What is the Impact of the Global Financial Crisis on the Banking System in Asia?

Michael Pomerleano, Visiting Fellow at the Asian Development Bank Institute (ADBI) presented a paper on What is the Impact of the Global Financial Crisis on the Banking System in Asia? at an ADBI seminar on 9 June 2009.

A healthy financial system is said to be the lifeblood of a country's economy. We have witnessed Japan's moribund economy in the 1990s where ailing banks kept afloat by public money peppered the economy. With some signs of an economic turnaround, Mr. Pomerleano's timely lecture provided a comprehensive overview of Asia's financial situation in light of the current market developments.

Mr. Pomerleano's discussion started with a risk analysis of Asia's banking systems using the standard supervisory framework, which assesses capital and reserves adequacy, asset quality, management earnings, liquidity, sensitivity to market risk; also known by the acronym CAMELS.

Using the International Monetary Fund's 2009 Financial Stability Indicators data, the CAMELS test revealed that Asia's banking system is reasonably capitalized except for Japan and the People's Republic of China (PRC), whose capital quality and rapid credit growth respectively, could be causes for concern. While asset quality has markedly improved in the region, government pressure on banks to boost lending may increase future non-performing loans (NPLs); yet allowance for loan losses varies among countries in the region. Earnings are modest, except in highly competitive environments, like Japan where it remains low. Only the Republic of Korea faces liquidity issues, as its loan-to-deposit ratio is found to be high. Finally, unlike their counterparts in the United States and Europe, Asian banks are less exposed to credit and market risks. Overall, asset quality is expected to deteriorate, eroding profits and shrinking capital base. Given this scenario, contraction in lending is the likely outcome, painting a dim picture of Asia's banking system as downgrades by rating agencies are expected to continue in 2009.

Mr. Pomerleano then discussed major forms of bank support in the Asia-Pacific region, namely (1) blanket deposit guarantees, (2) removal and guarantees of bad assets, (3) direct capital and liquidity support, (4) obligation guarantees, and (5) regulatory forbearance measures.

With the recent widespread use of guarantee schemes to promote financial stability, Mr. Pomerleano pointed out their limitations, such as moral hazard and exit problems. He recommended full disclosure on the rare instances that they are employed. As for (2), resolution process of bad assets should rely on market forces as governments lack the expertise to handle this problem. Banks should meet certain prerequisites prior to receiving direct capital support to minimize moral hazards. Currently, (3) mainly serves to maintain the public's confidence in banks and to keep the flow of bank lending while (5) is primarily designed to increase liquidity.

Mr. Pomerleano employed stress tests to better understand the region's capital shortfall. He assumed NPLs of 8% of assets, a 100% coverage ratio of reserves to NPLs, and a leverage ratio of capital to assets at 5%. Surprisingly, Asia's largest economies face a capital shortfall of US$758 billion, of which US$518.8 billion are needed by Japan and US$109 billion by the PRC. Other countries that face capital shortfalls are Hong Kong, China (US$30 billion); Republic of Korea (US$44 billion); Taipei,China (US$37 billion); New Zealand (US$14 billion); Indonesia (US$5 billion); Malaysia (US$3 billion); and Singapore (US$5 billion); while Thailand and the Philippines will not need additional capital.

Given the continuing global integration, Mr. Pomerleano proceeded to analyze the costs and benefits of the internationalization of foreign banks which have increasingly lent to, and invested in many developing countries, easing credit constraints around the world. They also created competition in the local banking system which improved the efficiency of local banks. But at the same time, developing countries are made more vulnerable to financial shocks transmitted by international banks. Independent sources of finance can also fuel domestic credit booms, undermining monetary policies to reign in inflation or restrict capital inflows. For instance, countries with active international interbank markets such as the PRC, India, Kazakhstan and the Republic of Korea may face funding difficulties if liquidity pressures remain high in interbank markets.

Mr. Pomerleano then discussed the next phases of the crisis. Given gradual recovery, default losses to creditors are expected to be manageable as Asia's corporate sector entered the crisis with low leverage ratios and high profitability. Mr. Pomerleano's examination of the evolution of private sector credit in the aftermath of the crisis using Reinhart and Rogoff's (2008) methodology revealed that on average, it takes about 3.5 years for credit to resume growth. To meet long-term finance, equity and debt markets could offer the needed funding in lieu of banks. However, his assessment of both the supply and demand sides of non-bank financial institutions (NBFIs) disclosed that only the Republic of Korea has vibrant NBFIs. The underdeveloped money markets in the region limit NBFIs' role in providing Asia's needed capital. But at the same time, according to Shigeto Nagai from the Bank of Japan, this has shielded most of the region from the devastation brought about by sophisticated financial products in countries with highly developed financial markets.

In conclusion, Mr. Pomerleano stressed the urgent need to implement corporate restructuring and to address the region's banking problems, not only to hasten economic recovery, but also to reduce the public cost of recovery. Peter Morgan, a senior consultant for research at ADBI pointed out that as the crisis is mainly external to Asia, corporate restructuring has to be done cautiously. He suggested examining corporate balance sheets in the region to locate sources of possible weaknesses. Mr. Pomerleano's presentation ended with a positive note on Asia's long-run economic prospects. He believes Asia will outperform other regions owing to its strong underlying economic growth.