09 July 2012

Laeven/Valencia: The curse of advanced economies in resolving banking crises

While conventional wisdom would have it that advanced economies with their stronger macro-economic frameworks and institutional setting would have an edge in crisis resolution, the record thus far supports the opposite: advanced economies have been slow to resolve banking crises, with the average crisis lasting about twice as long as in developing and emerging market economies.

While differences in initial shocks and financial system size surely contribute to these different outcomes, in a recent working paper, the authors suggest that the greater reliance by advanced economies on macro-economic policies as crisis management tools may delay financial restructuring, with the risk of prolonging the crisis. They refer to this as the ‘curse’ of advanced economies.

This is not to say that macro-economic policies should not be used to support the broader economy during a crisis. Macro-economic policies should be the first line of defence. They stimulate aggregate demand and sustain asset prices, thus supporting output and employment, and indirectly a country’s financial system. This helps prevent a disorderly deleveraging and gives way for balance sheet repair, buying time to address solvency problems head on. However, by masking balance sheet problems of financial institutions, they may also reduce incentives for financial restructuring, with the risk of dampening growth and prolonging the crisis.

The crisis response during the ongoing global financial crisis, dominated by advanced economies, has also heavily relied on monetary and fiscal policy. These countries also used a much broader range of policy measures compared to past crisis episodes, including unconventional monetary policy measures, asset purchases and guarantees, and significant fiscal stimulus packages, in part reflecting the better macro-economic and institutional setting of the countries involved. These policies were combined with substantial government guarantees on non-deposit bank liabilities and ample liquidity support for banks, often at concessional penalty rates and at reduced collateral requirements. Liquidity support has been particularly large in the eurozone, indicating the significant role played by the Eurosystem in managing the crisis. The absence of a common fiscal authority surely also plays a role here.

Taken together, these actions have mitigated the financial turmoil and contained the crisis. But it means that the bulk of the cost of this crisis has simply been transferred to the future, in the form of higher public debt and possibly a dampened economic recovery due to residual uncertainty about the health of banks and continued high private sector indebtedness. While monetary policy has avoided an even sharper contraction in economic activity, it has also discouraged more active bank restructuring. The lingering bad assets and uncertainty about the health of financial institutions risk prolonging the crisis and depressing growth for a prolonged period of time. Macro-economic stabilisation policies should supplement and support, not displace financial restructuring.

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