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What makes banking crisis resolution difficult? Lessons from Japan and the Nordic Countries

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Abstract

Banking crisis resolution is often a long-lasting process with large fiscal and social costs. We ask which difficulties authorities face when choosing and implementing resolution packages. We survey the literature analyzing the impact of single resolution instruments on moral hazard and fiscal costs. We argue that no best-practice resolution package exists and that the implementation of a package is subject to coordination failures. Since crisis resolution packages are country-specific, we follow a case-study approach and describe how regulators in Japan and the Nordic countries during the 1990s solved their financial crises. We identify several obstacles the authorities in these countries were faced with and analyse their crisis resolution in the context of moral hazard and fiscal costs. Finally, we use these lessons to reassess the policy reactions in the US and in Europe during the recent financial crisis.

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Notes

  1. Since our main interest is in crisis reaction mechanisms (after the breakout of the crisis), we do not discuss consequences for future crisis prevention; on this, see White (2008), Freixas (2010), Allen and Carletti (2010), Cukierman (2011) and Vollmer and Wiese (2013). Political measures for crisis prevention have already been incorporated into the EU framework for bank recovery and resolution. See the Bank Recovery and Resolution Directive (BRRD).

  2. Under monetary easing, the CB increases the size of its balance sheet and provides liquidity to the markets above the benchmark allotment. Under credit easing, the CB alters the structure of its balance sheet towards riskier/longer-term assets.

  3. For a review of the early literature on liquidity provision and bank risk-taking, see also Freixas et al. (2000).

  4. For empirical evidence concerning the impact of short-term interest rates on banks’ risk-taking incentives, see Jiménez et al. (2009); Ioannidou et al. (2009); Altunbas et al. 2010) and De Nicoló et al. (2010).

  5. This arises from the fact that interventions, which reduce the probability of default, increase the recovery value of debt. Since the bank value remains constant in the Modigliani-Miller setup, a higher debt recovery involves a lower value for shareholders. Thus, they do not have incentives to agree with these kinds of interventions unless they are compensated by a regulator, for example.

  6. Purchases of shares in a bank’s assets and purchases of equity shares differ in such that the latter provides a share in the bank’s assets and investment opportunities.

  7. In this framework, all depositors are secured by a deposit insurance. A bank bailout enables the bank (the shareholders) to generate a charter value.

  8. Duchin and Sosyura (2013) and Black and Hazelwood (2013) analyse for the US the relation between capital injection and risk-taking in the course of the Troubled-Asset-Relief-Program (TARP). Initially, the TARP was launched to purchase troubled assets in order to stabilize the US financial system. However, a short time after, the Capital Purchase Program (CPP), as part of the TARP, was unveiled.

  9. Acemoglu (2003) applies PCT to policies as well as institutions, i.e., to the choices made within a given framework and to the choice of the framework itself. Since institutions change only gradually, we restrict ourselves to the choice of policies. Moreover, Acemoglu (2003) also considers a “modified PCT” according to which societies choose different policies because of different choices made by leaders taken under uncertainty.

  10. For thorough surveys of banking regulations and the political reactions to the financial crisis in Japan, see Nakaso (2001), Fukao (2000), Fukao (2003), Bebenroth et al. (2009), Hoshi and Kashyap (2000) and Hoshi and Kashyap (2010). Shirai (2014) analyzes Japan’s more recent monetary policy stance.

  11. The payoff cost limit was a limit to the amount of financial assistance the Japanese Deposit Insurance Company (DIC) could legally offer in any single case. It was defined as the insured deposits times the loss ratio where the loss ratio was the part of liabilities which was not covered by sound assets (Nakaso 2001).

  12. Participation by private institutions was voluntary. According to Article 25 of the Bank of Japan Law, the BoJ was authorized to provide liquidity support and to inject risk capital into distressed banks as well (Nakaso 2001).

  13. For surveys of the deregulation and crisis period in the Nordic countries, see Englund and Vihriälä (2009); Drees and Pazarbasioglu (1995); Jonung et al. (2008) and Vale (2004).

  14. Although both funds were not state-funded, representatives from the “Banking, Insurance and Securities Commission (BISC)” and from the Norges Bank were members of their boards.

  15. Its funding was open-ended to avoid political misgivings about the commitment to support the banking system (Jonung 2009).

  16. Later, these banks as well as “Merita Bank”, “Unidanmark” and “Christiania Bank” formed the “Nordea banking group”, the largest in Scandinavia (Englund and Vihriälä 2009).

  17. This applies at least to the US and to the subprime crisis in Europe. With respect to the European sovereign debt crisis since 2010, Europe differs from Japan, which did not suffer yet from a sovereign debt crisis.

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  1. Institute for Theoretical Economics, University of Leipzig, Grimmaische Strasse 12, 04109, Leipzig, Germany

    Michael Diemer & Uwe Vollmer

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Diemer, M., Vollmer, U. What makes banking crisis resolution difficult? Lessons from Japan and the Nordic Countries. Eurasian Econ Rev 5, 251–277 (2015). https://doi.org/10.1007/s40822-015-0026-5

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