Avoiding banking crisies should be established as an explicit, high priority goal by policymakers and institutions.
Strong economies can withstand a banking crisis and solvent banks can survive macroeconomic shocks. Conversely, if the economic is fragile and the banking system weak, the risk of a crash is high and the effects can be devastating.
Strong economies and healthy banks can be achieved only by good economic policies and effective banking supervision.
Several Latin American countries are currently dealing with severe banking sector insolvencies and need to move out of crises situations. In these circumstances, how banking failures are handled become especially important.
Adequate crisis management can help contain the losses, restore confidence in the banking system and the country, and turn the crisis into an opportunity. Thus an agenda to avert banking crisis requires not only good economic policies and effective banking supervision, but also special efforts to resolve immediate problems.
A macroeconomic strategy to avert banking crises must focus on the goals of monetary stability and real growth: avoiding speculative bubbles, management of cross-border capital flows, close coordination between the central bank and the government, and a sustained commitment to economic reforms.
Speculative bubbles are highly damaging to the banking system. During a boom, banks tend to lend imprudently, invest heavily in assets whose prices are rising, and enter into new business without assessing the risks involved. When the bubble burst asset values fall and the decay of borrowers’ financial positions undermine banks’ solvency and may lead to failure.
Sound economic environment for banking means a good economic program, fiscal restraint, and prudent monetary policy, backed by a strong institutional framework to support monetary stability.
In this process, an independent central bank is crucial
Latin American economies have relied excessively on short-term foreign borrowing and have underestimated the disruptive effects of volatility on world financial markets.
As a general rule it is desirable to allow capital to move freely into and out of a country. However, sometimes governments want to control this in order to protect the financial sector from volatile flows.
The degree to which a country can sustain financial liberalization will ultimately depends on the soundness of the macroeconomic fundamentals, the health of its banking system, and the quality of banking supervision.
To deal with cross-border capital flows and speculative attacks on the exchange rate, countries must develop a coherent set of foreign exchange and monetary policies that rely on market-oriented mechanisms.
Close Coordination Between the Central Bank and the Government
Speculative attacks on a country’s currency can trigger a widespread banking crisis when the financial system is weak. Bank deposits tend to fall sharply and the banks may find it increasingly difficult to honor their obligations to depositors. Weak banks are usually hurt the most.
If foreign exchange policy is decided by government, not by the central bank, the rules must ensure that the decisions are made after proper consultation with the central bank and are implemented by mutual consent.
Good economic policies provide an environment in which real interest rates can be low and stable. They also serve to promote sustainable growth, which in today’s world of open capital markets and free financial flows can only be achieved through a sustained commitment to economic reforms.
Effective bank supervision requires strong and independent bank supervisors. They must have political support to perform their role.
Should banking supervision be placed in the central bank or a separate body? Independent central banks can contribute significantly toward effective banking supervision, either directly or by actively participating in the national supervisory system.
If the central bank has no supervisory powers and cannot act directly to prevent or contain a banking crisis, its goals of monetary stability and an efficient payment system will be difficult to fulfill.
Strong accountable bank supervisors, while necessary, are not enough to ensure safe and sound banking. Appropriate rules must also be established and enforced and compliance must be monitored.
Banking Supervisors around the world are adopting the rules established by the Basle Committee. The philosophy of the Base Accord is to allow for healthy competition in banking while improving discipline through sufficient capitalization.
As a complement to adapting the Base banking rules in Latin America, supervisors must look closely into the quality of the banks’ assets. The main goal is to prevent potential problems due to insider lending and imprudent asset valuation criteria. Frequent, effective on site inspections are the best way to achieve this goal.
To improve bank monitoring capabilities we must strengthen accounting and disclosure rules, use liquidity as an early warning system, and expand the role of external auditors and private rating agencies.
One of the most important requirements in banking regulation is to ensure that those who control and manage banks have the skills, prudence, and ethics required for sound and safe banking. Some countries, such as the UK apply a screening and approval process to those who seek to enter the banking business. In other countries, there are legal, institutional or political barriers to adopting such a practice.