Financial Stability, Resolution of Systemic Banking Crises and COVID-19: Toward an Appropriate Role for Public Support and Bailouts

Abstract

A wide range of approaches has been applied to address banking and other financial crises. The nature of the approach depends on the nature of the crisis, its origins, evolution and context. Systemic banking crises are among the most common and costly to address. The experiences of the three major international financial crises of the past 25 years – the Asian Financial Crisis, the Global Financial Crisis, and the European Debt Crisis – offer critical lessons regarding the most effective approaches in tackling bank solvency during a systemic crisis. One of the most common and also effective methods has been the transfer of non-performing loans (NPLs) to an Asset Management Company (AMC) that performs workouts or liquidates stressed loan portfolios at a more opportune time to amortize losses. In most cases the use of AMCs has delivered positive results for the taxpayer.

Contemporary consensus as regards tackling bank solvency during a systemic financial crisis focuses heavily on prevention of government bailouts in order to protect state finances and curb moral hazard. However, an overly dogmatic focus on preventing public financial support in the context of a systemic bank solvency crisis may place insurmountable obstacles to the use of state-backed AMCs and other forms of resolution of NPLs and bank recapitalization. This paper provides a new perspective on the common belief that public support in the context of systemic bank insolvency – i.e. bank bailouts – is an inefficient use of public funds or conducive to moral hazard.

Our study finds that state-backed AMCs can be effective in recapitalizing banking systems, depending on the modus operandi of the restructuring, funding and the conditions attached to the fiscal backstop. With respect to systemic banking crises or those caused by exogenous factors, such as the unprecedented disruption of economic activity due the COVID-19 pandemic, preservation of financial stability and not containment of moral hazard should be policy-makers’ predominant goal. Thus, we suggest that a combination of balance sheet restructuring and the use of AMCs to manage NPLs is the optimal approach.