Financial systems and development

will not be necessary because defaulting borrowers ing implicit or explicit deposit guarantees and by
will start to repay or because banks will make ade- regularly granting assistance to troubled banks
quate provisions for their bad loans. But, as Box and firms, governments have suppressed the mar-
5.5 argues, the likelihood of spontaneous recovery ket forces that otherwise would have eliminated or
is low. Other considerations-the budgetary costs reorganized unprofitable firms and allocated the
of restructuring, issues of fairness in allocating the associated losses. Until governments take the furlosses,
the embarrassment of bad loans made to ther step of performing the market's losspublic
enterprises or political allies, or fear of bank allocating function, losses will continue. As losses
runs-also lead governments to ignore the prob- mount, so do the costs of supporting the losslem
as long as they can.
making institutions. The continuing costs of peri-
If there is no crisis, should governments inter- odic support will eventually outweigh the onevene
merely to relieve financial distress? One rea- time cost of restructuring.
son most may have to is that earlier interventions Governments can either take the next step, by
have made a market solution unlikely. By provid- performing the market's loss-allocating function,
Box 5.5
Can banks "muddle through"?
Governments have often refrained from intervening in A "wait and see" approach is likely to prove costly.
the financial sector in the hope that ailing banks will To recapitalize themselves, banks with large losses
recover spontaneously. Rather than obliging the banks (losses greater than their capital) must increase earnto
make provisions for their losses (which might force ings substantially. If efforts to increase earnings lead
those with losses larger than capital into bankruptcy), bankers to engage in overly risky behavior, however,
many governments have permitted them to operate new losses will make spontaneous recovery even less
with impaired capital positions. For banks to recover feasible.
unaided, at least one of two things must happen:
enough defaulting borrowers must resume servicing
their debts or banks must earn enough to restore capital
adequacy.
Box figure 5.5 Lending margins needed to recover
Simply waiting for economic upturn is risky. In the in five years from given levels of loss
meantime, only banks whose remaining good assets
can generate more than enough income to cover costs
will be able to begin recapitalizing themselves. In re- Percent
cent years the earnings of many large U.S. banks, for 50
example, have been sufficient to enable them to make
substantial provisions against nonperforming international
loans. The larger a bank's nonperforming loans, 40 -
however, the smaller its income and the longer it will
need to recapitalize itself. If a bank is losing money, 30
spontaneous recovery is impossible.
To increase income, banks may increase the spread
Lending rate\
between deposit and loan rates. Box figure 5.5 shows 20
the spread necessary for a "typical" bank (as defined
in the note to the figure) to recapitalize itself through
retained earnings over a period of five years. A bank 10 -
with initial losses equaling 20 percent of assets, for ex-
/ Deposit rate
ample, would need a spread of 7.1 percent to recapitalize
itself in five years. In practice, competition will limit 0
the amount by which spreads can be enlarged. Banks 0 10 20 30 40 50 60 70
that set lending rates too high or deposit rates too low
Lost assets as a percentage of total assets
eventually lose business to competitors. Similarly, government
efforts to assist the entire financial sector by Note: This example assumes administration costs of 2 percent of
mandating larger spreads are likely to aggravate banks' assets, a required capital-to-assets ratio of 5 percent, a reserve requirernent
of 10 percent of assets, a deposit rate of 5 percent, and no
difficulties: too large a gap between deposit and loan defaults among new borrowers.
rates causes lenders and borrowers alike to seek
cheaper intermediation.
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