Can Emerging Market Central Banks Bail Out Banks?

The recent financial crisis in mature markets has put the role of central banks in financial stability in the spotlight. In the large advanced economies， central banks played an active role to prevent the collapse of their financial systems. Central banks initially provided aggregate liquidity in money markets without expanding their balance sheets as they were able to mop up excess of liquidity. Later， they granted large amounts of financial support to individual illiquid and even insolvent， banks and reserve money eventually increased. Central banks provided assistance not only to banks， but also to non-depositary institutions， arguing that the former are no longer the only financial intermediaries that pose a systemic risk.

This paper argues that emerging markets and developing countries should be cautious when using central bank money to cope with financial crises as large scale monetization may cause further macroeconomic unrest. The main conclusion is that pouring money into the financial system to confront banking crises tended to fuel macroeconomic and financial instability as it increased the chances of a simultaneous currency crisis.

The response of central banks and its macroeconomic impact

Latin America has a long and painful history of banking crises. Recurrent episodes of financial turbulence became a key source of macroeconomic instability up to the mid-2000s. Specifically， Latin America had 28 systemic banking crises from 1970 to 2007， which is a disproportionate number compared with other regions in the world， except for Africa. Systemic banking crises were more frequent in the wake of the debt crises of the early-1980s， and during the mid- and late-1990s and the early-2000s， following episodes of terms of trade deterioration and/or of capital outflows.

We start by identifying the episodes of financial distress and crises. We consider both full-fledged banking crises and also small idiosyncratic episodes. Thus， we include the well known banking crises in Argentina， Ecuador， Dominican Republic， Mexico， Uruguay， and Venezuela， and also some small crises， which are almost unknown in the banking crisis literature.

The root cause of these crises is not very different than in the recent financial crises in the advanced countries. The story that better describes the origin of Latin American banking crises is the well known “boom and bust cycle.”Latin America had liberalized financial markets during the late-1980s and early-1990s and this encouraged growing capital inflow， attracted also by increasing macroeconomic stability. As a result， real interest rates declined and the domestic currencies appreciated， all of which fostered a credit boom. Unfortunately， financial liberalization was not coupled with better financial surveillance and enforcement capacity of bank regulators. Thus， the combination of financial liberalization， capital inflows， and loose financial supervision， laid the ground for the development of a variety of new and risky financial transactions. This cycle of credit expansion only lasted until successive shocks hit Latin America starting in the mid-1990s， which triggered massive capital outflows. These resulted in liquidity and credit crunches in many countries， bringing to the forefront significant deficiencies in the quality of banks’ assets and leading eventually to banking crises.

In the recent history of financial instability in Latin America， central bank financial support was often used intensively to cope with banking crises. In many cases， a lack of appropriate institutional foundations to effectively address banking problems forced the central bank to step in， in order to prevent the collapse of the payments system. In some cases， it may also have been that in the absence of central banks’autonomy， governments induced them to monetize banking crises to avoid using， or at least postponing in the short-term， tax payers’ money to fund the cost of resolving the crises.

In a number of countries， central bank money was also used to support bank restructuring and resolution. This policy typically aimed at cleaning the troubled banks’ balance sheet and at easing its subsequent rehabilitation or purchase by another bank. For instance， central banks issued securities and swapped them for nonperforming assets of the impaired bank directly or through a bank restructuring institution (Bolivia 1999， El Salvador， Mexico， among others). They also issued securities to be used in purchase and assumption operations(PA) (Nicaragua)， or simply extended credit to the acquiring institution to pay deposit withdrawals following PA(Brazil).

As in several advanced economies during the recent financial crisis， the Latin American countries injected central bank money in large scale during periods of systemic crises.14 A number of central banks more than doubled their balance sheets during the first two years of their crisis， like theincrease observed in various advanced countries， during the recent crisis. However， while in the latter group of countries the monetization of banking crises served to mitigate the economic downturn and did not fuel inflation， in Latin America similar policies induced macroeconomic disarray.

In non-systemic crises monetization also took place， but in smaller amounts， and hence， central banks managed to mitigate the adverse macroeconomic effects. Bolivia and Paraguay in the mid-1990s， and Guatemala in the late-1990s and early-2000s， are cases in point. In this group of countries， in addition to providing liquidity assistance， the central bank honored most or all withdrawal of deposits fearing the possibility of contagion. However， since the crises were small， central banks managed to mop up the expansion of liquidity.

In general， as financial turbulence escalated， monetary policy no longer fulfilled its primary role of preserving price stability. This is because central banks put at the forefront the goal of containing the banking crisis and preserving financial stability. However， the large use of central bank money to cope with banking crises and its effect on the exchange rate eventually fueled inflation. In small and open economies， like the Latin American countries， the transmission mechanism from money to prices generally passes through the exchange rate， because of the direct impact of depreciation on the price of tradable goods. So as the excess money supply increased， the exchange rate depreciated and inflation accelerated. In some countries， where the exchange rate peg was abandoned in the midst of the financial crisis， there was exchange rate overshooting and inflation soared.

The impact of the monetization of banking crises on economic growth was also negative. There are at least two channels through which injecting large amounts of central bank money could affect growth in the short-run: an exchange rate channel and an indirect interest rate channel， although they may operate in opposite directions. Provided the central bank can hold inflation below the rate of nominal depreciation， real exchange rate depreciation materializes and， thus， exports may increase， thereby fostering economic growth. On the other hand， there is a negative impact on economic growth because the sustained exchange rate depreciation also induces an increase in domestic interest rates， which， in turn， fosters a decline in credit demand. Furthermore， because of the dislocation of money markets resulting from financial distress， and since sound banks hoarded excess liquidity as a precautionary measure against possible contagion， chances are that the availability of credit disappears. In financially dollarized economies， exchange rate depreciations immediately hit unhedged bank borrowers， they suffered a sudden and sharp decrease in net wealth—which not only damages banks’ balance sheets， but also undermines aggregate demand and， hence， economic activity.

Against this background， the vast majority of countries in our sample that suffered large crises also experienced an economic contraction， as real GDP shrunk by at least 3 percent. While large nominal and real depreciations boosted economic growth in the medium term， in the short run， as the crises unraveled， economic activity was almost frozen and plunged because credit market collapsed as a result of the uncertainty associated with the deterioration of the countries’macroeconomic and financial conditions.

Concluding remarks

The role that central banks played in the industrial world in the recent financial crisis will probably set a new standard for policies of LLR. Injecting large amounts of money to support troubled financial institutions averted a financial meltdown and later， in tandem with fiscal stimulus， mitigated recession trends， without fueling inflation pressures. It is likely that other countries worldwide would be led to implement similar policies in a future parallel scenario.

Based on the Latin American experience， this paper stresses that emerging and developing countries should be cautious if they want to follow the same strategy to tackle financial crises. As opposed to the United States and most European countries， these countries do not issue a reserve currency. This makes them more vulnerable to currency depreciations and volatility in the event of large scale injections of central bank money to cope with banks’ distress. While many of these countries have strengthened central bank credibility， improved macroeconomic fundamentals， created buffers to absorb external shocks， and strengthened fiscal institutions， these new conditions have not been fully tested against the effects of simultaneous real and financial shocks， like those that hit the developing world in the past.

Thus， revisiting the recent history of financial crises in Latin America is warranted. Subject to the caveats established above， we found that confronting banking crises using exclusively monetary policy was not effective to avert and manage financial crises. Moreover， expanding central banks’balance sheets tended to exacerbate macroeconomic instability and fueled currency crises.

Alternatively， the roadmap to cope with financial distress in these countries should put bank restructuring and resolution at the forefront. Countries should design a comprehensive strategy to prevent and manage banking crises in which central banks are part of the policy response. Efforts should focus on imposing corrective actions before liquidity and capital shortages become severe， and on implementing bank resolution measures before the crises unfold. Strengthening financial regulation and supervision to keep the pace of the permanent innovation of financial instruments is also a must.

In addition， maintaining strong macroeconomic fundamentals is critical to help reducing the uncertainty that would otherwise invade markets’ perceptions and feed financial instability， including attacks on the domestic currency. This is particularly relevant for emerging economies because they are closely integrated to global markets， which makes them more vulnerable to the vagaries of capital flows. Thus， emerging countries should build more resilient economies， in particular， maintaining flexible exchange rates， keeping public finances and debt in check， strengthening international reserves， developing money and capital markets， and reducing financial dollarization.