Financial Globalization: Opportunities and Challenges for

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					 Dealing with Systemic Crises:
Seismic Zones and Financial Earthquakes
             Augusto de la Torre
              The World Bank




      3rd Annual International Seminar
   on Critical Issues in Financial Stability:
 Preventing and Confronting Bank Insolvency

       Washington, DC - June 4-6, 2003
                 Seismic zones under financial globalization
                                                                           Wretched Trinity:
                                            Multiple equilibria
                                                                           Weak currency
Contagion Risk


                                                                          Nominal inflexibility
                  Current account / fiscal deficits  Exploding public
   (Runs)


                                                       debt dynamics       Weak institutions

                  Overvalued currency

                              II                         IV
                                                                         Currency mismatches




                                I                                           Weak institutions
                      Blessed Trinity:                  III
                   International currency
                     Nominal flexibility
                     Sound institutions
                                                                    Incentive Distortions
                 Seismic zones under financial globalization
                                           Multiple equilibria
Contagion Risk



                  Current account / fiscal deficits   Exploding debt
   (Runs)


                                                          dynamics
                                         Run on the currency
                                                                    Depositor run on system

                               II                       IV
                                                                     Currency mismatches

                                                                       Run by foreign
                                                                      portfolio investors
                      Low currency & maturity
                           mismatches

                                I
                                                        III
                                                                            Depositor
                                                                        flight to quality


                                                                   Incentive Distortions
 Management and Resolution Issues
 Differ Substantially Depending on Crisis Type

Containment
  International reserves, interest rates
  LOLR, deposit guarantees, expensive debt rollover
  Breach of contracts -- deposit securitization, debt
  defaults, forcible stock pesification

Loss allocation and restructuring
  Inflation (if not dollarized) versus admin. allocation
  Bank and corporate resolutions, with risk of
  socialization of bad assets (bailouts)
  Government bond based restructuring?
Management and Resolution Issues (cont.)
   Differ Substantially Depending on Crisis Type

  Regeneration (flows and incentives)
    Hyperinflation – permanent impairment of national
    currency as store of value
    Bailouts – permanent erosion of market discipline
    Forcible containment (widespread contract breaches)
    – permanent weakening of institutional arrangements
    and credibility


Regeneration and learning from crises – a function
  of the quality of political institutions
Type IV crises – regeneration issues
Growth regeneration depends on…
  Confidence and capital re-flows
  Degree of openness in trade structure
  Speed/effectiveness of loss allocation and restructuring
…but its sustainability requires regeneration of
financial intermediation…
  Establishment of currency as “store of value”
  Questions on new industrial organization of sector
  (narrow banks, offshores, etc.)
  Segmentation of access
…and institutional regeneration
  Contractual and regulatory environment
  Democratic governance
Type IV crises – int’l architecture issues
Imperfections of int’l financial markets
  Contagion (Calvo’s EMF)
  Defaults (int’l bankruptcy, exit consents, UDROPs,
  floor to debt to facilitate agreement on haircuts)
  Potential role of IFIs in peso debt markets development
  Externalities of fluctuations in international currencies
Fixing them would benefit EMs the most…
…but incentives for industrial countries are weak
Multilateral & regional institutions have a major
responsibility

				
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