Dealing with systemic crises seismic zones and financial earthquakes
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Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes. Augusto de la Torre The World Bank 3 rd Annual International Seminar on Critical Issues in Financial Stability: Preventing and Confronting Bank Insolvency Washington, DC - June 4-6, 2003.

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Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes

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Dealing with systemic crises seismic zones and financial earthquakes

Dealing with Systemic Crises: Seismic Zones and Financial Earthquakes

Augusto de la Torre

The World Bank

3rd Annual International Seminar

on Critical Issues in Financial Stability:

Preventing and Confronting Bank Insolvency

Washington, DC - June 4-6, 2003


Seismic zones under financial globalization

Seismic zones under financial globalization

Wretched Trinity:

Weak currency

Nominal inflexibility

Weak institutions

Multiple equilibria

Exploding public

debt dynamics

Current account / fiscal deficits 

Contagion Risk

(Runs)

Overvalued currency

IV

II

Currency mismatches

Maturity mismatches

Excessive risk taking, looting

I

Weak institutions

III

Excessive leverage 

Blessed Trinity:

International currency

Nominal flexibility

Sound institutions

Incentive Distortions


Seismic zones under financial globalization1

Seismic zones under financial globalization

Multiple equilibria

Exploding debt

dynamics

Current account / fiscal deficits 

Contagion Risk

(Runs)

Run on the currency

Depositor run on system

IV

II

Currency mismatches

Maturity mismatches

Run by foreign portfolio investors

Low currency & maturity

mismatches

Excessive risk taking, looting

I

III

Excessive leverage 

Depositor

flight to quality

Incentive Distortions


Management and resolution issues differ substantially depending on crisis type

Management and Resolution IssuesDiffer Substantially Depending on Crisis Type

  • Containment

    • International reserves, interest rates

    • LOLR, deposit guarantees, expensive debt rollover

    • Breach of contracts -- deposit securitization, debt defaults, forcible stock pesification

  • Loss allocation and restructuring

    • Inflation (if not dollarized) versus admin. allocation

    • Bank and corporate resolutions, with risk of socialization of bad assets (bailouts)

    • Government bond based restructuring?


Management and resolution issues cont differ substantially depending on crisis type

Management and Resolution Issues (cont.) Differ Substantially Depending on Crisis Type

  • Regeneration (flows and incentives)

    • Hyperinflation – permanent impairment of national currency as store of value

    • Bailouts – permanent erosion of market discipline

    • Forcible containment (widespread contract breaches) – permanent weakening of institutional arrangements and credibility

      Regeneration and learning from crises – a function of the quality of political institutions


Type iv crises regeneration issues

Type IV crises – regeneration issues

  • Growth regeneration depends on…

    • Confidence and capital re-flows

    • Degree of openness in trade structure

    • Speed/effectiveness of loss allocation and restructuring

  • …but its sustainability requires regeneration of financial intermediation…

    • Establishment of currency as “store of value”

    • Questions on new industrial organization of sector (narrow banks, offshores, etc.)

    • Segmentation of access

  • …and institutional regeneration

    • Contractual and regulatory environment

    • Democratic governance


Type iv crises int l architecture issues

Type IV crises – int’l architecture issues

  • Imperfections of int’l financial markets

    • Contagion (Calvo’s EMF)

    • Defaults (int’l bankruptcy, exit consents, UDROPs, floor to debt to facilitate agreement on haircuts)

    • Potential role of IFIs in peso debt markets development

    • Externalities of fluctuations in international currencies

  • Fixing them would benefit EMs the most…

  • …but incentives for industrial countries are weak

  • Multilateral & regional institutions have a major responsibility


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