Crisis-Related Measures in the Financial System and Sovereign Balance Sheet Risks

The IMF has released a new report that lays out general principles that should guide governments in managing public interventions in the banking system.

Full paper here.

Summary here.

4 replies on “Crisis-Related Measures in the Financial System and Sovereign Balance Sheet Risks”

The government is very lucky that this report has just been published. As usual, it is written to a very high standard, with significant depth of understanding and wisdom.
But what chance that any or all of these IMF recommendations are finally put into effect….? And if not, what chance that the press or opposition understands them well them to shame the present government into action?

Here is what the IMF proposes:

Clarity about macro-goals is a precondition for articulating an appropriate ALM framework. 19

A clear medium-term macroeconomic strategy is key for maintaining confidence in fiscal solvency 18

Information about the risks associated with interventions should be published. 21

Risk assessment must play a central role in
informing the ALM strategy. 20

Assessing value accurately is crucial for understanding the impact of the interventions on fiscal solvency. As some uncertainty about valuation is unavoidable, ALM policy design should focus on incentives for price discovery. In asset acquisition, a balance needs to be found between too high a price, which risks fiscal solvency and taxpayer anger, and too low a price 22

Adherence to accepted accounting standards will enhance countries’ accountability. 23 Most GAAPs require “fair value” asset valuation. where markets are illiquid or shallow, then other approaches, such as discounted future cash flows, or the price at which similar types of assets trade, can be used to determine “fair value.” Recent developments have led to pressures for a retreat from marking-to-market.23 However, too aggressive a shift away from marking-to-market valuation could be counter-productive, since it could lead to second-guessing by rating agencies and investors.24 Recent proposed IFRS amendments to accounting for financial instruments retain a preference for “fair value” and limit alternatives to simple debt instruments held for their underlying cash flows. While there might be a case for a different approach where assets are being held to maturity, as a rule it is better for governments to ‘know the worst’ and use full information when making policy decisions. 24

Establishing a centralized asset management companies can be efficient in certain circumstances. It can provide important economies of scale or help overcome coordination problems where institutions have been closed, expertise is limited and there are many claims on the same borrower. Centralized AMCs were used in Indonesia, Korea, and Malaysia following the Asian crisis… others have announced new ones (e.g. Ireland’s NAMA). 30 The most appropriate approach will reflect the potential market appetite for troubled assets and degree of market development. 29

[This description so clearly fits… Ireland ?]

Decentralized asset management may facilitate private involvement. 31

[an option it seems not countenanced under the incumbent government]

Access to support should be made increasingly less attractive. 59

Governments need to maintain a level playing field between institutions, and support market-based financial intermediation. To ensure fair competition across institutions, support should not leave “bad” institutions in a better position 45

[Does this extend within the EU, or does a level playing field only extend to the border?]

Public participation, whether full or partial, should be governed by clear and transparent rules. A mandate should be clearly specified that: (i) establishes criteria for acquiring and selling assets; (ii) addresses valuation issues; and (iii) avoids market distortions and provides operational autonomy isolated from political interference. For example, the mandate of U.K. Financial Investments, Ltd (UKFI) specifies that it will develop and execute an investment strategy for disposing of assets in an orderly and active way, while protecting taxpayer value, maintaining financial stability by paying due regard to asset price impact, and promoting competition. 33

[I don’t see NAMA taken as a reference here]

Public participation needs to be managed taking account of taxpayer costs, shareholder incentives, and flexibility for unwinding. To limit taxpayers’ costs, consideration might also be given to imposing a haircut on unsecured creditors. Given that assessments of recapitalization needs are in the process of being fully determined, establishing a contingency plan for further recapitalization would help avoid costly ad-hoc measures. 34

[The IMF often uses “could” or “might”. This is diplomatic par for the course]

Guarantees have been widely used. Typically they can be implemented rapidly and, when successful, they are costless. However, they can create perverse incentives for insolvent banks by allowing them to postpone the required restructuring and potentially bias operational decisions towards riskier behaviour. Moreover, a guarantee may not be credible if the government is financially constrained. Indeed, the existence of a large guarantee may precipitate a shock if investors bet against it. The cost, or value, of a guarantee, is particularly difficult to assess. 35

[The IMF says this is true for all guarantees. Hard not to see Ireland top of the list, with 1 year of zombie banking to its credit to date]

Until the interventions are dismantled, they need to be managed effectively. This requires protecting government net worth 17

Developing a credible strategy to unwind the interventions would enhance their effectiveness. 48

Fiscal management will be facilitated by building flexibility in the budget to respond to calls on guarantees. Mechanisms to improve flexibility include contingency appropriations, supplementary budgets, and guarantee funds. 41

[No use crying over split milk, some say, but I wonder]

The debt management strategy needs to be robust to the risk that contingent liabilities will materialize 42

[So no short-dated bonds, unless horribly constrained]

It may be prudent to restructure or refinance this debt using longer-dated maturities where cost-effective. For example, the Netherlands and the U.S. have already begun to reverse the reductions in average maturity of their debt. 42

[Desirable, but the feasibility will be a function of soundness all the previous steps]

Experience shows that the process may remain incomplete for decades and that costs may not be easily recovered. In past crises, advanced economies recovered
55 percent of costs 51

@Ciaran O’Hagan

Many thanks for posting your notes on the report.


Thoughts that strike me on reading the summary:

1. Exit strategy.

The Govt has indicated thaqt they hope to exit large portions of NAMA quickly by bundling loans and selling them or by bundling properties which they have taken possession of and selling them. Hopefully this is achievable as it could allow for a quick winding down of large portions of the NAMA balance sheet.

2. Winding down of liquidity provisions.

the time frame for implementing a banking solution for Ireland is growing ever shorter. The ECB has already indicated that they have an exit strategy for the wind-down of exceptional liquidity provisions. Ireland has doen a good job of keeping its head above water and managing the crisis until the opinions of the international community and markets and the commentariat have coalesced around a number of credible rescue strategies and variations thereof. Now that the environment will allow os to take the necessary remedial action we must do it very quickly or risk missing the boat we have waited so patiently for (not on the pier but in the water and out of our depth).

3. Insulating States from the cost and risk of guarantees

The IMF is changing the playlist in this regard. This is welcome as it should help Ireland get out from under the tower of doom that is the guarantee without startling anyone.

4. Comments on valuations

“Accurate valuation of assets and liabilities is crucial for understanding the impact of the financial support on fiscal solvency, the IMF said. The paper discourages any aggressive deviation away from the use of mark-to-market accounting, which allows for price discovery through the “fair value” granted the asset in a liquid market. As a rule, it is better for governments to “know the worst” and use full information when making policy decisions, according to the study.” The reference to values in post-crisis liquid markets mirrors the Irish legilation to an extent. However this part of the summary will be quoted endlessly, interpreted variously and may crowd out the other aspects of the report in debate in Ireland for the moment.

5 Future Agenda Setting and Sentiment Management

Watch this space!: “As part of its ongoing work to help governments and central banks tackle these issues, the IMF will host a high-level conference to discuss the complex policy implications of unwinding public interventions in the financial system. The meeting will be held on October 29 in Washington, D.C. and will include government and central bank officials, as well as academics and private sector participants.”

6. Pulling Back on Stimulus Too Early

The IMF may not be reading from the same page as the Fed. Krugman’s fears that the stimulus may be withdrawn too early thereby repeating the mistakes of FDR will be heightened by the anxiety to move towards lower deficits:
“Getting from a phase of large interventions and stimulus to an unwinding phase will require governments to be clear in deciding their deficit and debt targets, in order to establish timetables for returning to a more normal state of affairs, according to the study. The trajectory of deficits and debt over time will in turn define governments’ financing needs and inform the management of their assets and liabilities.”

Clearly this thread – with only 3 contributions – does not attract much interest.

Now we have the press conference

What chance progress in Ireland on the points below… critical I believe?

Access to support should be made increasingly less attractive and risks should be gradually transferred to the private sector, and you do this by raising interest rates, guarantee fees, and other charges over time. Past crises have shown that central to any plan is a clear communication strategy by the government outlining its intentions. This is important for all players, including financial markets. They need to know what to expect.

We also caution about the importance of getting as much information about valuation as possible and we advise against moving away from marking to market where marking to market is possible. As a rule, it is better for governments to know the worst and use full information when they are making their policy decisions.

We recommend that countries issue comprehensive fiscal risk statements.

As a rule, it is better for governments to know the worst and use full information when they are making their policy decisions.

there are several aspects of the intervention measures that when they begin to unwind, then they would require the authorities who have intervened to be very cautious about the cross-border spillovers. The Fund will continue, as a part of its analytical and surveillance work, to analyze those, come up with a framework that could further reassure the authorities as well as the markets that this is moving on the right path.

This approach by construction is indeed the best way in which countries can safeguard and preserve their sovereign creditworthiness. And more and more of analysts are looking at not just one component of the balance sheet or one entity’s balance sheet, but are looking at these interdependencies among different balance sheets of the sovereign.

It’s very hard to ask governments to say what they intend their deficit to be, you know, each year from now on until the debt comes down to the level that they want it to be at. And so we are recommending that they pay even more attention than usual to doing, you know, stress testing, different scenarios. We also recommend that governments issue comprehensive fiscal risk statements.

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