Crisis Management Lessons

Reflecting differences in political, economic, and legal systems, as well as the nature and scope of different crises and the availability of different tools, a single template for crisis management cannot be outlined. There is no “Good Housekeeping” book on crisis management even though the crisis management experience does suggest that there are pitfalls to be avoided. In addition, it is not easy to place the approaches to crisis management into simple boxes such as “market friendly” or “state led” or “fast track” versus “slow track.” Crises by their nature are highly complex, a mix of different approaches is usually taken to manage them, and there is not a single one-size-fits-all template to crisis management that can be transported across countries and over time. It is not possible, for example, to argue that it is always better for crisis managers to restructure the system quickly rather than slowly (the quality of the restructuring matters as much as the speed), that market rather than official decisions should play the largest role in picking winners and losers (very often markets are not working well during a crisis), that official guarantees should not be used (often they seem essential), or that temporary nationalizations of the financial system will not be needed In addition, perverse negative feedback loops during crises can imply knife-edge possibilities regarding systemic financial stability that need to be navigated around carefully on a case-by-case basis.

Based on the crisis experience, it is possible nonetheless to note a number of broad but important lessons that can guide crisis management as well as some key areas where the strengthening of crisis resolution frameworks would be desirable. Arguably, the experience during the current turmoil, during which the scale and intensity of state support has been virtually unprecedented, makes it essential to revisit crisis management strategies to determine the appropriate boundaries for state intervention and address the moral hazard implications of the widespread use of official guarantees and bailouts.

Key general principles or lessons for crisis management that can be distilled from the very large number of recent crises are as follows.⁵⁴

Lesson I. The need for a correct early diagnosis of the nature of the crisis and the adoption of a consistent overall crisis strategy that has the support of the highest level of government;

Lesson II. The importance of the crisis resolution strategy being cast within a sustainable macroeconomic framework;

Lesson III. The need for the state to have adequate tools and instruments to intervene in the system where and when necessary;

Lesson IV. The importance of recognizing losses, writing down impaired assets and facilitating the injection of new capital as needed;

Lesson V. The importance of a high degree of transparency and independence in the key decisions regarding the allocation of losses, intervention of firms, and injection of official capital;

Lesson VI. The need for the independence of the crisis management strategy from vested political and financial interests;

Lesson VII. The need for a high level of cooperation, coordination, and information sharing among key state agencies, ministries, and the central bank;

Lesson VIII. The need for a clear exit strategy for the orderly unwinding of extraordinary measures.

In what follows, a number of observations are made about these lessons and their implications. Before doing so, however, two general observations seem pertinent. The first is that all the lessons are deliberately cast within a relatively broad framework rather than involving very specific points. The key reason for adopting this approach is that it is very difficult to be prescriptive at the level of fine detail. There are several ways in which crises can be managed. The second pertinent observation is that, as with any “best practice” guidelines, the failure to follow the lessons does not usually translate into “costs” or “losses” that can be easily identified. Crises can be managed well and crises can be managed badly, but it will rarely be easy to specify the implications of not following particular lessons. That said, however, and as noted below, the lessons can be used to identify some critical areas where crisis management frameworks could be usefully strengthened.

As noted in the previous sections, a common mistake in the early stages of any crisis is to ignore the signals in the first tremors and respond to them in a relatively ad hoc manner. Arguably, the failure to correctly diagnose the systemic nature of the crisis at an early stage can delay the adoption of the appropriate measures to deal with the financial sector weakness, and can damage confidence as the problems worsen and spill over to other sectors. In addition, the misdiagnosis of the problem and the provision of extensive liquidity support and guarantees may risk overwhelming central banks and finance ministries. As a result, both monetary policy and fiscal policy can become overly expansive with adverse implications for the exchange rate and inflation. In addition, extensive liquidity support can lead to a sharp deterioration in the quality of the central bank balance sheet and the need to eventually recapitalize the central bank.⁵⁵ Based on these considerations, it is clear why it is important to correctly and quickly diagnose the systemic nature of problems and adopt a coherent overall strategy. A key component of such a strategy is to address in a holistic way the impaired asset and institutional problems in the financial system, and not rely excessively on temporary painkillers such as liquidity support, regulatory forbearance, and government guarantees.

More generally, it is important to recognize that there can be important two-way feedback effects between financial sector difficulties, on the one hand, and monetary and fiscal policies, on the other. In some financial crises, the problems may be directly caused by macroeconomic policy weaknesses such as high and variable inflation or unsustainable fiscal policies and pubic debt (Boorman et al. 2000). In these cases, addressing the macroeconomic imbalances will be the sine qua non for addressing the financial sector problems. It is also possible, however, that macroeconomic policies were not part of the problem in the lead up to the crisis but subsequently become a problem. This is why the key features of the crisis management strategy, such as the amount of official assistance and government guarantees, need to be provided within the available amount of macroeconomic policy space.

Based on crisis experience, the key vulnerability in many crisis management strategies is the fiscal situation. This is due to the typically high direct and indirect costs of public sector bailouts and capital injections, the adverse effects on revenue and spending from the accompanying weakening of economic activity, and the costs of any fiscal stimulus measures adopted (IMF 2008b,c; BIS 2009). As discussed in the preceding section, these costs were very large during the Asian crisis and have been extraordinarily large during the current international turmoil. In those cases where the sizes of these costs threaten the sustainability of the fiscal situation, there will typically be adverse consequences for the cost of issuing public debt and both monetary and fiscal stability may be put at risk. Less common, but of equal concern, are situations in which crisis management strategies involve guaranteeing cross-border foreign currency loans or, in the case of dollarized economies, foreign currency deposits. In these cases, there may be both fiscal and external problems and it is critical to cast the crisis management strategy within a consistent and sustainable macroeconomic framework to ensure that systemic financial risk does not create excessive systemic fiscal or external risk (Collyns and Kincaid 2003; IMF 2008a).

It is also important for the crisis management strategy to be transparent and independent from political and vested interests. An analogy may be useful to understand the importance of transparency and independence. In many countries, regular bankruptcy and related procedures will typically involve a stay on creditor claims before losses are estimated and distributed across claimants (Adams, Litan, and Pomerleano 2000). Generally, the willingness of the concerned parties to go into bankruptcy proceedings, and for creditors to stay their claims, is based on the belief that the resolution process is fair and transparent, with established rules and procedures. The problem in a systemic crisis is that many of the resolution procedures may be done out of court without the regular legal protections. Essentially, approaches to absorbing and distributing losses during a systemic financial crisis will be like a large “out of court” bankruptcy proceedings. Unless the process is transparent and independent, it may easily be seen as inequitable and become subject to abuse.

The reason why cooperation and coordination among state agencies is critical is based on the desirability of the crisis management strategy addressing in a holistic way the interrelated components of the crisis. And, during the crisis, there will also be a need for a high degree of cooperation in the regular assessments and evaluations of the strength and resilience of different parts of the financial system (using inputs from various supervisory and other bodies), the amount of fiscal and monetary space, and the chosen balance among different policy instruments. Arguably, many state agencies and central banks will need to be involved in these processes. From a public policy perspective, many of the decisions made in managing the crisis will also have implications for taxpayers, implying that ministries of finance should be involved at many points during the crisis. This is most evident in the case of instruments, such as government guarantees and bailouts, but can also arise in the case of central bank liquidity support that puts its balance sheet at risk. Arguably, many of the crisis support mechanisms will have actual or potential fiscal dimensions and should receive input from the ministry of finance.

Exit strategies are important for a number of reasons, and especially in circumstances where a range of extraordinary measures have been taken to deal with the crisis. Among all the aspects of crisis management, this is perhaps the area where the least amount of research has been done. At least in broad terms, the preferred approach is to unwind extraordinary measures as fast as feasible so as to return to normal market functioning. In practice, however, it is rarely clear when systemic risk has returned to a comfortable level and whether extraordinary measures should be unwound gradually or in a big bang. As a result, as was the case following the Asian crisis in the late 1990s, measures are frequently unwound slowly (Adams, Litan, and Pomerleano 2000). For example, in the case of some countries in the region, the blanket guarantees introduced during the 1990s crisis were still in place when the current turmoil erupted. Looking forward, significant challenges will arise when exiting from the exceptional and other supports introduced during the current turmoil (IMF 2008a 2009a; ADB 2008b).

Based on the earlier discussion, there are three aspects of crisis management that could usefully be strengthened. These concern: (i) the tools and instruments available to involve the private sector in crisis resolution, (ii) the ability to credibly impose losses on systemically important financial institutions while keeping them afloat, and (iii) the approaches used to identify and manage systemic risk.

The ability to involve the private sector in crisis resolution (and avoid bailouts) will depend ultimately on there being sufficient capital in the system to absorb losses. Accordingly, progress in this area is linked closely to ongoing efforts with regard to capital adequacy and ensuring that the capital involved is “real.” In the case of banking, these efforts have, of course, been pursued in the context of the Basel Committee and, arguably, and notwithstanding certain shortcomings with the Basel II capital adequacy framework, progress is being made. The second key area in need of strengthening the tools and instruments available to deal with systemically important financial institutions. Arguably, the increased resort to guarantees, bailouts, and liquidity support during the recent crisis has reflected both the assessment that the systemic risk implications of allowing certain financial firms to fail are too high, and, in some cases, a lack of instruments to allow for their orderly unwinding. The longer-term consequences of such approaches for moral hazard are, of course, potentially disturbing. One possible approach, suggested, by Mervin King is that if an institution is judged to be too important systemically to fail, then it should not be allowed to operate.⁵⁶ Such an approach seems unlikely to be workable in practice, however, and could imply forgoing the economies of scale and scope of large financial institutions. Either because the problem of too large or too interconnected to fail is unlikely to go away, or because it is only during a crisis that it becomes clear who is too important to fail, an approach is needed to deal with systemically important firms that run into difficulty. One possibility would be the “living will” approach in which systemically important financial firms are required to regularly draw up plans for their orderly termination as discussed inter alia by Mervin King and Buiter (2009). But this may not go far enough and would require a correct ex ante identification of systemically important firms. What would arguably be more desirable (and feasible) would be to set up crisis resolution systems in which the owners of systemically important financial institutions could be forced both to take large losses (and ultimately fail) even while the business operations of these firms could be wound down in a slow and orderly manner. In short, what would be required, as discussed by Buiter (2009), would be crisis resolution regimes in which the owners of systemically important financial institutions can be credibly allowed to take large losses while the firms are kept afloat until such time as they can be wound down without adverse systemic consequences. Or, alternatively put, these financial firms must be made “safe to fail.” The key elements of such an approach would be: (i) the creation of special crisis resolution regimes in which the state is provided with flexible powers to intervene in a timely manner in all systemically important financial institutions (based on an ex ante or ex post determination of systemic importance) and, if necessary, keep them afloat; (ii) the existence of real⁵⁷ capital and other cushions in these institutions that are sufficiently large to absorb losses in extreme events and which can be written down even as the firms are kept on life support; and (iii) the ability to flexibly provide assistance to innocent bystander financial firms that are adversely affected by spillovers and collateral damage from the financial firms in distress. Very clearly, many details of such an approach need to be developed, but the approach has the potential for imposing credible market discipline, lessening moral hazard, and addressing the problem of too big or interconnected to fail.

An essential ingredient in crisis avoidance and management is the early detection and containment of systemic risk.⁵⁸ Against this background, there is an urgent need to strengthen the oversight and understanding of systemic risk. Since the current turmoil erupted, there has been a considerable amount of work on how frameworks for macroprudential surveillance could be strengthened and systemic risk better assessed. Hence, for example, taxonomies of several types of systemic risk situations are being studied, such as those related to large and interconnected players, common trading strategies of many small players, common funding and market liquidity problems, and the effects of common shocks. In addition, efforts are being made to strengthen the understanding of the links within financial systems during extreme events, using tools such as co-risk models and network models.⁵⁹ These latter models could be used to help identify the systemic risk implications of alternative crisis resolution strategies. Even though it is too early to assess their usefulness, the approaches carry the promise of enhancing the understanding of systemic risk and how it might best be managed.

For the most part, the work program on systemic risk has been directed towards ex ante crisis prevention in the spirit, perhaps, that an ounce of prevention is worth a pound of cure. But very clearly, financial crises will invariably occur and there can be important payoffs in better managing them when they arise. Arguably, therefore, there would also be benefits to systematically addressing the links between systemic risk in normal times (ex ante), the particular crisis management strategies adopted (ex post) to deal with the realization of systemic risk, and how crisis management strategies influence systemic risk in the future. Hence, for example, efforts to understand the systemic risk posed by particular financial firms could usefully take into account the manner in which the crisis resolution regime will deal with such firms under stressed conditions and how spillover effects might be contained. In addition, account can usefully be taken of how alternative crisis management strategies will impact on systemic risk in the future through moral hazard and other effects. In short, account could usefully be taken of the two-way interactions between ex ante and ex post systemic risk oversight. And, arguably, assigning the same state entity overall responsibility for systemic risk may facilitate the linking of ex ante and ex post oversight. Under most current structures, such an assignment of responsibilities does not appear to be common (Davies and Green 2008).

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