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Asian financial reform: progress, lessons and challenges
Journal of Asian Economics 11 (2000) 1– 6
Asian financial reform: progress, lessons and challenges Robert A. O’Sullivan* Federal Reserve Bank of New York, New York, NY 10045,USA
1. Introduction As we approach the dawn of a new century, here in Asia we can also celebrate the remarkable progress achieved since the very dark days of just over 2 years ago. In several countries in the region, and especially here in Korea, significant headway has been made, first in stabilizing a very difficult situation, and then in moving toward recapitalizing the banking system, ridding bank balance sheets of problem loans and improving the supervisory and regulatory frameworks. And the hard work has not gone unnoticed. Asian equity markets have rebounded impressively, local currencies have strengthened and yields on government securities have been cut by two-thirds as foreign capital has begun to return. Having said all that, it is equally clear that we are not out of the woods just yet. Important and even difficult work still lies ahead. At this critical juncture in the recovery process, the countries in question must resist the temptation to declare victory prematurely but instead remain focused as they continue to build on the solid progress already achieved. In thinking about the present situation in Asia, I am reminded of another time, not that long ago, when we in the United States faced a number of similar problems stemming from our own lending-related banking crisis. As you may recall, in the late 1980s and early 1990s, record levels of problem assets had slashed bank earnings, eroded capital levels and increased the annual number of bank failures from just a half-dozen or so in the early 1980s to over 200 at the height of the crisis. While the specific causes of the asset quality crisis in the United States differed from the causes of the crisis experienced here, the similarities are significant enough that a review of
*Corresponding author. Fax: 212-720-2098 E-mail address: ⬍robert.o’[email protected]⬎ 1049-0078/00/$ – see front matter © 2000 Elsevier Science Inc. All rights reserved. PII: S 1 0 4 9 - 0 0 7 8 ( 0 0 ) 0 0 0 4 1 - 5
2
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
our experience in the United States might prove useful and encouraging as Asian countries continue to pursue policies designed to promote renewed financial health and stability.
2. Factors contributing to the crises With the advantage of hindsight, it can be seen that the crisis in the United States was brought on by a number of mistakes in the mid-1980s to late 1980s committed by the industry as well as by financial supervisors. On the industry side, U.S. banks were increasingly forced to look for new lending opportunities as more and more corporations—formerly the bread-and-butter business of banks—were able to access capital markets directly and as accelerating information technologies enabled nonbank lenders to compete directly with banks. Heightened competition for profitable loan assets resulted in growing portfolio concentrations in, among other things, commercial real estate, highly leveraged transactions (HLTs) or leveraged buyouts (LBOs) and energy sector lending. Larger institutions also amassed substantial exposures to developing countries, particularly in Latin America. Further contributing to the concentration problem was a trend toward larger individual credit and related exposures. This basic problem of insufficient diversification was further exacerbated by other deficiencies. First, many banks had moved away from good, old-fashioned due diligence and instead had adopted a rather permissive, numbers-driven lending process (lending on forecasts). There was also very little rigorous analysis of intersector relationships, such as the correlation between energy prices and real estate values in places like Texas. Finally, in retrospect, stress-testing programs and procedures were often flawed and/or inadequate. If any of this sounds remotely familiar, it is because similar problems were at the root of Asia’s lending-related crisis. Too often the credit decisions of Asian banks were based on government-mandated policies or relationship concerns, rather than on rigorous assessments of fundamental creditworthiness. In fact, because of government direction and the prevalence of relationship lending, many Asian banks never honed the skills and know-how required to make sound credit decisions. The result, of course, was a mountain of problem assets. Another problem that stemmed from the less-than-impartial credit decision process was high concentrations. Many Korean banks developed imprudently large exposures to conglomerates in the same family of industries, while in Thailand and Malaysia overzealous real estate lending was the problem. In addition, heavy reliance on volatile, short-term, dollardenominated funding left many banks vulnerable. It must be also be acknowledged that in both crises, the supervisory frameworks in place at the time were not up to the task. In the United States, conventional measures used to gauge industry conditions such as nonperforming loans and charge-offs, interest margins and capital levels were all lagging indicators. By the time amber lights began flashing, significant deterioration had already set in. On the subject of capital, it should be noted that the regime in place prior to 1988 did not adequately distinguish between high- and low-risk assets. The Basle Committee’s 1988 Accord improved on the old regime by assigning risk weights to various asset categories for the purpose of determining minimum capital levels. Still, the Accord’s distinction between
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
3
low- and high-risk credits was rather poor, and the standards were not implemented immediately. The result was that capital levels at many banks in the early 1990s were not sufficient to support the risks associated with their loan portfolios. Perhaps most importantly, the on-site examination process, the very foundation of our supervisory framework, was of limited diagnostic value. As an annual validation of balance sheet data, the examination amounted to a point-in-time snapshot of a bank’s condition based largely on historical information. In other words, the perspective was largely backwardlooking—a peek in the rear-view mirror—rather than focusing on the road ahead, let alone around the next bend. Simply put, these shortcomings in the supervisory process translated into an official response that was several steps behind the developing crisis. By the time problems had registered in the lagging indicators and were confirmed by the backward-looking examination process, the crisis was well under way. As asset quality deteriorated, loan spreads narrowed, expenses soared, core earnings declined and capital and reserves dwindled. The specific supervisory deficiencies in Asia differed from those in the United States, but the effect was the same—a slow and insufficient supervisory response. First, poor accounting conventions and rather permissive loan classification standards hid mounting trouble for years. And even after crisis conditions became clear, staffing deficiencies, a lack of a clear supervisory mandate and ambiguity regarding the independence of supervisors from governmental direction hampered decisive and effectual action.
3. Resolution of the crisis Resolution of the crisis in the United States followed corrective measures taken both by the industry and by supervisors that really changed the way we do business. For their part, many banks developed and submitted to the U.S. supervisors corrective action plans built on a renewed commitment to basic lending and credit administration discipline. Though the specifics of each plan varied to reflect the unique circumstances at the institution, all the plans contained certain common elements. A major component was the development of a detailed operating plan that included specific targets for, among other things, reducing problem asset levels and augmenting capital and reserves. More frequent and more detailed reporting of asset quality indicators was another important component. In addition, in case identified targets were not met or other difficulties were encountered, a list of contingency measures was drawn up. These options typically included the sale of selected assets, divestiture of certain subsidiaries or branches, staff reductions, the closing of overseas offices, and the raising of additional capital. The basic goals of the corrective action programs were to help banks square away their operations and to renew the industry’s credibility with the market. Discipline is always tough, but the efforts proved quite successful. It should also be acknowledged that a much more favorable interest rate environment and improving economic conditions after 1992 significantly reduced the various costs associated with the industry’s asset quality problems and greatly accelerated the recovery. A number of changes were also made on the supervisory side. I’ve already mentioned the 1988 risk-based
4
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
capital Accord, which predated the worst of the crisis but has now been fully adopted. A few years ago the scope of the regime was broadened to included market risk and, just this past July, the Basle Committee released for comment the latest round of proposed improvements, which are intended to further fine-tune the approach to credit risk by making use of bank internal risk models and credit mitigation techniques. Another major change in the United States was the introduction in 1991 of the prompt corrective action provisions contained in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The prompt corrective action framework established five categories of capitalization, moving from “well capitalized” to “critically undercapitalized,” and stipulated specific supervisory actions to be taken as a bank’s capital declines. These automatic responses include restrictions on new activities or expansion plans, dividend payment restrictions and possible enforcement actions. Perhaps the most important changes, however, have been the significant improvements made to the centerpiece of our supervisory framework—the on-site examination. Rather than being backward-looking processes based on stale historical information, examinations now focus on the principal risks faced by each particular institution and on the management and control processes in place. Before going into a bank, examination leaders now perform a risk analysis of the institution and preplan an examination strategy that will focus on identified risk areas and supervisory concerns. Examinations are then staffed by people with expertise in the various risk areas identified. Purposeful transaction testing is still performed to verify findings, but the thrust of the examination is on assessing management and control processes. The result is a more flexible approach that yields more meaningful results and provides a better understanding of a bank’s ability to effectively and safely handle challenges today and tomorrow. Taken together, these refinements in the regulatory framework and improvements in our supervisory techniques have positioned us to deal much more effectively with challenges and changing conditions. As in the United States, significant corrective measures have been taken in Asia, by both the banks and their supervisors. First, estimates are that roughly 50 percent of the recapitalization of the banking system has been funded. In most countries, the better part of the funding has been supplied by the government, whereas in Thailand more has come from private investment, both foreign and domestic. Significant progress has also been made in ridding balance sheets of problem credits. Supervisory frameworks have also been strengthened. Training initiatives—some with the support of the International Monetary Fund, the World Bank and other outside consultants— are improving the quality and sophistication of supervision, while clearer mandates have bolstered the authority of supervisors. Equally importantly, bankruptcy and foreclosure laws have been strengthened, and accounting standards have been upgraded.
4. Lesson learned The lessons that can be taken from both our experience in the United States a decade ago and the experience in Asia more recently are really very much the same.
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
5
First, the importance of corporate governance should be underscored. A tightly run ship with a disciplined crew led by an experienced, competent captain is far better able to survive a long journey that will inevitably encounter sudden storms. In the corporate context, the basic elements of good governance are Y Y Y Y
Independent and competent outside directors, Capable, experienced management, A coherent corporate strategy and business plan and Clear lines of responsibility and accountability.
Together, these elements contribute to an overall operating process conducive to long-term health and prosperity, and one that best enables the company to deal with the inevitable bumps in the road. Closely related to good corporate governance is a rigorous internal control apparatus. Examples include Y Y Y Y Y
Sound operating policies and procedures, Effective internal audits and reliable follow-up on identified problems, Meaningful self-assessments, Reliable financial reporting and Compliance with applicable laws.
Rigorous internal controls represent the set of tools by which sound corporate governance is exercised. Firmly rooted on the foundation of these first two elements is the central importance of risk management. Each institution must have in place the technical systems and management processes necessary to identify the risks associated with its activities and to effectively measure, monitor and manage these risks. Last but certainly not least is reliable accounting and disclosure. It is hard to overstate the importance of this element. Free markets are fueled by information. As the crisis in Asia amply demonstrated, the enemy of stable financial markets is flagging confidence, and nothing is more undermining of confidence than a shortage of reliable information. Market discipline might not always be pleasant, but more, higher-quality information—in a word, transparency— can only bolster investor confidence and therefore make doing business easier and more secure. In summary, think that two fundamental lessons can be taken from the American experience and the Asian experience. First, problems left unaddressed do not go away by themselves—they only get worse. And relatedly, a slow supervisory response to problems usually results in a more costly and painful resolution. It is with these lessons in mind that the four pillars of sound banking operations just mentioned— good corporate governance, a rigorous internal control apparatus, effective risk management and disclosure and transparency—now represent internationally accepted best practice.
6
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
5. Conclusion In conclusion, let me congratulate you. Truly impressive and meaningful progress has been made over two very difficult years. And as I mentioned at the outset, progress has not gone unnoticed. Foreign investment has begun to return to Asia, which is the ultimate expression of confidence. Investors have concluded, as I have, that you have what it takes to confront problems head-on and to make the changes necessary to restore financial stability and economic prosperity in Asia. It must be acknowledged, however, that there is more work to be done. Problem loan levels remain too high, internationally accepted best practices regarding sound lending and effective supervision will require time to be fully implemented, and recent improvements in the legal framework have yet to be meaningfully tested. The major risk to the ongoing recovery process is the temptation to declare victory and drop your guard. This is an excellent opportunity to enact fundamental change, and we strongly encourage the countries of Asia to stay the course. Bear in mind the hard lessons learned by way of our lending-related crisis and yours, and, as we say in America, keep your eyes on the prize. Given the impressive progress made so far, I have no doubt that you will reach your goal.
Acknowledgment I thank the joint sponsors—Seoul National University, the American Committee on Asian Economic Studies, and the Korea Institute for International Economic Policy—for inviting the Federal Reserve, and me personally, to participate in this conference. I would also like to thank Edna for thinking of us, although if you know Edna and something about her background, you know there’s a connection.
Asian financial reform: progress, lessons and challenges Robert A. O’Sullivan* Federal Reserve Bank of New York, New York, NY 10045,USA
1. Introduction As we approach the dawn of a new century, here in Asia we can also celebrate the remarkable progress achieved since the very dark days of just over 2 years ago. In several countries in the region, and especially here in Korea, significant headway has been made, first in stabilizing a very difficult situation, and then in moving toward recapitalizing the banking system, ridding bank balance sheets of problem loans and improving the supervisory and regulatory frameworks. And the hard work has not gone unnoticed. Asian equity markets have rebounded impressively, local currencies have strengthened and yields on government securities have been cut by two-thirds as foreign capital has begun to return. Having said all that, it is equally clear that we are not out of the woods just yet. Important and even difficult work still lies ahead. At this critical juncture in the recovery process, the countries in question must resist the temptation to declare victory prematurely but instead remain focused as they continue to build on the solid progress already achieved. In thinking about the present situation in Asia, I am reminded of another time, not that long ago, when we in the United States faced a number of similar problems stemming from our own lending-related banking crisis. As you may recall, in the late 1980s and early 1990s, record levels of problem assets had slashed bank earnings, eroded capital levels and increased the annual number of bank failures from just a half-dozen or so in the early 1980s to over 200 at the height of the crisis. While the specific causes of the asset quality crisis in the United States differed from the causes of the crisis experienced here, the similarities are significant enough that a review of
*Corresponding author. Fax: 212-720-2098 E-mail address: ⬍robert.o’[email protected]⬎ 1049-0078/00/$ – see front matter © 2000 Elsevier Science Inc. All rights reserved. PII: S 1 0 4 9 - 0 0 7 8 ( 0 0 ) 0 0 0 4 1 - 5
2
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
our experience in the United States might prove useful and encouraging as Asian countries continue to pursue policies designed to promote renewed financial health and stability.
2. Factors contributing to the crises With the advantage of hindsight, it can be seen that the crisis in the United States was brought on by a number of mistakes in the mid-1980s to late 1980s committed by the industry as well as by financial supervisors. On the industry side, U.S. banks were increasingly forced to look for new lending opportunities as more and more corporations—formerly the bread-and-butter business of banks—were able to access capital markets directly and as accelerating information technologies enabled nonbank lenders to compete directly with banks. Heightened competition for profitable loan assets resulted in growing portfolio concentrations in, among other things, commercial real estate, highly leveraged transactions (HLTs) or leveraged buyouts (LBOs) and energy sector lending. Larger institutions also amassed substantial exposures to developing countries, particularly in Latin America. Further contributing to the concentration problem was a trend toward larger individual credit and related exposures. This basic problem of insufficient diversification was further exacerbated by other deficiencies. First, many banks had moved away from good, old-fashioned due diligence and instead had adopted a rather permissive, numbers-driven lending process (lending on forecasts). There was also very little rigorous analysis of intersector relationships, such as the correlation between energy prices and real estate values in places like Texas. Finally, in retrospect, stress-testing programs and procedures were often flawed and/or inadequate. If any of this sounds remotely familiar, it is because similar problems were at the root of Asia’s lending-related crisis. Too often the credit decisions of Asian banks were based on government-mandated policies or relationship concerns, rather than on rigorous assessments of fundamental creditworthiness. In fact, because of government direction and the prevalence of relationship lending, many Asian banks never honed the skills and know-how required to make sound credit decisions. The result, of course, was a mountain of problem assets. Another problem that stemmed from the less-than-impartial credit decision process was high concentrations. Many Korean banks developed imprudently large exposures to conglomerates in the same family of industries, while in Thailand and Malaysia overzealous real estate lending was the problem. In addition, heavy reliance on volatile, short-term, dollardenominated funding left many banks vulnerable. It must be also be acknowledged that in both crises, the supervisory frameworks in place at the time were not up to the task. In the United States, conventional measures used to gauge industry conditions such as nonperforming loans and charge-offs, interest margins and capital levels were all lagging indicators. By the time amber lights began flashing, significant deterioration had already set in. On the subject of capital, it should be noted that the regime in place prior to 1988 did not adequately distinguish between high- and low-risk assets. The Basle Committee’s 1988 Accord improved on the old regime by assigning risk weights to various asset categories for the purpose of determining minimum capital levels. Still, the Accord’s distinction between
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
3
low- and high-risk credits was rather poor, and the standards were not implemented immediately. The result was that capital levels at many banks in the early 1990s were not sufficient to support the risks associated with their loan portfolios. Perhaps most importantly, the on-site examination process, the very foundation of our supervisory framework, was of limited diagnostic value. As an annual validation of balance sheet data, the examination amounted to a point-in-time snapshot of a bank’s condition based largely on historical information. In other words, the perspective was largely backwardlooking—a peek in the rear-view mirror—rather than focusing on the road ahead, let alone around the next bend. Simply put, these shortcomings in the supervisory process translated into an official response that was several steps behind the developing crisis. By the time problems had registered in the lagging indicators and were confirmed by the backward-looking examination process, the crisis was well under way. As asset quality deteriorated, loan spreads narrowed, expenses soared, core earnings declined and capital and reserves dwindled. The specific supervisory deficiencies in Asia differed from those in the United States, but the effect was the same—a slow and insufficient supervisory response. First, poor accounting conventions and rather permissive loan classification standards hid mounting trouble for years. And even after crisis conditions became clear, staffing deficiencies, a lack of a clear supervisory mandate and ambiguity regarding the independence of supervisors from governmental direction hampered decisive and effectual action.
3. Resolution of the crisis Resolution of the crisis in the United States followed corrective measures taken both by the industry and by supervisors that really changed the way we do business. For their part, many banks developed and submitted to the U.S. supervisors corrective action plans built on a renewed commitment to basic lending and credit administration discipline. Though the specifics of each plan varied to reflect the unique circumstances at the institution, all the plans contained certain common elements. A major component was the development of a detailed operating plan that included specific targets for, among other things, reducing problem asset levels and augmenting capital and reserves. More frequent and more detailed reporting of asset quality indicators was another important component. In addition, in case identified targets were not met or other difficulties were encountered, a list of contingency measures was drawn up. These options typically included the sale of selected assets, divestiture of certain subsidiaries or branches, staff reductions, the closing of overseas offices, and the raising of additional capital. The basic goals of the corrective action programs were to help banks square away their operations and to renew the industry’s credibility with the market. Discipline is always tough, but the efforts proved quite successful. It should also be acknowledged that a much more favorable interest rate environment and improving economic conditions after 1992 significantly reduced the various costs associated with the industry’s asset quality problems and greatly accelerated the recovery. A number of changes were also made on the supervisory side. I’ve already mentioned the 1988 risk-based
4
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
capital Accord, which predated the worst of the crisis but has now been fully adopted. A few years ago the scope of the regime was broadened to included market risk and, just this past July, the Basle Committee released for comment the latest round of proposed improvements, which are intended to further fine-tune the approach to credit risk by making use of bank internal risk models and credit mitigation techniques. Another major change in the United States was the introduction in 1991 of the prompt corrective action provisions contained in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The prompt corrective action framework established five categories of capitalization, moving from “well capitalized” to “critically undercapitalized,” and stipulated specific supervisory actions to be taken as a bank’s capital declines. These automatic responses include restrictions on new activities or expansion plans, dividend payment restrictions and possible enforcement actions. Perhaps the most important changes, however, have been the significant improvements made to the centerpiece of our supervisory framework—the on-site examination. Rather than being backward-looking processes based on stale historical information, examinations now focus on the principal risks faced by each particular institution and on the management and control processes in place. Before going into a bank, examination leaders now perform a risk analysis of the institution and preplan an examination strategy that will focus on identified risk areas and supervisory concerns. Examinations are then staffed by people with expertise in the various risk areas identified. Purposeful transaction testing is still performed to verify findings, but the thrust of the examination is on assessing management and control processes. The result is a more flexible approach that yields more meaningful results and provides a better understanding of a bank’s ability to effectively and safely handle challenges today and tomorrow. Taken together, these refinements in the regulatory framework and improvements in our supervisory techniques have positioned us to deal much more effectively with challenges and changing conditions. As in the United States, significant corrective measures have been taken in Asia, by both the banks and their supervisors. First, estimates are that roughly 50 percent of the recapitalization of the banking system has been funded. In most countries, the better part of the funding has been supplied by the government, whereas in Thailand more has come from private investment, both foreign and domestic. Significant progress has also been made in ridding balance sheets of problem credits. Supervisory frameworks have also been strengthened. Training initiatives—some with the support of the International Monetary Fund, the World Bank and other outside consultants— are improving the quality and sophistication of supervision, while clearer mandates have bolstered the authority of supervisors. Equally importantly, bankruptcy and foreclosure laws have been strengthened, and accounting standards have been upgraded.
4. Lesson learned The lessons that can be taken from both our experience in the United States a decade ago and the experience in Asia more recently are really very much the same.
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
5
First, the importance of corporate governance should be underscored. A tightly run ship with a disciplined crew led by an experienced, competent captain is far better able to survive a long journey that will inevitably encounter sudden storms. In the corporate context, the basic elements of good governance are Y Y Y Y
Independent and competent outside directors, Capable, experienced management, A coherent corporate strategy and business plan and Clear lines of responsibility and accountability.
Together, these elements contribute to an overall operating process conducive to long-term health and prosperity, and one that best enables the company to deal with the inevitable bumps in the road. Closely related to good corporate governance is a rigorous internal control apparatus. Examples include Y Y Y Y Y
Sound operating policies and procedures, Effective internal audits and reliable follow-up on identified problems, Meaningful self-assessments, Reliable financial reporting and Compliance with applicable laws.
Rigorous internal controls represent the set of tools by which sound corporate governance is exercised. Firmly rooted on the foundation of these first two elements is the central importance of risk management. Each institution must have in place the technical systems and management processes necessary to identify the risks associated with its activities and to effectively measure, monitor and manage these risks. Last but certainly not least is reliable accounting and disclosure. It is hard to overstate the importance of this element. Free markets are fueled by information. As the crisis in Asia amply demonstrated, the enemy of stable financial markets is flagging confidence, and nothing is more undermining of confidence than a shortage of reliable information. Market discipline might not always be pleasant, but more, higher-quality information—in a word, transparency— can only bolster investor confidence and therefore make doing business easier and more secure. In summary, think that two fundamental lessons can be taken from the American experience and the Asian experience. First, problems left unaddressed do not go away by themselves—they only get worse. And relatedly, a slow supervisory response to problems usually results in a more costly and painful resolution. It is with these lessons in mind that the four pillars of sound banking operations just mentioned— good corporate governance, a rigorous internal control apparatus, effective risk management and disclosure and transparency—now represent internationally accepted best practice.
6
R.A. O’Sullivan / Journal of Asian Economics 11 (2000) 1– 6
5. Conclusion In conclusion, let me congratulate you. Truly impressive and meaningful progress has been made over two very difficult years. And as I mentioned at the outset, progress has not gone unnoticed. Foreign investment has begun to return to Asia, which is the ultimate expression of confidence. Investors have concluded, as I have, that you have what it takes to confront problems head-on and to make the changes necessary to restore financial stability and economic prosperity in Asia. It must be acknowledged, however, that there is more work to be done. Problem loan levels remain too high, internationally accepted best practices regarding sound lending and effective supervision will require time to be fully implemented, and recent improvements in the legal framework have yet to be meaningfully tested. The major risk to the ongoing recovery process is the temptation to declare victory and drop your guard. This is an excellent opportunity to enact fundamental change, and we strongly encourage the countries of Asia to stay the course. Bear in mind the hard lessons learned by way of our lending-related crisis and yours, and, as we say in America, keep your eyes on the prize. Given the impressive progress made so far, I have no doubt that you will reach your goal.
Acknowledgment I thank the joint sponsors—Seoul National University, the American Committee on Asian Economic Studies, and the Korea Institute for International Economic Policy—for inviting the Federal Reserve, and me personally, to participate in this conference. I would also like to thank Edna for thinking of us, although if you know Edna and something about her background, you know there’s a connection.