Thursday, January 22, 2004

A letter to my colleagues on the "Global Insolvency Initiative"

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

• The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

• The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

• The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.

Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct. They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the Economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.