Financial crises like those that afflicted East Asia and Russia present governments with a herculean task of restructuring — but also with an opportunity to bring their financial systems into line with world standards.
Dominic Barton, George Nast, Roberto Newell, and Greg Wilson
Ecuador, Indonesia, Russia, and South Korea, as well as many other countries, have all been hit by typhoon-force financial storms during the past three years — an indication that national financial crises are increasing in frequency and severity. Many other countries could be at risk for similar economic disasters unless they act now.
Oddly, one cause of these crises lies in the economic-reform programs undertaken by the affected countries. From our work in 20 crisis-hit nations, it appears that governments often embark on liberalization without taking into account market fundamentals (such as exchange rate regimes, corporate governance, and risk-management policies) and then run into trouble.
During a financial crisis, there is always a real temptation to yield to chaos. Currency values plummet; banks declare bankruptcy; capital flees the country; politicians have a field day looking for villains, real or imaginary; and many groups within the government clamor to take charge. To minimize these effects, governments must swiftly and effectively seize control of the situation.
Although each crisis varies with the economic, political, and cultural legacy of the country where it breaks out, some lessons apply to all. Within the first 100 days, it is crucial to establish clear leadership, to create a long-term vision for the restructured financial system, to devise a clear blueprint for managing failed institutions, and to dispose of their assets quickly. A decisive start reduces the cost of the recovery program to taxpayers and restores confidence to investors and consumers. When the economy has been stabilized, longer-term initiatives to address the root causes of the crisis can begin.
During the 1980s and early 1990s, many of the countries that were later to be overtaken by financial disaster initiated programs of reform aimed at limiting state intervention in their economies. (Note: The motivation for reform varied. In Latin America, it was disappointment with a decade of zero growth and unwillingness to tolerate high inflation, mounting debt, and recurring exchange rate crises. In Asia, it was a growing conviction that economies had matured enough to allow market forces to begin replacing government intervention). The reforms varied from country to country but generally involved deregulating domestic markets to promote competition as well as privatizing government-owned enterprises, liberalizing the financial sector, and allowing foreign competition, direct investment, and capital flows. Most countries also implemented pegged or managed exchange rate regimes. (Note: In Latin America, these regimes were meant to control inflation).
Such market-oriented programs were necessary and laudable, but they inadvertently set in motion a series of dynamics that were not properly managed and usually culminated in disaster. Essentially, the pace and scope of reform gave governments too little time to ensure that the prerequisites of a market-oriented financial system were in place. Instead of behaving as competitive, profit-maximizing businesses, banks and other financial institutions continued to have close relationships with their corporate borrowers, just as they had before liberalization. In Mexico, for example, two of the three largest banks, Bancomer and Serfin, were still owned or indirectly controlled by industrial conglomerates to which they lent money. Governments often aided and abetted these relationships, sometimes as part of an industrial policy but more often merely as an expression of cronyism and shared interest. In South Korea, it was not uncommon for the government to be directly involved in corporate lending decisions.
Excessive familiarity between banks and borrowers led to poor lending decisions and lax monitoring. It was common in many countries for banks to roll over a loan when payments were missed rather than declare the borrower in default. Loan portfolios lacked balance, tending to be heavily weighted toward traditional companies even though many of them actually destroyed value because they didn't earn their cost of capital. In Colombia, in late 1998, just as several large banks were failing, more than 80 percent of all commercial loans went to sectors that had negative annual growth rates in the preceding three years—although the rest of the economy was growing. In Ecuador, 70 percent of the commercial loans of one bank went to companies connected to it through shareholder and management relationships.
In many cases, the credit decisions that underpinned loans were based not on future cash flows and ability to repay, but on credit histories or collateral value. Banks used these criteria partly because they lacked reliable financial information about borrowers but also because they were wedded to outdated management practices. Such banks thus favored past borrowers even though they were among the high-risk cases.
The problem was exacerbated by the fact that many financial institutions lacked experience in credit analysis and risk management. An effective "credit culture" didn't exist. A review of one bank revealed that almost none of its defaulted loans should have been approved in the first place; flawed credit-risk analysis, inadequate loan structuring, and insufficient monitoring had prevailed. The same review found that credit risks were not sufficiently differentiated and priced and that security documentation was often weak and poorly maintained. Loans that were not repaid were often covered up and only rarely subjected to workouts. These factors were not unique to the bank under review.
Underpaid and underskilled government regulators, hampered by supervisory gaps and government interference, failed to catch the bad loans and glaring risks accumulating on the banks' balance sheets. In Mexico, companies used financial derivatives to get around limits on foreign borrowing. In Indonesia and South Korea, government bodies directed loans to industrial conglomerates in amounts that often exceeded prudential limits. Regulators looked mostly for fraud; they almost never examined credit or market risk and rarely forced banks to segment credit risks, thus failing in their primary responsibility for prudential supervision. And the failures were expensive: we estimate that the present value of the cost to perpetuity of establishing and maintaining world-class regulation in South Korea would have been less than 1 percent of the cost of the crisis.
All of this would have been less of a problem had banks not been the dominant source of financial intermediation in these economies (Exhibit 1). In other circumstances, equity and bond financing would either have dried up or been repriced as a company's deteriorating performance and financial situation became known. As it was, cozy relationships between banks and borrowers, substandard credit skills, and poor bank supervision enabled troubled companies to take new loans long after it was wise for them to do so. Weak corporate-governance practices that didn't provide even a basic check on bank behavior compounded the problem. The outcome—a banking system almost bankrupted by uneconomic and unpaid loans—should have been easily foreseen. It was not.
The dynamics of the meltdown that followed were essentially the same in each country. Free to borrow abroad, banks and finance companies were flooded with cheap foreign-currency loans from international banks. They then rapidly expanded their lending (Exhibit 2), both to traditional borrowers and to risky new ones such as consumers, people seeking mortgages, and real-estate speculators. The quality of credit deteriorated as large traditional borrowers faltered in the heat of competition and new borrowers turned out to be less creditworthy than expected. On the eve of the crisis, nonperforming loans in most of the countries ranged from 15 to 35 percent of total bank assets, compared with 1 or 2 percent in stable economies. The banking systems were almost insolvent.
Anatomy of a crisis: Mexico
In 1989, Mexico began an economic-reform program that culminated in the signing of the North American Free Trade Agreement (NAFTA). As part of that program, the financial sector was liberalized and opened to foreign competition, and 18 state-owned banks were privatized. The new bank owners, many of them inexperienced, paid a high price: 202 percent of book value on average. (US banks were selling then for 120 percent of book value.) The new owners sought to recoup their investment through rapid expansion.
At the same time, the banks found themselves awash in funds thanks to the elimination of reserve requirements, an increase in deposits (in part prompted by the confidence the reforms inspired), loose monetary policy, and foreign borrowing. As restrictions were lifted, the Mexican banks' foreign borrowing, partly encouraged by the country's pegged exchange rate (exhibit), actually trebled. Most foreign loans were for short maturities and denominated in dollars, leaving the banks vulnerable to changes in the exchange rate or in the opinions of foreign investors. (Note: Banks in turn made some loans to Mexican companies in dollars, apparently reducing the banks' foreign-currency exposure. But many borrowers didn't have dollar revenues, thus creating a significant credit risk for these banks).Not surprisingly, a lending boom ensued: domestic lending as a percentage of the gross domestic product grew from 16 percent in 1989 to 39 percent in 1994.
As credit expanded, the balance of the banks' loan portfolios shifted away from traditionally safe borrowers—notably the government and large corporations. Budget surpluses caused the government's share of borrowing to shrink to 3 percent, from 30 percent, while large corporations turned to newly available bonds, equities, and foreign loans to meet their need for funds. Banks filled the void by lending to lower-rated corporations, small businesses, and consumers but didn't have the credit analysis skills required to screen them. Bank regulators failed to monitor the very serious risks arising from these new types of lending.
Fundamental shifts in the Mexican economy caused a further deterioration of loan portfolios. Positive economic growth rates concealed the fact that many Mexican companies, now faced with new competition, were in trouble and failing to earn their cost of capital. Yet lending to these companies continued. On the eve of the crisis in 1994, had Mexican banks valued their portfolios at market prices, they would have registered at least $25 billion in loan losses—equivalent to 5 percent of the GDP and certainly enough to wipe out all the equity in the Mexican banking system.
The crisis erupted in 1994, when political instability and rising interest rates in the United States eroded investor confidence in Mexico, and the pegged exchange rate broke. (Note: Mexico held an election in 1994, and Mexican elections historically have been times of crisis. In 1994, the first designated candidate of the ruling party was assassinated early in the year, and a rebellion broke out in the Chiapas region). Interest rates and foreign-debt repayments proceeded to soar while credit dried up and many companies went bankrupt.
A currency crisis finally brought the system crashing down. All of the crisis-hit countries had previously pegged their exchange rates to a foreign currency (usually the US dollar) or to a basket of foreign currencies. For many years, the pegs appeared to be stable, and this apparent security prompted many local banks to take advantage of lower foreign interest rates by borrowing abroad. Eventually, however, the credibility of the pegged exchange rate began to erode. (Note: The cause of the erosion of credibility differs by country. In Mexico, it was political issues coinciding with national elections; in South Korea, the crash of the Thai baht; in Colombia and Jamaica, fiscal imprudence and lax monetary policy). Hoping that the pressure on the exchange rate would be temporary, central banks responded by raising interest rates to defend the peg—pushing many banks further into insolvency as deposit rates rose and borrowers found themselves unable to service their debts. Central-bank reserves ran out, and the currencies depreciated sharply anyway. The cost of repaying foreign loans rocketed, wiping out the banks' remaining capital and wreaking devastation on national economies.
The costs of a crisis
The financial and social costs of rebuilding a nation's financial house after a storm affect everyone in the economy, especially unsuspecting consumers and businesses that ultimately pay for the crisis through a devalued currency, higher taxes, and a loss of employment and savings. Companies go bankrupt as access to credit dries up. Unemployment rises. And government debt rockets as the state pays off depositors, bails out banks, and restructures the financial sector. As a result of all these actions, the growth of the gross domestic product slows sharply, and the nation's standard of living falls (Exhibit A). Social unrest mounts, and governments may be destabilized, as Ecuador, Indonesia, Russia, and other countries have found.
Rebuilding a country's financial sector carries a staggering price. A decade ago, it cost Sweden and the United States 4 to 5 percent of their GDP to recover from financial crises. For many emerging markets today, the cost will easily amount to 15 or 20 percent of GDP and may reach 40 percent for some countries, such as Indonesia. And the recovery can be long and arduous, taking up to six years before a healthy, vibrant financial sector emerges. In the meantime, the flagging financial system is a drag on economic growth. In some countries, crises can drag on unresolved for years and even deteriorate further.
Postponing a restructuring, or rushing to a finish with partial solutions and half measures, only makes a bad situation worse. Failing banks continue to make uneconomic loans while foreign and domestic investors pull their money out of the country. Had many of the countries hit by recent crises restructured their financial sectors years ago, they would surely be better off today. By failing to manage the tough issues posed by a banking crisis promptly, Mexico, for example, saw its nonperforming loans rise from 12 percent of total loans in 1995 to roughly 30 percent in 1997.
Moreover, the speed of restructuring has an important impact on the resumption of private-credit growth and foreign investment (Exhibit B). South Korea quickly embarked on the most comprehensive restructuring program in Asia and returned to healthy lending levels within a year of the crisis. Foreign investment took off. Delays in Indonesia's restructuring program have resulted in low lending levels and little foreign investment.
Surviving the storm
Many lessons were learned from the various responses of governments to the storms that hit the countries in crisis. The most important lessons can be summarized in the following series of vital steps.
1. Establish clear leadership
Within the first few days of a crisis, it is essential to designate a leader, to assemble a multidisciplinary "control tower" team, and to set milestones and performance targets. Although these might seem to be obvious first moves, they are often omitted or needlessly delayed because of bureaucratic infighting and a lack of political consensus.
Ecuador offers an example of what happens when these steps are overlooked. As the country neared the brink of a full-blown financial catastrophe, a crisis-management team including officials from the finance ministry, the central bank, and other agencies was created. But this team, reflecting the deep divisions in the country, was hamstrung by political differences and institutional loyalties. The country's financial situation continued to deteriorate, and riots erupted when banks couldn't meet the demands of angry depositors. A coup eventually toppled the government.
Successful restructuring teams share several characteristics. First, the leader must have the courage needed to break completely with the status quo policies that caused the problem. Hence, restructuring leaders are often outsiders who are not beholden to the previous political regime or to a particular institution. Second, the leader must be given the authority to make decisions independently and quickly, often with just a "quick-and-dirty" analysis. Third, a new, independent restructuring agency is often required, and to ensure that progress is made, a program of change, with explicit milestones, must be set forth.
To complete the establishment of the necessary leadership apparatus, the multidisciplinary restructuring team must be formed in the early days. Ideally, it should consist of senior executives from government agencies with direct financial-sector responsibilities—people who can not only speak for their respective agencies but also get those agencies to act responsibly. Crucially, these executives must be able and willing to break with past policies and embrace reform. The team should be chiefly responsible for setting and managing the strategy to resolve the crisis and reform the financial sector, leaving basic operational responsibilities to the agencies and other stakeholders.
2. Create a long-term vision for the financial system
Restructuring efforts must be guided by a vision, which must be developed while the crisis-management team is being formed.
South Korea got it right when it devised a plan for its financial sector early in its crisis. At the beginning of 1998, Kim Dae Jung, then the country's president-elect, publicly voiced his strong support for reform and his vision for the country: "We will use this severe crisis as a lesson and prompter for us to move to a market-driven economy. The government's role must be reduced dramatically, and we will open up our markets completely to foreign direct investors and competition. Ensuring that the financial markets can work properly and efficiently and that corporations focus on shareholder value rather than size will be essential to our business."
The government then developed reform principles that built upon the president's vision and set the direction and tone for South Korea's restructuring. To carry out the task, the government created a new agency with cabinet-level status: the Financial Supervisory Commission. Although it will be years before the vision is fully realized, the government at least has a well-defined plan in place.
By contrast, in Thailand reform has suffered from the absence of a long-term goal. The government quickly and successfully liquidated 56 bankrupt finance companies during the upheavals of 1998, but since then reform has stalled over the issue of what to do with the rest of the financial system. Defaulted loans (now 35 percent of the total) remain on the books of the country's banks, and a backlog of bankruptcy cases languishes in the courts.
In creating a long-term vision for the financial sector, choices must be made about the nature of competition, the role of government regulation and supervision, and the extent of consumer protection. Defining this long-term vision will entail answering questions such as these: Will the government ensure the emergence of a few national winners or leave the outcome of competition purely to market forces? How many banks and other types of financial institution can the country support, and is consolidation needed? What role should foreign banks play? How will the country be linked to global capital markets to ensure the lowest possible cost of capital? What is the right mix of market and regulatory incentives and penalties? How should world-class corporate-governance practices be established? Does the country have the skills for risk management in general and for lending in particular? The answers to these questions should guide the restructuring effort.
3. Diagnose the extent of the problem
Almost by definition, countries undergoing a financial crisis are surprised by the breadth and depth of their problems. The reasons for the lack of readiness range from the protection of entrenched political and economic interests to willful ignorance. A shortage of accurate, timely data can hide problems as well.
However much a government is caught off guard, it must move swiftly to test the liquidity and solvency of each bank. Our experience has taught us that a two-week exercise can provide enough information to make it possible to assess the condition of the financial sector as a whole by extrapolation. Liquidity can be assessed by analyzing the cash positions of individual institutions and comparing these positions with the institutions' remaining repo capacity under various scenarios. Solvency can be assessed by applying estimates of nonperforming loans to the banks' books to determine whether bad lending practices have wiped out shareholders' capital. Once the extent of the problem is estimated, an external auditor applying internationally accepted standards should be brought in to go through each institution and identify those that are weak or failing. Any bank that offers patchy or unreliable data must be considered a prime suspect.
The problems uncovered can be shocking. One Latin American country found that up to 90 percent of its banking system was at medium to high risk of failing—a far cry from the 1 to 2 percent officials had predicted. Most of the failed banks had understated their bad loans by at least half; others had reported less than 1 percent of the true figure (Exhibit 3). Typically, crisis economies face nonperforming loans that may amount to 25 to 40 percent of total loans, against 1 to 2 percent in stable economies.
4. Intervene in weak institutions quickly
Crisis teams must seize weak and failing financial institutions as soon as they are identified. The experience of the US Federal Deposit Insurance Corporation (FDIC) shows that swift and total seizure, and the expulsion of the old senior management, are vital. Banks are usually taken over by a bank seizure team on a Friday and reopened on the following Monday under government control to maintain seamless service to customers. This tactical-operations team, which should have auditing, information technology, and communications skills, as well as expertise in physical security, manages the bank until it is liquidated or rehabilitated.
The ultimate fate of a seized bank—whether it is liquidated, merged, or restructured—depends on various factors. Banks can be rehabilitated if they have sufficient scale, franchise value, national coverage, robust product lines, and managers with adequate skills. The government typically injects capital, puts in a new management team, and develops a detailed revitalization plan. But if a bank has only some of these elements, it might be merged with another institution. Banks with none should be liquidated, their deposits and performing loans transferred to another bank, and their other assets sold.
At this point, a question arises: is it better to liquidate seized assets quickly to recoup losses or to wait until the market turns around? In a crisis, we have found that the longer seized assets are held, the lower the probability of recovery. The likelihood of recovering defaulted loans drops as borrowers' assets deteriorate, business relations are severed, employees plunder artwork and furniture, and owners drain away company cash before the restructuring agency can dispose of it. Branch networks become worthless as customers switch to stronger—and frequently foreign—institutions. Bank buildings and other durable forms of property decay from lack of maintenance. If Indonesia had begun to liquidate bad loans as soon as its crisis began, the government might have recovered 45 to 50 percent of seized assets. But political instability delayed liquidation for two years, and Indonesia will probably recover only 10 to 15 percent.
Extended delays also create opportunities for fraud. Former bank owners have been known to set up foreign companies to repurchase bank assets at rock-bottom prices, aided by accomplices who ensure that there is no serious bidding. This practice ultimately robs the country's taxpayers.
Delay carries political costs as well. Expectations of the recovery rate for seized assets are usually too optimistic. In one country, the government expected to recover 80 percent of seized assets but actually got 40 percent or less from most banks. Managing these expectations is crucial to achieving the political support necessary to a successful resolution. But the task grows more difficult if delays cause the recovery rate to sink further.
Usually, a workout agency is formed to dispose of nonperforming loans and other seized assets. Whether loans are restructured to enhance their value before disposal depends on the resources and skills of the agency and the ease with which the task can be outsourced. Korea Asset Management Company, which manages the task of liquidating South Korea's nonperforming loans, undertakes minimal loan workouts itself. Instead, it has sold packages of unrestructured loans to workout specialists such as Deutsche Bank, Goldman Sachs, and Lone Star, which are willing to purchase these defaulted loans because South Korean commercial law offers strong protection to creditors. The Indonesian Bank Restructuring Agency, by contrast, is restructuring some of its larger loans itself because of the weakness of the Indonesian legal system.
5. Introduce foreign competition
Emerging economies often bar foreign competition for fear that their financial sector will be taken over by global banks such as Citigroup or HSBC and that a potent symbol of national sovereignty therefore will be lost. But some element of foreign competition is crucial to revive a troubled financial sector, especially in emerging markets where banking skills are in short supply. Foreign banks force domestic competitors to achieve world-class standards of service and efficiency. They bring much-needed skills in areas such as credit assessment and risk management by training locals who may eventually work in domestic banks. They can also provide much-needed capital injections in cash-starved countries and therefore save taxpayers large amounts of money.
Mexico realized the value of foreign competition too late. In the early 1990s, the country privatized many of its state-owned banks as part of a broader program of economic liberalization. The government barred foreigners from buying stakes, however, and many of the new owners had little or no banking experience. As a result, these banks rapidly and recklessly expanded their lending, a move that contributed to the 1994 crisis. Today, Mexico's banking sector is becoming mostly foreign owned. Bancomer, the country's number two bank, has been acquired by Banco Bilbao Vizcaya Argentaria (BBVA). Serfin, the number three bank, has been purchased by Banco Santander Central Hispano. Both buyers are Spanish.
Difficult though this might be to accept, foreign banks are often the salvation of a country emerging from a crisis. Strong foreign participation has been a factor in the restoration of the financial systems of many Latin American countries—including Argentina, Chile, Mexico, and Venezuela—and of Jamaica (Exhibit 4). In Argentina, foreign banks now control nine of the ten biggest private banks and half of all bank assets. These banks have brought new technology that has met the needs of many households and small businesses formerly excluded from the system.
Policy makers may decide how they capture the benefits of foreign competition and whether some national players should survive. While welcoming competition, Canada, the Netherlands, Spain, and Switzerland are committed to ensuring that their national banks endure. New Zealand, the United States, and the United Kingdom, by contrast, allow the market to determine the winners and losers. In the early 1980s, for instance, the government of Britain allowed most of the country's old merchant banks to be acquired by foreigners as part of a financial-sector liberalization.
Some countries, such as Malaysia, have chosen to open themselves up to foreign competition gradually to give local banks time to compete. This works if there is a clear and credible time frame for introducing foreign competition. Jamaica, on the other hand, has allowed the market to determine the winners in the country's restructured system, making foreign banks the main providers of financial services for the foreseeable future. This outcome has saved Jamaican taxpayers some expense, though the total cost of the country's financial crisis will be a drag on economic growth for years to come.
The emergence of a crisis should not be used as a reason to halt or reverse market reform. Instead, reform should be extended to cover the revamping of regulation and supervision, the upgrading of bank-management practices, and the promotion of arm's-length relationships between banks and their borrowers. Other priorities for reform include increased transparency in financial reporting and the establishment of capital markets to discipline banks and corporations.
Building this financial-market infrastructure is undoubtedly a herculean task that even most developed countries have yet to complete. But the alternative is to revert to the status quo, a course that would produce only marginal economic growth and risk further crises. Seizing this opportunity gives countries a chance to redesign their financial systems in line with world standards and to join the ranks of mature economies enjoying sustainable economic growth.
Notes:Dominic Barton is a director in McKinsey's Seoul office; George Nast is a consultant and Roberto Newell is a director in the Miami office; Greg Wilson is a principal in the Washington, DC, office.
The authors thank Lisa Finneran for her help with the research.