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Policy issues 77
Another important tool for crisis prevention is credible debt restructuring
mechanisms. The existence of such mechanisms is in itself a powerful deterrent
to the accumulation of excessive debt, given that it makes investors and debtors
more clearly exposed to the consequences of default, thereby mitigating moral
hazard problems.
While robust debt restructuring mechanisms should reduce the frequency
and scale of bailouts, it remains the case that limited and conditional bailouts
may sometimes remain the least worst policy option during a crisis (Tirole,
2012). In particular, systemic risk factors and the fear of contagion can prompt
a government to bail out individual banks or even non-bank debtors. Similarly,
at the international level, sovereigns may receive official funding from the
international system in order to avoid the disruptions associated with nonorderly
defaults.
(ii) Managing deleveraging and debt crises
An important element in the dynamics of the leverage cycle is a slowness to
recognise that income prospects deteriorated. If debt capacity is set back, either
with a reduction that falls below the current level of debt or one constraining
future debt accumulation (a lower target), then there is scope for policy to offset
some of the adverse consequences for economic activity.
As shown in the schematic below, there are three stages in the process of
coping with the leverage cycle. The first is the recognition that debt capacity
has declined. The same calculation of the net present value of future output
that matters for determining debt capacity also comes into play for calculating
the market value of assets, such as equities and homes. As a consequence,
simultaneously with the recognition that borrowing capacity has fallen, there
will be a wealth loss as those capital values are written down. When those assets
serve as collateral, there are additional hits to credit intermediation. The prospect
for repayment diminishes with the declines in debt capacity and the value of the
collateral securing those loans.
Figure 5.1
Stages of the leverage cycle
Recognition
of the loss
Allocation
of the loss
Offset of the loss
through other policies
Policymakers can facilitate the recognition of these losses in their role as
prudential supervisors. This is where stress tests of financial intermediaries enter
as a means for the joint acknowledgement of asset impairment. In that regard, the
initial asset and liability review in the US provides a model of the strict grading
of a test with an option to fill the hole with government resources. In the event,
because the aggregate deficiency was below the resources available through the
Troubled Asset Recovery Program, the private sector provided the funding given