What are the best-practice policies for managing systemic risk and banking crises?

Macro prudential policy measures focusing on the financial stability of financial institutions and their actions at the individual level are insufficient to foster financial stability at the aggregate level.

Central banks (as in the Czech Republic, South Africa, and Thailand) seem to be best equipped to assume the responsibility for macroprudential policy. First, they have an advantage in monitoring macroeconomic developments. Second, centralizing macroprudential supervision in the central bank improves coordination of crisis management activities, especially if the central bank is also the banking sector regulator. Third, monetary policy decisions undertaken by the central bank have potential implications for financial leverage (debt load) and risk taking.

Choose the right indicators of systemic risk

Interestingly, emerging markets have been three to four times more likely to use macroprudential tools than advanced economies. For instance, in 2011, the Republic of Korea imposed a levy of up to 0.2 percent on bank noncore financial liabilities to manage speculative inflows of foreign capital. Some macroprudential tools are intended to mitigate externalities that occur in the upturn of the financial cycle, while others are deployed to build buffers to mitigate any bust. For example, caps on debt-to-income and loan-to-value ratios could be effective in reducing risk exposures in booms, while countercyclical buffers, such as additional capital and reserve requirements, could help mitigate excessive deleveraging in severe downturns. In any case, the use of macroprudential tools needs to be calibrated to the specifics of a given country.

Seek private sector solutions to pass bank losses to existing shareholders, managers, and in some cases uninsured creditors first.

The fiscal cost of banking crises averaged almost 7 percent of GDP during 1970–2011 (4 and 10 percent of GDP in advanced and developing countries, respectively). The two costliest banking crises occurred in Indonesia (1997) and Argentina (1980), with fiscal costs reaching 57 and 55 percent of GDP, respectively. Countries must devote time and resources to preparing such frameworks in normal times because crises are not likely to go away.

Financial inclusion can aid stability

Greater financial inclusion can also enhance financial stability indirectly by providing households (and firms) with access to savings, credit, and insurance tools that can bolster resilience and stability of the real economy and thus the financial system that serves it.

Stability is endangered when financial inclusion is excessive

Inclusion of everybody in each and every financial service cannot be the social objective. The U.S. subprime crisis showed that subsidized, excessive access to credit, combined with tolerated predatory lending, is bad policy. Similarly, in Russia, where consumer loans grew from about $10 billion in 2003 to more than $170 billion in 2008, people with low financial literacy underestimated the increased burden of debt-servicing costs in bad times, which significantly impaired their spending capacity.65 Preliminary evidence suggests that excessive credit growth can impose heavy financial burdens on people when market conditions deteriorate.