1999 | nr 10 Proceedings of the Ace/Phare Conference on Building Financial Institutions in Transition Economies: Poznań, Poland, 14-15 May, 1999 | 402--419
Allow Banks to Fail
Explicit and implicit guarantees of banks' creditors and shareholders set the competitive mechanism out of play in several ways. There is widespread agreement among economists that qarantees of depositors make the banking system crisis-prone, and that supervisory activities do t easily correct this problem. Only in the USA is the deposit insurance of such coverage that it is likely to be a strong ;incentive for bank-runs. Authorities in most other countries with partial deposit insurance (the J) and no explicit insurance offer implicit guarantees by not allowing banks to fail and be liquidated. By bailing out banks, authorities actually offer a broader guarantee than a complete :posit insurance. Even shareholders obtain a "safety net" when bail - outs are expected. When insolvent banks are not allowed to "exit", inefficient financial institutions survive id hinder the expansion of the well - managed ones. In particular, the reward to skillful project id risk evaluation is weak. Is it possible to restore the competitive mechanism in the banking industry without eating unacceptable risks of bank - runs and "contagion" through the settlement systems among inks? The competitive mechanism requires the "exit" of inefficient firms on the banking industry as in other industries. Efficiency also requires that the expanding banks are those with i advantage in the evaluation and pricing of risk. These considerations imply both that banks should be allowed to fail and that liability holders including depositors should be made "risk - concious." At the same time this consciousness must not be so strong that one bank's failure causes a run on others. A regime for dealing with problem banks must also take into account the political realit that governments' fear of contagion may be so strong that they bail - out banks in order to remove any risk of contagion. Thus, in order to be credible the regime must enable banks to fai without inducing authorities to intervene for the protection of any creditors. Such credibility ca probably be achieved only if the risk facing large groups of depositors and liability holders is very smali. The risk must be smali both in terms of probability that they will face losses, and ir terms of the magnitude of the potential losses. The risk must not be removed completely, however. We will suggest that the solution to the dilemma outlined above lies in the specificatior of insolvency procedures for banks. In fact, we argue that the appropriate insolvency procedur* are those that would be induced by the competitive mechanism, if governments credibly would be able to take a complete hands - off attitude. Since such an attitude cannot be expected, the procedures must be specified in law or regulation. Section 2 describes how banks with implicit or explicit guarantees tend to be crisis - prone, and how insolvency procedures for both fmancial and non-financial institutions contribi to a "stop - Go" banking system in some countries. Principles and proposals for dealing with problem banks are discussed in Section 3. Finally, in Section 4, insolvency procedures for ban are discussed in more detail. (original abstract)
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