Going forward, the world is likely to continue to be plagued by financial crisis. History has shown that there has been more than 100 distinct banking crises in the past two decades. While the trigger factors for such financial crises may be different, for most, there was a general loss of confidence, disruptions in the financial intermediation process and a general downward spiral of asset prices. While it is argued that what is needed is the reform of the international financial architecture, for any individual country, the prospect of surviving such a crisis is not only about building resilience, but also having the capacity to effectively manage the crisis.
Such a crisis was experienced in the Asian region 10 years ago. Several parallels can be drawn between the Asian financial crisis and the current financial crisis. In both cases, the crisis followed a period of strong growth, rapid credit expansion and rising asset prices. Prior to the Asian crisis, there was indiscriminate lending by the banking sector. Similarly, the current financial crisis originated from imprudent lending practices and excessive risk taking that resulted in the formation of asset bubbles. In Asia, domestic credit rose to unsustainable levels, reaching 180% of gross domestic product (GDP). In the US, the ratio was 240% in 2007.
In both cases, there was a lack of capacity to manage the increased risks associated with the transformation of the financial sector. For Asia, the increased liberalisation was not accompanied by the necessary financial infrastructure or the capacity to manage the associated increased risks. In the current crisis, financial innovation occurred at a pace that outstripped the ability to manage the associated risks with such innovations. This resulted in an underestimation of the risks involved and the capital buffers necessary.
The ensuing turmoil in the financial markets resulted in illiquidity in the financial markets and the subsequent breakdown in the functioning of the markets. As the crisis advanced, financial stress and insolvencies emerged in the financial sector. In both crises, this precipitated a pull-back in lending activities and the damaging consequences on the economy.
In the Asian financial crisis, the economic contraction was severe, in the range of 7% to 13%. In the current financial crisis, the spillover effect on the economy has yet to be fully felt. The Asian crisis, however, ran its course within a short period of time. Asset prices and the foreign exchange rate plummeted to lows following significant market adjustments. The policy focus during the Asian crisis was on restoring the functioning of the intermediation process to promote economic recovery. For most countries, growth resumed within 18 months of the start of the crisis.
Policy actions
The important action that needs to be taken in managing a financial crisis seems to be already apparent, as evidenced by the series of policy announcements made by the respective governments, the multilateral agencies and the various international groupings. The announced policy actions have included providing huge liquidity injections into the system, removing the troubled assets from the portfolio of financial institutions, strengthening their capital position and providing depositors with protection. In addition, the implementation of monetary and fiscal stimulus has also promoted economic recovery.
These were, in fact, among the series of measures that were implemented during the Asian crisis. The experience with these measures may, however, not produce similar outcomes in terms of containing the severity of the current global financial crisis and the degree to which confidence is restored and conditions normalised.
Several key elements are vital in order to achieve the desired outcomes. From Malaysia’s own experience, measures implemented at the early stage of the crisis raised the prospects for restoring stability and the resumption of lending. Such early and pre-emptive action requires anticipation of the trajectory of the crisis. Reacting to developments or delayed action diminishes the effect of the measures to contain the deterioration. It will also raise the cost of the crisis.
Comprehensive response
A second key element is that the response must be comprehensive. Having clarity of the objectives to be achieved, and being focused on the necessary actions, are important in an environment in which the demands are to address everything that has gone wrong. In Malaysia’s experience, institutional arrangements were put in place early to restore lending activities by the banking sector. This involved the establishment of an asset management corporation to carve out the bad assets from the banking system. The assets were predominantly acquired at a discount that ranged from 40% to 60% of the value of the asset.
The asset management corporation managed the assets to enhance its value. On the disposal of the assets, any return in excess of the value at which it was acquired was shared with the banking institution. A special purpose vehicle was also established for the recapitalisation of affected banking institutions. To avoid foreclosures of borrowers at the margin, a corporate debt restructuring committee was also formed to restructure loans. Vital in this process was the government machinery to facilitate the establishment of these institutional arrangements. Within six months of the operationalisation of these measures, lending resumed and economic recovery began. Having the supervisory function residing at the central bank also facilitated the swift action taken.
A great deal of liquidity was provided during this period. The implementation of selective foreign exchange controls that were put in place more than one year into the crisis drew significant attention at the time. The purpose of the controls was to stabilise the foreign exchange market. This was important given that severe disruptions in this market had not abated, more than one year into the crisis. It must be recognised, however, that while the stability the controls provided was important, on their own they would not have resolved the crisis. It was the comprehensive set of measures involving resolution and growth supporting policies that resolved it.
Perhaps a significant difference in the management of the crisis in Malaysia was the adoption of a more pragmatic approach. Relying on ideologies that the market mechanism would eventually restore stability and equilibrium did not take into account the irrational market behaviour and herd instinct that occurs during a crisis. Deviating from the conventional approach may therefore be necessary. Such policies, however, need to be undertaken with a high degree of transparency.
Disclosure and communication, under these circumstances, becomes critical. Therefore, regular information was provided, sometimes on a daily basis. Information was given about all measures that were taken. Extensive communication channels with the public, the industry, the exporters, the corporate sector and foreign investors were maintained to promote understanding of the developments and the policies.
Leadership in crisis management is also important. In Malaysia, a National Economic Action Council was established and chaired by the prime minister. For several months it met daily. These meetings involved the private sector, professionals and technocrats. It provided the potential for co-ordination, consistency and comprehensiveness of the policy actions. Another element was the key role given to professionals and technocrats, which raised the prospect for achieving the desired results and avoided actions that were based on political considerations.
Some 10 years since the Asian crisis, structural transformation has taken place in most of the economies and financial systems in Asia. This has enhanced its economic flexibility to adjust to external shocks. In addition, financial reforms have been aggressively pursued. Surveillance and supervisory oversight have also become more rigorous and robust. A more recent development is the deepening of regional surveillance and co-operation. This has also been reinforced by an integrated regional crisis management framework that may be activated in the event of any potential destabilising financial developments in the region.
In the global environment of increased inter-dependence, the prospect of future shocks that could translate into a financial crisis cannot be ruled out. To deal with this vulnerability, the strategy is therefore to strengthen further the foundations and therefore the resilience and capacity to manage such shocks. This is the approach to be pursued to ensure sustainability through episodes of such financial turmoils.
Dr Zeti Akhtar Aziz is the governor of Bank Negara Malaysia.
