and severity of crisis can
be mitigated through appropriate public policy actions. This is the grandly-titled "new international
financial architecture" about which you have no doubt heard.
I want to discuss some of the efforts of the official sector in redesigning the international architecture
achievements to date and, importantly, challenges for the future. While a lot has been achieved, much
remains to be done. I will also suggest where I think the official community's future efforts might best
be directed.
Dealing with financial crisis
The first priority of the official community must of course be crisis prevention. And on this front good
progress has been made. For example, we now have a substantial array of codes and standards of best
practice covering public policy issues: transparency in macroeconomic policies; core principles for the
supervision of banks, insurance companies and securities firms (including the changes to the Basel
Accord which I have just discussed); principles for corporate governance, insolvency and market
integrity; and standards for data, auditing and accounting. Implementation of these codes of best
practice is now the key - ensuring that crisis-prevention principles are put firmly into practice, in both
developed and emerging economies. The IMF has a key role to play in this implementation process,
through their assessments of compliance with standards and transparency about these assessments.
But even with preventative measures in place, liquidity crises will still occur from time to time.
Creditors may sometimes choose to flee simply for fear of other creditors doing so before them. A
country can face a liquidity "run" in much the same way as a bank. And these types of coordination
failure are difficult to resolve with standard macroeconomic policy tools, like monetary policy.
So what policy alternatives are available? One means of resolving this rush for the exits is for the IMF
to provide emergency liquidity support in potentially unlimited amounts - a classic international lender
of last resort. But virtually no-one envisages the IMF (or anyone else) playing such a role. As a
practical matter, the IMF simply lacks the resources. Its usable resources are currently less than
$150 billion. The external debt of the developing countries is well over $2 trillion. So the IMF's
ability to fill financing gaps is already heavily circumscribed and will become more so over time.
Even with the resources, it is very doubtful whether unlimited IMF lending would be desirable. More
likely, it would simply stoke-up moral hazard problems for the future, potentially increasing the
incidence of crisis and the corresponding cost for taxpayers. So an international lender of last resort
appears both impractical and undesirable.
This recognition that it is neither practical nor desirable to see the IMF in a role of Lender of Last
Resort has prompted considerable thinking about the nature of private sector involvement in crisis
resolution and the modalities of sovereign payments suspensions or standstills. Payments suspensions
are in some ways the obverse of recognising the limits on IMF lending. And, reflecting this, sovereign
standstills litter history over the last two centuries: in Latin America in the 1820s; among the US states
in the 1830s and 1840s; in Latin America again in the 1870s; among the majority of sovereign debtors
in the 1930s; and in Latin America once again in the 1980s.
All too often in the past, however, sovereign standstills have also been a recipe for chaos and
confusion. The recent sovereign defaults in Russia, Indonesia and Ecuador are good cases in point. But
looking back over history, it is clear that messy and protracted sovereign standstills are very much the
rule rather than the exception. Historical experience with sovereign standstills probably looks quite a
lot like corporate experience before insolvency rules were put in place, with the work-out process
inefficient and inequitable. I will return to that corporate bankruptcy analogy later on.
Against this backdrop, the key issues facing the official community seem to me to be twofold. First,
how do we establish a more coherent framework for crisis management, that recognises and reconciles
the countervailing forces of large and rising capital flows on the one hand, and small and limited
official lending on the other. Second, given these constraints, is it possible within that framework to
establish a role for standstills that are efficient, equitable and expeditious. I discuss each in turn.
A framework for crisis management
The Cologne Summit statement by G7 finance ministers and central banks in June 1999 was a step
towards establishing a framework for international crisis management. It listed the "principles" and
"tools" underpinning this framework - if you like, the ingredients. It did not, however, provide a recipe
for combining these ingredients. The official community's framework for crisis management remains
a discretionary, "case-by-case" one.
This approach has benefits. Crises clearly differ in form and severity, which calls for flexibility in the
official sector's approach to dealing with them. But discretion also carries some costs. For private
creditors, it adds to uncertainty when framing their lending plans. The IMF's latest Capital Markets
Report states that the private sector is "highly uncertain, if not outright confused about the official
community's approach to achieving its goals".
Discretion also has costs for the official community. It risks "gaming" by the private sector, with the
official sector providing more money ex-post than would have been optimal ex-ante. By altering
official and private sector behaviour in this way, a discretionary approach to crisis management
potentially increases both the cost and the incidence of crisis.
Are there feasible, rules-based alternatives? One simple means of establishing an official
"line-in-the-sand" would be to place an explicit cap on IMF lending. No rule is of course inviolable.
But publicly-stated constraints are likely to have greater credibility. This would reduce uncertainty
among private creditors. And it would drive home the point that "bail in" by private creditors would
need to be greater, the larger a country's financing needs, which provides the right set of incentives
from a moral hazard perspective.
Payments standstills as a crisis management tool
This limited pool of IMF lending would need to be complemented with other crisis management tools.
Voluntary rollover agreements with creditors - the like of which were put in place in Korea and Brazil
recently - would be an important part of that crisis management toolkit. So too would voluntary bond
restructurings, as have recently been undertaken in Pakistan, Ukraine and Ecuador. An ongoing
dialogue between country debtors and their private creditors - what the Institute for International
Finance call "Country Clubs" - would facilitate both of these voluntary tools for crisis resolution.
Involuntary payments suspensions also deserve consideration as part of the official sector's toolkit,
however. As a crisis management tool, they may be beneficial in certain situations. Where a country is
vulnerable to short-term capital movements, standstills could serve as a potentially important
circuit-breaker. They might be an efficient means of forestalling "runs" on a country because they
prevent pessimistic creditor expectations becoming self-fulfilling. More generally, whether capital is
short-term or not, they could serve as an important incentive device. Having standstills as a credible
backstop might in some circumstances increase incentives for debtors and creditors to seek voluntary
resolutions to crisis sooner.
Through both of these mechanisms, standstills might help resolve coordination failures among
creditors, and hence forestall liquidity crisis.
How do we ensure that standstills are efficient and equitable? The decision to default must be
principally for the debtor. But the official sector can alter debtor incentives in important ways. One
incentive device would be for the IMF to support standstills by agreeing to lend through their duration
- what the IMF call "lending-into-arrears" - provided the standstill process, once entered into, is
orderly and speedy. If standstills were a structured part of the IMF's ex-ante crisis management
framework, this would increase the chances of the standstill process itself proving ex-post efficient.
There is also encouraging work being done by the private sector on drawing up best practice
guidelines for sovereign debt work-outs.
Some have argued that articulating a clearer role for standstills may perversely alter debtor incentives,
by weakening the presumption that debtors should pay their debts in full and on time. But an orderly
standstills process should support, not supplant, market forces and market disciplines. Corporate
bankruptcy law grew up as it became clear that market forces delivered losers as well as winners and
that some orderly means was needed of dealing with the losers. In this way, bankruptcy law supports
the market mechanism.
The situation is no different in a sovereign context. A well-articulated framework for dealing with
sovereign liquidity problems should reduce the inefficiencies and inequities of the current unstructured
approach to standstills. It would support the international capital market mechanism. It would be no
more likely to induce debtors to default than bankruptcy law is to induce corporate debtors to default.
In neither case is default a soft option. We would of course hope and expect sovereign standstills to be
the exception rather than the rule. But it is better to plan for all contingencies, and to articulate these
plans, than have international public policy made on the hoof. In this respect, crisis-fighting shares
many similarities with fire-fighting. Fire-prevention is ideal, but will never entirely prevent fires
occurring. So it makes sense to have a fire-fighting plan, which everyone understands and abides by,
to minimise the damage when fires do occur.
Would standstills work?
The issue of whether standstills should form a part of the official sector's toolkit of responses remains
under active debate. A number of arguments against the use of standstills have been made by
policymakers, academics and the private sector. Let me try and articulate some of the concerns.
First, would standstills risk cutting-off capital flows to the emerging markets - if you like, killing the
goose that lays the golden egg? History offers some clues here. For example, there appears to be no
evidence from 1930s experience of defaulting countries having fared worse than non-defaulting
countries in terms of subsequent output growth. And looking across a broader sweep of history, some
empirical evidence has failed to find any discernibly negative long term effect of a country's prior
debt-servicing record on the terms or volume of its borrowing.
That is not to say that default is costless, certainly in the short to medium term. The loss of access to
capital markets and the time and effort involved with restoring credibility with creditors is, quite
correctly, a strong deterrent for any country contemplating default.
Historical evidence may in any case be uninformative about investor behaviour in the future under a
more structured framework for international crisis resolution. If this framework helped resolve the
collective action problem among creditors, it ought to benefit creditors as well as debtors. Indeed, by
reducing the risk to creditors in this way, standstills should be mutually beneficial to both parties. If
that is the case, there is no reason to believe that, in a world of structured standstills, there is much risk
of the golden-egg-laying goose being cooked.
Second, might the prospect of standstills prompt a pre