The IMF just released a study that analyzed 124 banking crises, and I wish everyone in Congress (well, at least their staffers), the Treasury, and the Fed read the paper. It provides insight into what worked and didn’t work in past banking crises, and gives an idea of what we might expect from various policy measures.

I’ve only skimmed it, and key bits stick out. Page 6:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance. Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

Now of course, one can argue that the IMF is biased and this paper is merely a defense of the cold-water remedies it imposed in the Asian financial crisis of 1997-1998, which produced a great deal of dislocation (business failures, rises in unemployment, riots, changes in government). But one reason the US would not suffer as badly is that we have the reserve currency. In Indonesia and Thailand, what made a bad situation worse was that companies had borrowed in foreign currencies, so that when the home currency plunged in value, the debt burden rose sharply, sinking a lot of businesses.

The paper contains other useful warnings that appear to be getting little heed. For instance:

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

And this:

Special bank restructuring agencies are often set up to restructure distressed banks (in 48 percent of crises) and asset management companies (AMC) have been set up in 60 percent of crises to manage distressed assets. Asset management companies tend to be centralized rather than decentralized. Examining the cases where AMCs were used, we find that the use of AMCs is positively correlated with peak non-performing loans and fiscal costs, with correlation coefficients of about 15 percent in both cases. These correlations may suggest some degree of ineffectiveness in AMC’s, at least in those episodes where asset management companies were established. In line with these simple correlations we find Klingebiel (2000) who studies 7 crises where asset management companies were used and concludes that they were largely ineffective.

So much for the idea that taxpayers might show a profit.

We have been advocating direct recapitlization of banks, and the research finds that even though it has larger up-front costs than some other options, economies that go this route fare better:

Another important policy used in the resolution phase of banking crises is recapitalization of banks. In 32 out of the 42 selected crisis episodes, banks were recapitalized by the government. Recapitalization costs constitute the largest fraction of fiscal costs of banking crises and takes many forms…. On average, the net recapitalization cost to the government (after deducting recovery proceeds from the sale of assets) amounts to 6.0 percent of GDP across crisis countries in the sample, though in the case of Indonesia it reaches as high as 37.3 percent of GDP. Recapitalizations seem to be associated with lower output losses. The correlation between recapitalizations and output losses is about -15 percent. A rationale behind this correlation is presented in Valencia (2008), who shows—in a rational expectations bank model—how a persistent credit crunch can generate significant output losses, following a shock to bank capital. Therefore, by replenishing banks’ capital, the supply of credit returns to normal sooner and the output losses become smaller.

These programs DO NOT pay for themselves:

Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3 percent of GDP on average, and can be as high as 55.1 percent of GDP. Recoveries of fiscal outlays vary widely as well, with the average recovery rate reaching 18 percent of gross fiscal costs

As we have suggested, there is no free lunch:

There appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses.

The New York Times’ Dealbook discusses a Merrill Lynch write-up of the IMF report: