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An
Incentive Approach to Identifying Financial System Vulnerabilities (Editor's Note: This article has two charts to illustrate the incentive approach to assess financial system vulnerabilities. The charts, omitted here due to our text format, are available from the author at jchai@imf.org.) I.
Introduction Different
analytical approaches can be used to assess vulnerabilities
in the financial systems (Johnston, Chai, and Schumacher 2001).
An economic or incentive structure approach focuses on underlying
sources of vulnerabilities in financial systems as identified
in the theoretical or empirical economic literature. This
approach emphasizes the implications of asymmetric information
and market structure for identifying factors affecting incentive
structures and potential sources of "structural"
vulnerability in the financial systems. A risk-assessment
approach seeks to quantify the risks and exposures in individual
financial institutions. Certain risk-measurement techniques,
including a number of macroprudential indicators and stress
tests, are designed to identify and to some degree quantify
the immediate, salient vulnerabilities in the financial institutions.
A supervisory approach emphasizes the adequacy of the supervisory
framework in which the assessment of international standards
and best practices plays a role. This approach helps to determine
whether the supervisory system is adequate to address the
risks confronting the financial system. Finally, a systemic
vulnerability assessment seeks to compare the risks confronting
the financial system with the capacity of the system to manage
those risks at the level of the financial systems as a whole.
A key economic concept underlying the incentive approach is asymmetric information (AI): a situation in which one party to a financial transaction has superior information to another. While financial intermediaries arise as a particular solution to the problems of AI, AI remains a crucial impediment to the effective functioning of a financial system. [1] Recent experience with banking and currency crises has underlined for example the role of moral hazard in reducing incentives to monitor performance, and the problems of adverse selection and herding behavior in creating vulnerabilities in financial systems. [2] The other key economic concept underlying the incentive approach is market structures. A growing theoretical literature has focused on the relationship between financial market structures and economic behavior, which is shown to potentially give rise to certain vulnerabilities for a financial system. [3] While it is not possible to eliminate AI and the problems associated with AI do not necessarily cause financial instability, the incentive approach recognizes that certain combinations of key structural and policy elements may aggravate the incentive problems to the extent of destabilizing a financial system. In this paper, we identify the three key structural and policy elements in a given environment that have been shown to affect the incentives of the main agents in the financial system operating within that environment. Specifically, we seek to understand how the environment within which financial transactions take place affects the risk taking, hedging and monitoring behavior of the main agents in the "core" of a financial system - investors, borrowers, intermediaries - as well as the incentives of the regulators and supervisors to monitor and regulate risk taking behavior, and the implications of the resulting net risk taking behavior for vulnerabilities in the financial system. The criteria used to make these assessments have to be drawn from theoretical and empirical understanding of the operation of financial systems. In our view, such an approach is the most effective because the AI-induced problems are most likely to cause destabilizing financial vulnerabilities through distorted incentives when such checks and balances are lacking or ineffective due to the incentive problems of regulators and supervisors. This approach differs in scope and philosophy from the other two main techniques that have been used in assessing financial vulnerabilities - statistical based assessments and the review of compliance with codes and standards in the financial system - by focusing directly on the factors that influence economic behavior. Such a focus can accommodate great diversity in the organization of financial systems, and go beyond relying on quantitative or regulatory benchmarks (such as regulatory standards) to assess vulnerabilities in financial systems. This paper is organized as follows: Section II discusses background to the concept of an incentive assessment; Section III outlines the general framework for conducting an incentive assessment; Section IV illustrates the role of such an incentive assessment in helping identify the sources of vulnerabilities in a country that has experienced financial problems; Section V concludes with suggestion for information necessary for applying the incentive approach. II. Background on an incentive assessment The rationale for an incentive assessment derives from the economic literature on financial intermediation. This literature provides a framework for classifying and analyzing the fundamental nature of financial systems, based on the incentives faced by the various participants. It is well recognized in this literature that certain types of incentives result in vulnerabilities in financial systems and unsound banking practices. AI
is a potential source of fundamental weakness in financial
systems because it leads to problems of adverse selection
and moral hazard: The effects of implicit and explicit exchange rate and deposit and loan guarantees in creating problems of moral hazard have been highlighted by the Asian currency and banking crises. Such guarantees contributed to large capital inflows and over investment due to an underestimation of the risks involved. In addition the severity of the crisis was compounded by herding behavior among investors in advance of the crisis and contagion when the crisis first occurred. Experiences with handling distress in banking systems have highlighted potential issues of moral hazard among the supervisors and regulators when there has been a tendency to regulatory forbearance rather than intervention to deal with banking problems because of the lack of independence of the regulatory agency. Poorly designed crisis management systems and procedures for closing banks have also given rise to risks of systemic vulnerability due to the risks of contagion. Financial crises have also been traced to weaknesses in ownership structures and corporate governance. In general, ownership structures and corporate governance can affect the incentives of managers to assume risks and owners to monitor risk taking. Interrelated ownership of financial and non-financial corporations has been an important source of financial sector vulnerability, especially where the incentives of other creditors to monitor performance have been weak, due for example to the expectation of official bailouts. Finally, policy and financial innovations, for example those associated with financial liberalization, have aggravated the problems of moral hazard and adverse selection, especially when the innovations led to changes in banking structure and erosion in franchise values in certain markets. It has been argued that the resulted excessive risk-taking and insufficiently monitored financial risks from the innovations were the main reasons for banking problems in Japan (see Section IV). III. Framework The incentive assessment involves an investigation of both the environment under which financial institutions operate and the core represented by the interrelationships between the main participants in the financial system. We first identify the three key elements in the environment, which include the sophistication of a financial system in terms of market structure and competing financial instruments, government safety nets, and the legal and regulatory framework. We then aim to categorize a financial system based on whether those elements play a major role in that system. Finally, we prioritize the set of questions in order to ascertain the effects of these elements on the incentive structure of the main agents within the core of the financial system that are most likely to cause financial vulnerabilities. Corresponding questions are asked to determine whether there are sufficient checks and balances to the moral hazard and adverse selection problems identified. A. Organization 1. Key elements in an environment A financial system is conditioned by the external environment in which the system operates. We describe the external environment of a particular financial system by focusing on three key elements that influence incentives in the financial system: the market structure and financial instruments; the existence or otherwise of official guarantees and safety nets; and the legal and regulatory framework. Market structure and financial instruments (MFI). The sophistication of a financial system in terms of the market structure and the availability of competing financial instruments in the system have mixed effects on the incentive structure of depositors and borrowers and the banks and non-bank financial intermediaries. First and foremost, the existence of competing financial instruments is a necessary condition for market discipline. Whether it is sufficient or not will depend on a number of additional factors (such as the adequacy and transparency of information) which we consider part of infrastructure of the "core" environment. A country with sophisticated financial system tends to be better positioned to battle financial instability since the market discipline imposed by the investors tends to mitigate moral hazard problems. At one end of the spectrum, many of the developed countries have sophisticated financial systems where market discipline plays a major role, facilitated by the highly developed debt and equity markets. In many developing countries, however, market discipline plays a minor or no role as there are few options for households, investors and financial intermediaries. Capital markets are nonexistent or underdeveloped. Among the least sophisticated financial systems, centrally planned economies have specialized state-owned banks allocate credit, limiting the role of banks in financial intermediation. But a greater degree of availability of financial assets may affect a financial system in ways more prone to financial vulnerabilities. A growing literature focuses on various effects of competition on the incentives for the screening of projects, banks' franchise value and hence their incentives for risk-taking, as well as the quality of bank loan portfolios. [4] For example, the availability of competing financial assets does not necessarily guarantee the access of households to alternative financial instruments, which should be distinguished from the access of the non-financial corporate sector to alternative external sources of financing. In the latter case, the adverse selection problem in corporate financial markets may worsen banks' balance sheets and reduce franchise value. Empirical evidence seems to suggest that countries undergoing financial deregulation and with a fairly sophisticated financial system as characterized by developed capital markets and availability of financial instruments tend to be in a more vulnerable position than those that have limited financial assets and underdeveloped, relatively controlled financial markets. But further research is needed to identify the conditions under which the maturing of a financial system leads to certain risks. Government safety net (GSN) A
form of GSN that is shown to have caused financial instability
is explicit or implicit exchange rate guarantees, which are
often provided to achieve external competitiveness or protect
selected domestic industries. Regardless of the rationales
for such guarantees, experience from a number of countries
has suggested that they may cause destabilizing capital flows
when fundamental inconsistency exists for example between
the exchange rate and interest rates, and when capital account
is sufficiently liberalized. Greater freedom of capital movements
implies that short-term interest rates in domestic markets
will increasingly be determined by the covered interest rate
condition, and attempts to set both interest rate and exchange
rates inconsistent with this condition is likely to lead to
short-term capital flows as markets respond to the incentives
created to switch investment between countries. Moreover,
an exchange rate policy may become inconsistent over time
when the decision to maintain the level of the exchange rate
in a future period is no longer feasible (too costly for example)
under the prevailing economic and market conditions. Understanding
the dilemma facing the policymaker, markets will view the
exchange rate policy as incredible and attack the currency
whenever there are signs of such inconsistency. Experiences
of the emerging markets have shown that when such attacks
did succeed, currency crises more often than not led to banking
crises because banks suffered large losses from large open
currency positions or loan losses from exposed borrowers.
Similar moral hazard problem may arise when depositors, other creditors, or supervisors perceive that implicit or explicit government guarantees in the form of credit line or bailout are granted to banks and/or corporate borrowers. Such perceptions not only tend to reduce monitoring efforts on the part of the creditors and supervisors but also give incentives to banks to take excess risks in lending, especially when the net worth of the banks are negative. Legal framework and quality of enforcement (LFE) Legal framework and the quality of enforcement affect the stability of a financial system for a number of reasons. First, a complete legal framework and high quality of enforcement are essential for disciplining the behavior of banks and firms through safeguarding property rights and providing investor protection against expropriation by insiders. For the same reason, countries with relatively complete legal framework and high quality of law enforcement tend to have more developed capital markets, which facilitate banks and corporate borrowers in raising external financing. Second, a key factor determining the quality of the enforcement is the degree of underlying weakness in public policies and institutions in an economy. A particularly relevant aspect for the stability of a financial system is the effect of institutional weakness on banks' lending behavior as well as the quality of the governance of corporate borrowers. Empirical evidence shows that a system with relatively complete legal framework may not be sufficient to protect the banking system from excessive lending to related parties who exercise corruption. Third, the importance (or lack thereof) of supervisory institutions in a legal framework varies across countries. A country with a relatively complete legal framework may have underdeveloped or weakened supervisory institutions. The latter often is associated with financial deregulation or liberalization, which reduces the quality of prudential oversight. As shown by the experiences of countries in financial distress, AI related problems are most likely to lead to financial instabilities when proper prudential oversight is lacking or weakened. 2. Categories of external environments To prioritize FSSAs, it helps to recognize that most financial systems fall into the following four categories: (1) MFI, LFE, and GSN play a major role in influencing the functioning of the financial system (most of advanced financial systems, with varying degree of importance of GSN); (2) Only MFI plays a major role, lack of LFE or GSN; (newly liberalized financial systems in transition economies, such as the former Soviet Union countries); (3) Only MFI and GSN play a major role, lack of LFE (liberalizing financial systems in newly liberalized economies, such as East Asian economies); and (4) Only GSN plays a major role, lack of MFI and LFE (liberalizing financial systems in transition or central planning economies, such as Pakistan). Once we decide whether certain key elements play a major role in a financial system, we need to be mindful of their likely effects on incentives of the main agents in the core of the system, where the literature on banking and corporate governance may be used to help identify AI related problems that are prone to cause financial instabilities. 3. The "core" environment The incentives of the main participants can be examined by drawing on the theoretical and empirical literature on banking governance and corporate governance. Banking governance issues concern the relationships between the incentives of bank management and depositors (and outside creditors) on the one hand and bank's ownership or liability structure, the extent of related lending, the nature of the banking power, and managerial incentives on the other hand. Some of the questions being addressed include: (1) Do holders of non-equity liabilities (depositors and outside creditors) have sufficient incentive to discipline banks against risk-taking? (2) Are banking concerns subordinated to the financial concerns of the related business group? Do banks extend credit to related enterprises in excess of prudent concentration limits or on noncommercial terms? (3) Is there evidence that universal banks free ride on other banks in reputation and monitoring of certain classes of borrowers? (4) Are management rewards related to profitability? (5) Is the net worth of the bank reduced to the extent of increasing the probability of management taking excessive risks? Moreover, based on the issues identified for a particular banking system, questions follow on whether there is sufficient internal and supervisory control in place. Finally, corporate governance issues address, among other things, the incentives of corporate borrowers as determined by their ownership/liabilities structure, internal and external controls and managerial incentives. A similar set of questions to the ones above may be raised to determine how they affect the behavior of the corporate borrowers. B. Applying an incentive assessment The incentive assessment may take the form of a pyramid of flow charts consisting of answers to questions about the incentives of the key players. The incentive assessment provides a framework for prioritizing the nature of question to be assessed under different systems. The following research agenda is identified from such a flowchart: 1. Quantifying the external environment A set of variables may be identified, from which we can infer whether MFI, LFE, or GSN plays a major role (that is, they take the value of 1) in a particular financial system. For example, the following indicators may be used to categorize a particular environment: MFI equals 1 if an average household holds non-bank-deposit assets and if there is some degree of capital mobility, and 0 otherwise. LFE equals 1 if there has been at least one case each of corporate bankruptcy and bank closures/restructuring in each of the past five non-crisis years, and 0 otherwise. GSN equals 1 if there is deposit insurance guarantee in place and if there has been no corporate bankruptcy or bank closures/restructuring in any of the past five non-crisis years, and 0 otherwise. 2. Questions to be prioritized under each category The purpose of categorizing the external environment of a particular financial system is to focus on the questions that are most relevant given the features of the system. Questions are structured in two tiers, depending on the elements contained under each category. Questions to be prioritized under each category are illustrated as follows: Category (1) - MFI, LFE, and GSN play a major role in influencing the functioning of the financial system: Questions concerning accounting standards and disclosure practices in order to ascertain the degree of market discipline imposed by competing financial instruments as well as the effect of market structure on banks' franchise value; Questions concerning legal rules for investor protections and the quality of enforcement to determine the degree of external discipline on the behavior of bank or corporate management; and Questions concerning supervisory controls to determine whether they are sufficient for mitigating moral hazard and adverse selection that may result from government safety net. If the answers to the above questions are yes, the incentives of banks and their borrowers are likely to be properly aligned with the level of risk that is appropriate for the system. If not, questions addressing the internal governance of a bank and its major corporate borrowers are needed. Category (2) - Only MFI plays a major role, lack of LFE or GSN (newly liberalized financial systems in transition economies, such as the former soviet union countries). Even in the absence of government safety net, supervisory controls are needed for mitigating moral hazard and adverse selection in banking. Obviously, the importance of supervisory control is less in this case than in the presence of government safety net. Again, if the answers to the above questions are yes, the incentives of banks and their borrowers are likely to be properly aligned with the level of risk that is appropriate for the system. If not, questions addressing the internal governance of a bank and its major corporate borrowers are needed. Category (3) - Only MFI and GSN play a major role, lack of LFE (liberalizing financial systems in newly liberalized economies, such as East Asian economies). Questions should be focused on accounting standards and disclosure practices as well as supervisory controls. However, in the absence of the checks and balances from the enforcement of supervisory and legal system, internal governance of a bank and its major corporate borrowers is likely to be important for the stability of the financial system. Category (4) - Only GSN plays a major role, lack of MFI and LFE. The incentives of state-owned banks under explicit or implicit government guarantees are crucial for assessing the vulnerabilities of the financial system, partly because there is no role for market discipline without the availability of competing financial assets or foreign assets, and the development of property rights is marginalized in the environment of state planning. IV. An illustrative example Two hypotheses have emerged from the corporate finance literature that explain some structural causes of Japan's banking problems, in particular, the deterioration in the quality of the banks' loan portfolios, which occurred during the 1980s. [6] The first is that an adverse selection problem developed in the Japanese bank lending market as a result of capital market reform, which encouraged high-quality borrowers to secure disintermediated forms of finance. The second is that the simultaneous deregulation of the wholesale funds and retail lending markets compressed the margins of banks. Given the various safety nets in operation in Japan at the time, the banks responded to the reduction in their franchise value by targeting borrowers who presented greater risks but offered higher nominal rates of return. Below we show how focusing on the effects of the three key elements in the changing environment in Japan on the incentives of the corporate and banking sectors may lead to the sources of the financial problems facing Japan's banking system since the beginning of the financial deregulation in 1980s. The effects of the key elements in the Japanese environment on the behavior of banks and corporate borrowers Greater degree of competing financial instruments The external environment for the Japanese banking system has undergone significant changes from the mid-1970s. Initially, borrowed capital gave way to internally generated funding as a major source of finance among larger firms. Then, during the 1980s, the declining dependence of major corporations on bank loans accelerated, as the deregulation of securities markets facilitated bond finance. Several macroeconomic developments contributed to the development of the securities markets (largely foreign and domestic issues of equity-related debt), although it remains that households have limited access to financial instruments. As shown later, this development of the competing financial instruments changed the borrowing behavior of non-financial corporations during the 1980s. In addition, the competition from non-bank lenders to firms led to a type of free-rider problem in which banks are pressured into reducing margins to the point of ineffective monitoring and screening. Gower (1996) shows that the bank competes in its lending markets with a perfectly competitive fringe of the firm's non-bank creditors. If the price set by the fringe is very low, then the opportunity cost of borrower failure to the bank is minimal, and the bank will not undertake the regular monitoring and screening which is necessary to prevent that failure. The structure of claims against the assets of a financially distressed borrower allows this to happen. Since the claim of minor creditors to a firm are senior to those of the firm's bank, competitive minor creditors can generate credit prices which will mean that their investments are not monitored. In doing this, their pricing and their seniority in adverse states may have put pressure on some Japanese banks to reduce the margins on some bank loans to the point at which banks cease to monitor and screen them effectively. Government safety nets The Japanese banking industry was subject to latent moral hazards, a number of which were related to the financial safety nets. First consider the protection offered to shareholders in banks. A quick look at the statistics shows exactly that: between the end of the Pacific War and 1996, no bank had been allowed to fail. As an alternative to formal liquidation, troubled financial institutions were merged - when necessary, and subject to official oversight - with more stable banks, and often on terms that respected the interests of shareholders in the troubled institution (Aoki et al 1994). These arrangements were certainly not at the expense of bank profitability. As a group, banks were much more profitable than industrial firms for most of the postwar period (Calder 1993). At best, this made the banks vulnerable to managerial slack; at worst, it may have encouraged individual bank managers to seek out projects with a high-risk/high-return profile, when franchise values were threatened. There were also problems with the protection offered to the depositors of banks. Between 1971 and 1996, deposit insurance premia were levied at a flat rate of 0.012 per cent of deposit liabilities. A set of questions that focus on the behavior of depositors would point out that the insensitivity of this pricing arrangement to the riskiness of portfolios may well have encouraged banks to target lending sectors that had high risks attached to them. Although banks were increasingly targeting high risk borrowers and monitoring their clients less effectively, households continued to use deposits as a store of wealth, most likely because alternative instruments were inaccessible to households, in spite of some financial deregulation, or households continued to hold their savings as bank deposits because they believed, with some justification, that those savings were subject to implicit guarantees. The attraction of this theory is that it helps to explain why depositors drove up the rate of return on savings to the point at which banks were compelled to target higher return, but riskier, borrowers. Without at least the perception of implicit deposit insurance, depositors are unlikely to lend to banks offering very high rates of return, since very high rates of return in a climate of low lending rates would have been a signal of low asset quality. Legal framework and quality of enforcement Although Japan has a cultural based on order and a relatively complete legal framework, a number of problems with the regulatory infrastructure have emerged during the 1980s. One problem was the inability of the authorities to exercise moral suasion over the banks. This may have been exacerbated by opaque accounting practices. A set of questions on tax law and judicial process would indicate that the opaque accounting practices as well as lax tax law and ineffective judicial process has allowed banks to conceal their problems in loans and to circumvent regulatory oversight. V. Concluding Remarks Two sets of questions are important for applying the above framework. One is on the quantification of the three key elements in order to categorize countries and thereby prioritize information collection on the next-level questions. The examples given in Section III (B) are not satisfactory since many of the observable variables may be caused by other un-specified variables. Research can be built on the existing empirical and theoretical literature on legal system, the different nature of government guarantees, and the effects of market structures. The second set of questions concern the next-level questions on banking and corporate governance, especially the questions of how the environment within which financial transactions take place affects the risk taking, hedging and monitoring behavior of the main agents in the "core" of a financial system - investors, borrowers, intermediaries - as well as the incentives of the regulators and supervisors to monitor and regulate risk taking behavior, and the implications of the resulting net risk taking behavior for vulnerabilities in the financial system. Research on theoretical and empirical understanding of the operation of banks, corporate borrowers, and supervisors will allow us to derive the criteria that can be used to make the assessments. Endnotes: (The authors are both staff economists at the International Monetary Fund.) References |