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Thank you. I am delighted to have this opportunity to discuss these issues at such a distinguished gathering.
Let me start by congratulating our hosts on their timing. Events in Asia have highlighted the difficulties of designing effective deposit insurance and banking regulations -- ones that will promote stability, without also promoting crises. These and other riddles have assumed center stage in recent months in considering the lessons from the crises. I doubt there are going to be many easy solutions. But with the combined efforts of the people in this room we will have a much better chance of finding effective ones.
A crisis that began in Asia more than a year ago has now spread to include Russia and raised concerns in markets around the world. This finds us in new and difficult terrain. But one thing is certain. Repairing troubled financial systems and building healthy ones for the future will both be crucial to crossing it safely.
I would like to discuss each of these challenges today, sketching some of the broad principles that have emerged for strengthening financial systems in emerging market economies and for dealing aggressively with the deep financial sector problems we see in Asia today. But let me start with a few general observations that should guide us in these efforts.
I. The Centrality of Finance and the Lessons of History
This week's Washington Post articles have underlined that interruptions in finance and financial disruptions have the most profound human consequences far beyond profits and losses. In Korea today, eleven year-old children are being plucked out of school to beg at car windows, and family firms of three generations' standing are being forced into bankruptcy. Yet it would be an even greater catastrophe if countries were to absorb the wrong lesson from these crises -- if they were to develop the idea that withdrawing from the global system was right and building better functioning market economy was wrong. Unfortunately, this concern is not without some foundation.
Ever since there has been finance there have been financial disturbances and no doubt countries will face financial disturbances and countries moving in the wrong direction in the years to come. But international financial citizenship -- respecting obligations and contracts and dealing cooperatively with creditors in exceptional circumstances where necessary -- is a crucial part of being a member of the world community and enjoying its benefits and support. Countries that choose to embrace unilateral actions as a substitute for reform and cooperation hurt the world system -- and by severing links with world markets hurt the prospects of their own citizens most of all.
So let there be no doubt about the basic ends and means: continued rapid growth in the developing world based on their moving more toward market principles and integrating more closely with the world economy is what we should all want to see. The challenge is not to halt the flow of capital around the world -- but to build financial systems that can channel those flows effectively and ensure that they can be sustained.
No country has been immune to financial sector problems in recent years and none has the monopoly on wisdom when it comes to finding the best way to address them. Even before the recent crises, more than two-thirds of the member countries of the International Monetary Fund -- developed and developing -- had had significant banking problems in the last fifteen years. These have often cost the economy and the taxpayer a great deal.
Spain ended up paying out 15 percent of GDP to clean up its banking problems. In Chile the price was closer to 20 percent. Our own Savings and Loan crisis ended up costing the taxpayer roughly 3 percent of GDP -- a sum that was greatly increased by mistakes of supervision and regulation which helped to cause the crisis and later perpetuated it.
But lessons have been learned -- and recent events have only underlined the need to work to see these lessons applied, both at the level of individual countries and internationally. For some time now the United States has taken the lead in mobilizing intensive dialogue about the international financial architecture among governments of industrial and developing countries. These discussions began in April and build on previous G7 efforts set in train at the Lyons Summit. They have been wide-ranging and constructive, leading to a number of potential areas for reform. Elaboration of specific proposals must await the conclusions of the international working groups. But let me sketch out some of the broad principles that have emerged for strengthening domestic financial systems to avoid crises and resolving them effectively when they strike.
II. Principles for Strengthening Domestic Financial Systems
Reducing the risk of financial crises is not primarily about reducing the quantity of international capital flows. It is about raising their quality. We have seen in recent months in Asia -- as at many points in the past in other countries -- the danger of opening up the capital account when incentives are distorted and domestic regulation and supervision is inadequate. Let me be very clear. Inflows in search of fairly valued economic opportunities is a good thing. Inflows in search of government guarantees or undertaken in the belief that they are immune from the standard risks is quite another matter.
The challenge across the emerging market economies is much less to slow the pace of capital account liberalization than to accelerate the pace of creating an environment in which capital will flow to its highest return use. That means governments pursuing strong, mutually consistent monetary, fiscal and exchange rate policies. It means governments putting in place all the legal and regulatory underpinnings for markets that lessen the probability that financial imbalances will arise, and can help contain the effects when they do occur.
Experience -- especially that of the past year -- points to a long list of critical ingredients for a strong and efficient banking system.
First on the list must be a strong supervisory regime. That means tough entry requirements; prudential norms for capital, liquidity and currency exposure; limits on connected and directed lending; strict rules governing income recognition, classification and provisioning; reporting and disclosure requirements; a risk-based regime for remedial actions; consolidated supervision; and an effective framework for dealing with insolvent institutions.
Let me add, here, that the Asian crisis has especially brought home the dangers of large amounts of connected and directed lending -- much of it opaque and undertaken on the basis of implicit or explicit commitments to government underwriting. Commentators and others have recently made much of the problem of moral hazard . There is has been too little emphasis on moral hazard problems in the misallocation of capital within these countries. .
Second, rules and standards need to be enforced by a thorough system of bank examination. Supervision needs to be backed up by an independent bank supervisory authority with the ability to enforce compliance. Elegant risk-weighted capital ratios are not enough. The bank examination process has to be on-site, detailed, regular and complete, focusing on credit quality and internal controls. Matched books, for example, is all very well: it means little if companies are taking on foreign currency debt service commitments on the basis of domestic assets that will not generate the ability to repay.
In the wake of the crises the IMF has worked with Thailand, Korea and Indonesia to put in place more effective loan classification and other procedures to address manifest failings in bank supervision and credit management. In the lead up to the crisis, loan classification and provisioning practices in these economies had often made it virtually impossible for market participants -- even supervisors -- to gain a true picture of the condition of institutions. The more general lack of effective risk management at the level of individual institutions and the supervisory community as a whole was a key factor allowing the excessive build-up of foreign exchange obligations in the Asian crises and will be a major focus of international reform efforts going forward.
Yet, the very depth of these crises underlines the need for a third element -- a true credit culture at the level of individual institutions and firms. This ultimately rests on the rules of law and all that that implies -- not least independent judiciaries and effective bankruptcy regimes. Corruption and other illicit practices cannot go unpunished if the public is to have any confidence in the safety and integrity of domestic financial institutions.
The crises have taught us that supervisory and broader financial infrastructures may not have fully kept pace with the rapid development of their domestic economy and their closer integration with global financial markets. The Basle Committee has already developed core principles for effective banking supervision that can serve as a blueprint for steps to improve supervision at the national level. The International Organization of Securities Commissions (IOSCO) is engaged in a similar project. Events in Asia have focused attention on ways that these might be broadened and expanded to address some of the particular problems highlighted by recent events -- for example, with the development of comparable core principles in the area of corporate governance.
Yet common standards and principles will achieve little if countries and institutions do not implement them. And experience suggests that the lag between words and deeds can be long indeed. The collective global stake in timely prevention of crises and the contagion they cause calls for creative thinking about more powerful incentive mechanisms-- including especially the role of enhanced disclosure requirements to strengthen the disciplining effects of the markets themselves. We will need also to explore ways of building on recent steps to improve cooperation among the international financial institutions in this area and upgrade their financial sector capability.
One related point that is worth stressing in this context the very valuable role that foreign participation in the financial sector can play. Last years's WTO agreement on financial services was an historic step in committing countries to openness and encouraging foreign financial service providers -- and all the capital, expertise and competitive pressure they bring with them. Here in the United States we discovered long ago that inter-state banking is more diversified and more stable. In the same way, greater internationalization of finance can reduce risks at the same time as lowering the cost of capital.
Mexico and Argentina have both successfully applied this lesson by encouraging widespread foreign financial sector participation in the wake of the 1995 Tequila crisis. The Korean and Thai reform programs include important liberalization of the domestic economy in addition to radical financial sector reform -- and look to foreign competition and participation as a way of supporting those efforts.
III. Principles for Resolving Financial Sector Problems
So far I have been reflecting on the basic elements of building healthy and enduring banking systems. But in several countries today the task faced is that of repairing very troubled financial systems at a time of acute economic distress. A recognized irony of financial crises is that, unlike most kinds of crises, simply stopping what caused them does not take you closer to a solution. In many ways, the opposite is true: resolving the crises in Asia will involve reviving some of the things that caused it.
The dilemma is simply put. Economies will not recover without a resumed flow of lending to the corporate sector. Yet lending activity will not resume unless banks are recapitalized and the debt burdens of corporations are assessed and then reduced. Yet merely restarting credit flows without a fundamental change in the practices of banks, corporations and regulators runs the risk of the same past mistakes being repeated, and corporate debt/equity ratios and nonperforming loans continuing to rise.
You will remember that we faced similar dilemmas -- fortunately on a very different scale -- during the Savings and Loan crisis. It is fair to say that in the early years the authorities tended to focus excessively on worries of a credit crunch and too little on proper supervision and regulation of banks. Underlying problems grew bigger as a result. Several years later, however, evidence of problems of a credit crunch did arise.
Thailand, Korea and Indonesia have each been working to address banking sector problems by merging, intervening in or closing banks and finance companies. In all three countries the problem is turning out to be much larger and more complex than originally expected -- and as a result the impact on growth has been more severe. Government estimates of the potential cost of restructuring run from $20 billion in Indonesia to upwards of $100 billion in Korea.
Across Asia the international community has an enormous stake in the right strategies being pursued to help countries and companies grow out of crisis and to put the financial sector back on a stable footing. The challenges are immense, but the past year's efforts have yielded some important lessons:
first, strategies that help solve a systemic crisis turn out to be very different from the ones that are needed to address more isolated financial sector problems -- it becomes more difficult to pursue case-by-case approaches when even "strong" firms are well below water.
second, in an environment of systemic financial crisis, financial sector restructuring cannot proceed independently of corporate restructuring. That is why Thailand's announcement last month of a major public recapitalization plan that recognizes this logic is such a welcome development.
third, governments need to be prepared to spend very large amounts of public funds and to do so aggressively. There are understandable fiscal concerns. Yet history suggests that governments who try to put off large public expenditures will ultimately raise their magnitude by prolonging the crisis.
fourth, maintaining liquidity support for banking systems in crisis can be extremely difficult when a country lacks the financial instruments to do it effectively. In many crisis countries, for example, the lack of well-developed government debt markets has limited or eliminated the scope for open market operations. Here, as elsewhere, the search is on for new and creative solutions.
fifth, attention needs to be paid to finding effective strategies for disposing of bad assets. Governments need to get bad assets off bank balance sheets and dispose of them in a way that allows markets to clear. Yet these efforts have been seriously impeded in Asia by large numbers of creditors having recourse. Legislation has been announced to address this problem in some of the crisis countries but the signs are that more sweeping changes -- and more streamlined disclosure procedures -- will be needed to break the bottleneck.
finally, we have learned that countries have to strike a difficult balance, both ex ante and ex post, in the design of deposit insurance -- avoiding confidence problems when banks are restructured yet not making them so generous that they undermine stability and overburden the budget. The irony of too many places in Asia is that while the belief in wide-ranging implicit guarantees did much to bring on the crisis -- the lack of credible and explicit depositor guarantees has in some cases helped to worsen it by causing indiscriminate pressure on banks.
It is fair to say that the challenges you will be addressing at this conference -- getting beyond general principles to devising concrete schemes for reducing the risk of crises and containing them effectively -- are as important as any challenge faced by the global policy making community at a particularly difficult time. The solution to the puzzle will contain many different elements -- and dealing effectively with banking sector problems, particularly in Japan, will be a very important part. But I do think that as financial markets are integrated in the future the rewards will be even greater. Thank you.