Zeti: Resilience and capacity to manage shocks key to surviving crises

GOING forward into the future, the world is likely to continue to be plagued by financial crisis. History has shown that there has been more than a hundred distinct banking crisis in the recent two decades.

While the trigger factors for such financial crisis may be different, for most, there was a general loss in confidence, disruptions in the financial intermediation process and a general downward spiral of asset prices. While it is argued that what is needed is the reform of the international financial architecture, for any individual country, the prospect of surviving such a crisis is not only about building resilience, but also having the capacity to effectively manage the crisis.

Such a crisis was experienced in the Asian region ten years ago. Several parallels can in fact be drawn from the Asian financial crisis and the current financial crisis. In both cases, the crisis followed a period of strong growth, rapid credit expansion and rising asset prices.

Prior to the Asian crisis, there was indiscriminate lending by the banking sector. Similarly, the current financial crisis originated from imprudent lending practices and excessive risk taking that resulted in the formation of asset bubbles. In Asia, domestic credit rose to unsustainable levels, reaching 180% of GDP. In the United States, the ratio was 240% in 2007.

In both cases, there was a lack of capacity to manage the increased risks associated with the transformation of the financial sector. For Asia, the increased liberalisation was not accompanied by the necessary financial infrastructure or the capacity to manage the associated increased risks. In the current crisis, financial innovation occurred at a pace that outstripped the ability to manage the associated risks with such innovations. This resulted in an underestimation of the risks involved and the capital buffers that were necessary.

The ensuing turmoil in the financial markets resulted in illiquidity in the markets and the subsequent breakdown in their functioning. As the crisis advanced, financial stress and insolvencies emerged in the financial sector. In both crises, this precipitated a pull back in lending activities and thus the damaging consequences on the economy.

In the Asian financial crisis, the economic contraction was severe, in the range of 7% to 13%.

In the current financial crisis, the spillover effect on the economy has yet to be fully felt. The Asian crisis, however, ran its course in a short period of time. Asset prices and the foreign exchange (forex) rate plunged to their lows following significant market adjustments that occurred. The policy focus during the crisis was on restoring the functioning of the intermediation process to promote economic recovery. For most countries, growth resumed within 18 months from the start of the crisis.

The important actions that need to be taken in managing a financial crisis seem to be already apparent, as evidenced by the series of policy announcements that have been made by the respective governments, the multilateral agencies and the various international groupings. The policy actions have included providing the massive liquidity injections into the system, removing the troubled assets from the portfolio of financial institutions, strengthening their capital position and providing depositors protection. In addition, the implementation of monetary and fiscal stimulus also promoted economic recovery.

These were in fact among the series of measures that were implemented during the Asian crisis. The experience with these measures may not produce similar outcomes in containing the severity of the current global financial crisis and the degree to which confidence is restored and conditions normalised.

Vital measures from Malaysia’s experience

Several key elements are vital to achieve the desired outcomes. From Malaysia’s experience, measures implemented at the early stage of the crisis raises the prospects for restoring stability and the resumption of lending. Such early and pre-emptive action requires anticipation of the trajectory of the crisis. Reacting to developments or delayed action diminishes the effect of the measures to contain the deterioration. It will also raise the cost of the crisis.

A second key element is that the response needs to be comprehensive. Having clarity of the objectives and being focused on the necessary actions are important in an environment in which the demands are for addressing everything that has gone wrong.

In Malaysia’s experience, institutional arrangements were put in place early to restore lending activities by the banking sector. This involved the establishment of an asset management corporation to carve out the bad assets from the banking system. The assets were for the most part acquired at a discount that ranged 40% to 60% of the value of the asset. The asset management corporation managed the assets to enhance its value.

On the disposal of the assets, any return in excess of the value at which it was acquired was shared with the banking institution. A special-purpose vehicle was also established, for the recapitalisation of affected banking institutions. To avoid foreclosures of borrowers at the margin, a corporate debt restructuring committee was also formed to restructure loans.

Vital to this process was the Government machinery to facilitate the establishment of these institutional arrangements. Within six months of the course of these measures, lending resumed and economic recovery commenced. Having the supervisory function residing at the Central Bank also facilitated the swift action that was taken.

Massive liquidity was provided during this period. The implementation of selective forex controls that were put in place more than one year into the crisis drew significant attention at the time. The purpose of the controls was to stabilize the forex market. This was important given that severe disruptions in this market did not abate after more than a year into the crisis. It must be recognised, however, that while the stability it provided was important, on its own, it would not have resolved the crisis. It was the comprehensive set of measures involving resolution and growth supporting policies that resolved the crisis.

Perhaps a significant difference in the management of the crisis in Malaysia was the adoption of a more pragmatic approach. Relying on ideologies that the market mechanism would eventually restore stability and equilibrium did not take into account the irrational market behaviour and herd instinct that occurs during a crisis. Deviating from the conventional approach may thus be necessary. Such policies however, need to be undertaken with a high degree of transparency.

Disclosure and communication in these circumstances was critical. Regular information was therefore provided, sometimes on a daily basis. Information was given on all measures that were taken. Extensive communication channels with the public, the industry, the exporters, the corporate sector and foreign investors were maintained to promote understanding of the developments and the policies.

Leadership in crisis management is also important. In Malaysia, a National Economic Action Council was established and chaired by the Prime Minister. For several months it met daily. These meetings involved the private sector, professionals and technocrats. It provided the potential for coordination, consistency and comprehensiveness of the policy actions. Another element was the key role that was given to professionals and technocrats which raised the prospect for achieving the desired results and avoided actions that were based on political considerations.

Ten years hence since the Asian crisis, structural transformation has taken place in most of the economies and financial systems in Asia. This has enhanced our economic flexibility to adjust to external shocks. In addition, financial reforms have also been aggressively pursued. Surveillance and supervisory oversight have also become more rigorous and robust. A more recent development, is the deepening of regional surveillance and cooperation. This has also been reinforced by an integrated regional crisis management framework that may be activated in the event of any potential destabilising financial developments in the region.

In this global environment of increased inter-dependence, the prospect of future shocks that could translate into a financial crisis cannot be ruled out. To deal with this vulnerability, the strategy is to further strengthen the foundations and thus the resilience and capacity to manage such shocks. This is the approach to be pursued to ensure sustainability through episodes of such financial turmoil.

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The Star-Tan Sri Zeti Akhtar, Gavenor of Bank Negara