FRBNY’s consortium arrangements would have to be adopted because no one could afford to let LTCM fail. Meriwether had 50 minutes to agree to the Buffet offer, but claimed he had no legal authority to accept it – all the partners would have to agree and it was impossible to do that in the 50 minute time frame, so the deal would, and did, lapse. Losses at LTCM had increased during the week, depleting its capital still further to $400 million. Earlier in the week, Bear Sterns had declared it would not clear LTCM’s trades if its capital was less than $500 million. McDonough was not prepared to challenge Meriwether’s decision. By evening, the major investment banks83 agreed to inject $3.625 billion, the principals would stay on at LTCM (supervised by traders appointed by the consortium), and they could keep the $400 million, though it now amounted to just 10% of the fund.84
Dowd (1999) and others argue that had LTCM been allowed to fail, the threat to the financial markets would have been minimal. He argues that the losses would have been in the billions, when there are trillions of dollars of capital in the global markets. However, the problems would have been concentrated in the investment banks, which would have seen their capital severely depleted. For example, Goldman Sachs’ IPO, which finally took place in May 1999, raised $3.6 billion. It was rumoured that Lehman Brothers was close to bankruptcy. The failure of respected investment banks would have added to the market turmoil. On the other hand, the rescue of LTCM did not quiet the markets, and those banks which were part of the bailout and quoted on the stock market suffered badly in the immediate aftermath. Merrill Lynch lost 75% of their market value between January and October 1998. The markets did not begin to recover until October 1998, when the Fed twice dropped interest rates by 25 basis points, in October and November 1998, and market calm was restored. Even then, the summer of 1999 saw another round of volatility. Countless numbers of hedge funds were forced to close.
By October 1999, LTCM had repaid $2.6 billion of capital to the consortium, after the consortium had sold off the big money machines, and its assets were reduced by 90%.85 Having repaid its loans, LTCM was liquidated in 2000.
Miller (2001) provides a good summary of the lessons learned from LTCM, and some of his points appear in the discussion here. First, arbitrage may not always be achieved, so trades that depend on price discrepancies between markets narrowing over time may find there are occasions when the differences actually widen, and if a fund is highly leveraged, it may not have the capital to fund the positions. At this point the old question of how efficient the market is arises, a debate that was briefly covered early in the chapter. Also, portfolios which appear to be diversified in normal markets may turn out to be highly correlated if traders want to liquidate their positions at the same time. Linked to this point is the role played by VaR models: if all banks are using similar risk management techniques linked to regulations they must abide by, it will encourage investors to sell at the same time. However, the phenomenon of an event (or events) causing all agents to sell simultaneously has been observed for centuries, so it is difficult to apportion much of the blame to VaR
83Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, Credit Suisse, UBS, Salomon Smith Barney, Bankers Trust, Deutsche Bank, Chase Manhattan and Barclays Capital each contributed $300 million; Societ´e´ Generale, Lehman Brothers and Paribas each contributed $100 million.
84The principals had held about 40% of LTCM’s equity.
85Dunbar (2001), p. 230.
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models alone. The issue to tackle is to identify the events which will trigger VaR breaches, and the subsequent downward spiral.
Miller makes a point about the method of financing hedge funds and its effects on the traders. If managers are paid a base sum – e.g. 2% of the assets and a share (25%) of the profits – then they have an incentive to take excessive risks because in good years, they do very well, but it is the investors who cover the losses if the fund fails. The only counter-argument to this point is that the managers (and traders) have often invested most of their own capital in the fund – LTCM is a case in point. Dunbar (2000), p. 223 talks about one of the LTCM traders breaking down because all of his savings had been invested in the firm.
A final point relates to the role of the regulators. It was Mr Buffet’s offer that should have been accepted. Meriwether appeared to know he could hold the regulators to ransom because of the financial carnage envisaged if the fund had failed. Surely if McDonough had insisted the Buffet deal be accepted, Meriwether and partners would have been forced to comply. Such remarks are easily made with the benefit of hindsight, and the bailout did not involve any public funds. However, Meriwether (and other partners) ended up as salaried employees (albeit low ones by their standards) rather than certified bankrupt, at the expense of investors of the consortium banks, a difficult pill to swallow. There are no constraints on their actions, and Meriwether is reported to be running another fund.
The actions of the FRBNY (supported by Alan Greenspan at the Federal Reserve) sends out somewhat worrying signals. It suggests that it is prepared to intervene in problem hedge funds (if it is thought they pose a threat to world markets) even though it does not regulate them, which is likely to aggravate the already inherent risk-taking activities of these funds, especially if they get into trouble.
8.7. Lender of Last Resort
8.7.1. The LLR Debates
The review of the Asian and Japanese crises has shown the domestic lender of last resort in action, i.e. the central bank intervening to supply liquidity to banks being crippled by runs. IMF intervention was needed to help resolve most of the crises in South East Asia, though Japan avoided it due to its wealth and the absence of a run on the yen. This section takes a more formal look at the issues surrounding the lender of last resort (LLR), and the calls for an international LLR (ILLR).
The passage of the Bank of England Act (1844) was a victory for the Currency School,86 which called for the central bank to stabilise the price level through control of the money supply. There was to be adherence to the strict quantity theory of money, reflecting an earlier acceptance of the Palmer Rule (1832), i.e. note issue was strictly limited to the amount of gold held by the Bank. It was thought the 1844 Act would put a stop to manias because agents knew the Bank of England could not intervene should there be a speculative
86 The Banking School argued the money supply should grow with output and trade. They opposed any law which restricted the quantity of note issue, no matter what the circumstances. See Andreades (1966) for further discussion.
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event. They were soon proved wrong, with a crisis in 1847 and two more in 1857 and 1866. The Act had to be suspended to allow the Bank of England to break the rule, and the panics were brought under control. Despite two investigations by the House of Commons following the first two crises, changing the 1844 Act was not thought necessary. It was not until the 1914 Bank of England Act that the Bank was given a dual role: supplying liquidity in the event of bank crises and using discretionary monetary policy to maintain price stability.
Henry Thornton (1802) had discussed the relative merits of a lender of last resort, but most attention is paid to the writings of Walter Bagehot, editor of The Economist and author of Lombard Street (1873). Bagehot advocated the Bank of England act as lender of last resort, calling on it to supply cash during banking crises:
‘‘Theory suggests, and experience proves that in a panic the holders of the ultimate Bank reserve (whether one bank or many) should lend to all that bring good securities quickly, freely and readily. By that policy they allay a panic; by every other policy, they intensify it.’’
(1873/1962, p. 85)
‘‘The Bank of England. . . in a time of panic it must advance freely and vigorously to the public out of the reserve. . . And for this purpose, there should be two rules: – First. That these loans should only be made at a very high rate of interest. . . This will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic. . . so that the Banking reserve may be protected as far as possible.
Secondly. That at this rate these advances should be made on all good banking securities. . .
The object is to stay alarm. . .. But the way to cause alarm is to refuse some one who has good security to offer – if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail. . . and the panic will become worse and worse. . . ’’ (1873/1962, p. 97)
The classic features of a LLR have hardly deviated from Bagehot’s recommendations. From the 1914 Act until 1997/98, the Bank of England assumed responsibility for dealing with runs, panics and financial crises. Though its role as lender of last resort was never formalised, it has, de facto, acted in this capacity. Its more recent interventions include:
žThe UK’s secondary banking crisis (1973).
žThe nationalisation of Johnson Matthey Bankers (1984).
žClosing the Bank of Credit and Commerce International (1993) and dealing with the subsequent fallout from its closure, requiring the Bank to supply liquidity to a number of smaller banks.
žIts attempt to launch a lifeboat rescue for Barings Bank in 1995, and when that failed, the Governor’s announcement that the Bank stood ready to supply liquidity to the financial markets should they be unsettled by the Barings failure. In the event, it proved unnecessary.
Following the 1998 Bank Act (see Chapter 4), responsibility for financial stability is now shared between the Financial Services Authority, HM Treasury and the Bank of England by a formal Memorandum of Understanding. This arrangement is yet to be tested.
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Compared to the UK, the US Federal Reserve System was given more formal responsibility for ensuring the stability of the banking system. A series of panics and runs on banks and trust companies had originated in New York in 1907, and spread to other states. The Federal Reserve Act (1913) created a central bank, and allowed it to provide an ‘‘elastic’’ currency (liquidity) in the event of a crisis. After the Banking (or Glass Steagall) Act was passed in 1934, the Federal Reserve was given the power to change the reserve ratio – up to this time, it could only be changed by Congress. The Act also sanctioned the introduction of bank deposit insurance.
Wood (2000) argues central banks should be confined to supporting troubled but solvent banks during a banking crisis. However, actions by central banks suggest that they have widened their remit to assist in a wide range of financial crises, not just banking crises. Examples include the Bank of England’s declared support of the financial markets post-Barings, the Fed-led injection of liquidity by key central banks in the aftermath of Black Monday in October 1987, the package to rescue a hedge fund, Long Term Capital Management, organised by the Federal Reserve Bank of New York because of fears that its failure would threaten the solvency of some of LTCM’s bank creditors and, more generally, disrupt financial markets, and the numerous interventions in currency markets to support a particular currency.
Thus, the function of the domestic lender of last resort has evolved over time. Central banks (and or another authority, though it is the central bank which supplies the liquidity) may be involved in the rescue of a single bank or substantial parts of the whole domestic banking system. The authorities in most countries supply liquidity during bank runs or financial crises. Apart from restoring financial stability, Kindleberger has identified two other potential advantages of a LLR. First, a LLR appears to have reduced the length of the economic slowdown that follows a crisis. Kindleberger (ch. 12) notes the crises of 1873 (Vienna, Berlin, New York) and 1929 turned into great depressions of the 1870s and 1930s; in both cases there was no LLR. Likewise, the slowdown was prolonged in 1720 (England and France), 1882 (France), 1890 (England) and 1921 (Britain, USA). By contrast, all the other crises from 1763 to 1914 had an LLR (or equivalent), which helped minimise disruption to the real economy.
Second, Kindleberger87 claims that the number of crises was less frequent in Britain after 1866 and in the USA after 1929, suggesting a LLR reduces the number of crises. But as was noted earlier in this chapter, a substantial increase in systemic crises has been observed, many of them international. These crises have been large, varying and, in some cases, very costly, as Table 8.1 illustrates.
LLR intervention also has a downside: problems related to moral hazard. Agents may be induced to change their subsequent behaviour.
žIt signals that future misfortunes for private banks (or countries – see below) may well be followed by future bailouts. The likely consequences are that banks exercise less care in assessing loans, and appraising risks, as do creditors who lend to banks.
87 Kindleberger (1978/2000, p. 211). Also, Kindleberger cites these advantages when he is writing about an international lender of last resort, but they could equally apply to a LLR.
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žThe wrong (i.e. insolvent) banks are bailed out, either because there is not enough information to distinguish between illiquidity and insolvency, or for other reasons such as political interference. Whatever the cause, it undermines future incentives and weakens market discipline.
žThe LLR could be influenced by political considerations (e.g. powerful lobbies persuade government to forbear and bend criteria) that override or distort financing or accounting judgements.
To counter moral hazard problems, most LLR operate under strict conditions, which date back to Bagehot. For illiquid banks, the LLR should accept commercial paper at a discounted rate88 and/or grant loans at a penal rate of interest, with the borrowing banks required to supply collateral. Insolvent banks should be closed and losses borne by shareholders, holders of subordinated debt, uninsured depositors and the deposit insurance corporations. While few dispute the necessity of these requirements accompanying a LLR facility, they are by no means straightforward.
Begin with the need to distinguish insolvent from illiquid banks. In practice, the boundary between the two can be fickle and unclear. The increased complexity of bank balance sheets can make it difficult to distinguish between the two. Many troubled banks, on the brink of failure, will have assets with a total ‘‘real’’ value (as quantified post-crisis) exceeding liabilities, even though this may well not be the case at the height of the panic. Furthermore, studies such as James (1991) have shown that liquidating insolvent banks is more costly than restructuring them, through, for example, a bailout or merger with a healthy bank, or nationalisation. This may explain why Goodhart and Schoenmaker (1995) found that out of 104 failing banks (in 24 countries), 73 were rescued and the other 31 liquidated. Santomero and Hoffman (1998) report that even though banks had poor CAMEL ratings, they were given access to the Fed’s discount window between 1985 and 1991.89
Charging a penal rate to illiquid banks can also be problematic, causing runs because of the signal it sends to the market, which will worsen a bank’s problems. Managers faced with a penal rate may ‘‘go for broke’’, adopting high risk strategies in the hope that the bank’s position will improve. A possible alternative would be to attach conditions to a loan, such as closer monitoring, restrictions on banks’ activities, and even changes in top management.
The demand for adequate collateral dates back to Bagehot, and he acknowledged the need to lower standards under certain conditions. The Asian and Japanese crises illustrate how collateral can be a healthy security one day and of no value the next. How can any bank be sure collateral is absolutely safe unless it is reduced to a narrow range of securities such as US Treasury bills or UK gilts? Even with these assets, problems could arise. Japanese government bond issues were once considered on a par with their US equivalent, but have been steadily downgraded in recent years.
88The central bank could accept banks’ commercial paper for delivery at some specified date in the future: If a central bank accepts a $100 bill for $90.91, to be repaid in 1 year, the implicit rate of interest is 10%.
89This is unlikely to be repeated. Since the Federal Deposit Insurance Corporation Improvement Act was passed in 1991 (see Chapter 5), the FDIC is required to use the ‘‘least cost’’ approach to resolve bank insolvency. Also, see Chapter 4 for an explanation of CAMEL.
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There may be an argument for using a case approach. If the LLR judges that a panic or bank run rather than a bank’s balance sheet is the source of the problem, it could lower the standards for collateral required, and/or lower the penal rate of interest. In some ways the case for the LLR is rather like that for a nuclear deterrent: a device aimed to prevent the panics that would occasion its use. Nonetheless, the recurrence of crises in countries where the authorities have granted emergency liquidity assistance, and failed to find other solutions for insolvent banks, does testify to the fact that it may have been misused.
These remarks are not intended to challenge the principle of having a lender of last resort. However, they do suggest that the function brings with it considerable complexities, and certain longer term risks if insolvent banks are assisted. Added to this is the expense of bank rescues and/or the whole system. The subsequent additions to public sector debt could lead to higher distortionary taxes to finance the bailouts, or threaten inflation targets or lower growth rates.
8.7.2. International Lender of Last Resort
With the advent of international crises has come the call for an international LLR. Goodhart and Huang (2000) use a theoretical model to show that the central bank, unable to meet the demand for foreign currency, can cause a currency crisis, which triggers a banking crisis. Though an international interbank market can help economies with the necessary liquidity, it also raises the size of the international financial contagion risk. An ILLR could, it is claimed, help to provide the liquidity and reduce this contagion.
The IMF has come closest to playing that role: it intermediates between private banks and countries in crises. Calomiris (1998) and Calomiris and Meltzer (1999) assign the role of an ILLR to the IMF, arguing it should adhere to the strict ‘‘Bagehot rules’’. Fischer also advocates the IMF as ILLR for countries with an external financing crisis, when the central bank lacks the reserves to meet the demand for foreign exchange.
However, the IMF is unlikely to assume the role of ILLR in the traditional sense of the term, because of its budgetary constraints, the absence of arrangements for member country central banks to supply it with liquidity,90 and its inability to print money.
The IMF is funded through contributions by member countries. Each member is assigned a quota, based on its relative size in the world economy. Quota contributions were last reviewed in January 2003, but kept at their 1998 levels, which means their total quota is just under $300 billion. However, the one year forward commitment capacity gives a rough indicator of the amount available for new91 lending, and as of September 2003, it was $88 billion. In view of the size of recent restructuring packages, the IMF could never be the sole source of finance. It has to rely on funds from development agencies (e.g. the World Bank), and government or private loans from other countries.
Consider the case of Mexico. In August 1982, the government suspended the principal of foreign debt after it became impossible to meet its debt service commitments. Its story is all too familiar. Oil rich, it had borrowed from foreign banks on the strength of the price
90It is worth stressing that a central bank is likely to supply liquidity in the event of a run or runs on a bank. However, the longer-term restructuring will require government and agency funds.
91Non-concessional.
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of oil, which rose sharply at the end of 1973 and again in 1978. There were large current account deficits in 1980 – 81, but the current account surplus almost doubled over the same period, keeping the value of the peso high against the dollar. The growing current capital surplus was largely due to high growth rates in dollar denominated sovereign external debt and commercial loans. Mexico was exposed to two shocks: a drop in the oil price and a rise in real interest rates, and soon found itself unable to service its dollar denominated debt. A moratorium was announced in August 1982. By 1983, the rescheduling agreement was in place. The IMF played a crucial role but it would not have been possible but for the $1 billion loan from the Fed, and the US government purchase of oil, worth $1 billion.
In 1994, a peasant revolt, the assassination of a presidential candidate, an earthquake and high inflation rates prompted a massive capital flight and depreciation of the peso: In April, the USA and Canada rescued Mexico, in view of its special status as a member of the North American Free Trade Agreement (November 1993). Canada contributed $700 million, and the USA $6 billion, to provide Mexico with a line of credit. The calm this restored to the currency markets was short-lived. In December 1994, there was another run on the peso as both domestic and American investors withdrew their capital. The USA led a rescue package totalling $50 billion (short-term loans at a penal rate): $20 billion from the US exchange stabilisation fund, $2 billion from Canada, $10 billion from a group of European banks, and $17.8 billion from the IMF. The size of this package immediately stopped the run on the currency – in the end, only $12.5 billion was drawn down, and repayments of that loan commenced in January 1995. The collateral was oil revenue.
The 1994/95 Mexican package nearly consumed all of the IMF funding available to it. The size of the Mexican rescue, and the Asian packages that followed, illustrate that when it comes to supplying the needed liquidity the IMF faces far more serious constraints (in terms of financial resources) than a domestic central bank.92
Nonetheless, the detailed review of the Asian problems shows the IMF can and does play a central role in dealing with global crises. Their activities tend to focus on the developing and emerging markets because these countries are in need of external finance and many tend to borrow. Foreign direct investment makes up a very small proportion of the Asian countries’ external finance, and these figures are typical of most developing or emerging market economies. However, when these countries get into trouble, the domestic authorities can supply liquidity to curb runs on local currency deposits, but they can do little about foreign currency deposits and debt or defend the external value of the currency in the face of a large, speculative attack.
Table 8.14 shows the relative speed with which the IMF became involved. Also, note the amounts involved – nearly $77 billion for the three Asian countries, another $64 billion for Russia and Brazil which were to suffer soon afterwards. However, the ‘‘support’’ package typically involves the IMF (including an IMF restructuring programme), together with banks and governments from several countries agreeing to provide credit.
Some of the restructuring programmes themselves are not without controversy. It has been argued that the IMF’s insistence that 16 Indonesian banks be closed in November 1997 only aggravated and lengthened the crisis. One bank closed was owned by the President’s
92 A domestic bank can always print more money, provided the debt is denominated in the home currency.
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Table 8.14
IMF Rescues
Date of Onset of
Date of IMF Agreement
Currency Crisis
Thailand
Jan– May 1997
20/8/97: $3.9 bn standby credit
20/8/97: $20.1 bn support package
Korea
Oct 1997
4/12/97: $21 bn of standby credit; $5.6 bn disbursed
immediately
Indonesia
7/97
5/11/97: $10.1 bn standby credit & $40 bn support package
Malaysia
7/97
Na
Russia
11/97 – 1/98
7/98: support package $22.6 bn
Brazil
10/97&9/98, 02
12/98: support package $41.5 bn
02: $30 billion
son, leading depositors to think the crisis must be very serious. Soon after, the same son was allowed to open up a bank under a new name, taking much of the business from the closed bank with him, which heightened concern about political interference and cronyism. The partial deposit insurance only applied to the closed banks – no announcement was made for banks that were kept open, nor were the 36 banks under surveillance identified. Not only were funds shifted from private to state banks, but about $2 billion left the banking system. It is reported that an IMF internal document on Indonesia reached similar conclusions.93 More generally, there is a great deal of resentment of IMF ‘‘interference’’ with the running of a sovereign economy. Many developing/emerging market countries are wary of approaching the IMF, which, in some cases, can delay the intervention needed to resolve the crisis.
A more general problem is increasing evidence that the catalytic effect is not working. The IMF packages (see above) are of high value, but conditional on the country adhering to IMF restructuring programmes. The objective is to signal such a show of confidence that these actions act as a catalyst for stimulating increased private capital flows, thereby reversing the capital flight that is often a principal cause of the crisis.
Ghosh et al. (2002) considered eight countries94 experiencing capital account crises. They report that capital outflows were larger than the IMF projected, i.e. the catalytic effect failed to restore the private capital inflows. Hovaguimian (2003) extends the study to include the more recent crises in Argentina, Brazil (2001 – 2), Turkey (2002) and Uruguay (2003), and reports similar findings, though the capital outflow projection error had risen. His own result, together with a survey of other studies which looked at the impact of the catalytic effect, leads Hovaguimian (2003) to conclude that this approach has been largely unsuccessful. In the absence of a catalytic effect, more IMF intervention will be required. As can be seen from Table 8.14, the initial IMF programmes had to be extended.
93‘‘IMF Now Admits Tactics in Indonesia Deepened the Crisis’’, New York Times, 14/1/98. See also Radelet and Sachs (1998b) and Radelet and Woo (2000).
94The countries were Turkey (1994), Mexico (1995), Argentina (1995), Thailand (1997), Indonesia (1997), Korea (1997), Philippines (1997), Brazil (1999).
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An additional issue to consider is the effect of these settlements on incentives. Mexico is one of many countries enjoying multiple rescues. Have the IMF rescues contributed to complacency and expectations of future support in Mexico and other countries? Furthermore, IMF-led intervention appears to have done little to minimise contagion effects.
Haldane et al. (2004), in an elegant theoretical model, consider the effectiveness, from the standpoint of efficiency, of various types of resolutions to crises. Their model shows that delaying debt repayments and provision of lender of last resort facilities are equally efficient means of dealing with a liquidity crisis. Given the limited resources of the IMF, the former may be preferable to the latter. Both approaches lower borrowing costs for countries compared to a case of no intervention. Surprisingly, their model shows there are no moral hazard implications. By contrast, if dealing with a solvency crisis, then from an efficiency standpoint, rescheduling debt repayments is preferable to bailouts, which are more likely to induce firms and banks to take on riskier projects. In light of this finding, the authors support new approaches to rescheduling such as collective action clauses (CAC: a debt write down agreed at firm level) or a sovereign debt rescheduling mechanism (SDRM), involving an international bankruptcy court. For more on CAC and SDRM, see Taylor (2002), and Krueger (2002), respectively. Though CACs are beginning to appear in some international sovereign bond contracts, little progress has been made on the SDRM proposal. The applied cases of Indonesia and Mexico suggest many issues need to be resolved in terms of the current approaches taken by the IMF. Taken together with the Haldane et al. paper (2004), it is clear that the question of the role of an ILLR will continue to be open to both theoretical and empirical debate, and is likely to be for some years to come.
8.8. Conclusions
This chapter began with a discussion of the debates over what constitutes a financial crisis and ended with a review of the possible functions of a lender of last resort. Three major crises were deliberately chosen, to illustrate the vast array of circumstances which can provoke these problems, and also the different approaches taken to resolve a crisis. In South East Asia, the crisis originated in Thailand and spread rapidly to neighbouring countries. In Scandinavia, three countries experienced crises but Denmark escaped the problems. Japan provides a good working example of a financial bubble, but banks and authorities alike adopted ostrich-like behaviour for close to a decade. LTCM illustrated how a single firm, left to its own devices, can end up on the brink of insolvency, provoking intervention by the authorities to allay fears that left to fail, it would, at the very least, have provoked costly financial volatility on world markets. What are the main messages coming from this review?
First, financial crises are very costly events in terms of GDP lost. They may be triggered by a sudden drop in export receipts (Finland, Norway), local equity and land prices (Japan), a sharp, adverse change in investor sentiment (Thailand), or contagion between economies with perceived similarities (other South East Asian countries). While the crisis and the accompanying GDP downturn are jointly precipitated by such developments, financial crises leave an aftermath of GDP weakness and depressed lending. A crisis in the banking
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system often coincides with grave problems in the currency markets, but need not – witness Japan. A grave threat to banks can be posed by a risk miscalculation in a large non-bank financial institution (LTCM), or in banks themselves – Japan, Sweden, Thailand.
Second, though financial crises are costly, they are, fortunately, infrequent. However, they have been much more common since the 1970s than in previous post-war decades. They can also become chronic (Japan) if decisive action is not taken, and unpleasant medicine swallowed. Prolonged crises may be exacerbated by excessively restrictive monetary policy (USA, 1930 – 33), by tardiness in restructuring or closing illiquid banks (Japan), or by official refusal, or inability, to adopt official changes in fiscal or exchange rate policy – as illustrated by Asian and Latin American examples.
Finally, official guarantees to depositors and/or creditors and emergency lending to banks may prevent a bank run, but can leave an unfortunate legacy of altered incentives for bankers and their customers that increase the likelihood of future crises. Bad decisions can also result when troubled banks exercise undue political influence (Indonesia and Japan). Moreover, despite the global nature of many recent crises, an international lender of last resort could quickly become part of the problem, rather than a solution. Policy makers cannot realistically prevent all financial crises, but prompt action to ensure that banks’ owners and managers bear the brunt of any losses whenever possible should help to minimise them and the costs to taxpayers.
Appendix 8.1. Japanese Financial Reforms (Big
Bang, 1996)
Prime Minister Hashimito announced Japan’s Big Bang in November 1996.95 The market reforms are based on ‘‘FREE’’ (emphasising free market entry, free price movements and the removal of restrictions on financial products), ‘‘FAIR’’ (introduction of transparent markets and rules, with an investor protection scheme) and ‘‘GLOBAL’’ (all financial markets to be opened up to global players, with adherence to international legal, accounting and supervisory standards). The key reforms are listed below, in chronological order.
1997
žThe ban on securities derivatives was lifted. New legislation was passed to allow the trading of options on specified stocks and over the counter derivatives by securities and banking firms.
žPensions fund management was to be deregulated.
žInvestment trust firms were allowed to sell their products at banks.
žBanks were permitted to offer asset management accounts, and could sell investment trust securities without going through subsidiaries.
žThe accounting books of financial firms had to separate the assets of their clients from their own.
95 For a discussion of earlier reforms, see Hoshi and Kashyap (1999).
