Bail-ins, Bailouts, Burden Sharing
and Private Sector Involvement in Crisis Resolution:
The G-7 Framework and Some Suggestions
on the Open Unresolved Issues
by
Nouriel Roubini
Stern School of Business
New York University
July 16, 2001
Introduction
PSI is the most controversial issue in architecture reform
The issue of bail-ins versus bailouts – or private sector involvement in crisis resolution - is the most controversial question in the debate on the reform of the international financial architecture. There is broad agreement on measures for crisis prevention; much less so about measures and approaches to crisis resolution. Even the definition of the problem has been debated with different terms used over time to characterize the problem: bail-in, burden sharing, private sector involvement in crisis resolution, constructive engagement of the private sector
Main Issue in PSI: what to do when there is a crisis and an external financing gap?
In principle there are three options:
1. A big “bail-out” in the form of an official support package filling the entire financing gap (where the term “bail-out” is loosely used to describe large official packages)
2. A full bail-in of private investors (debt rescheduling, restructuring, reduction)
3. A combination of official financing, “appropriate” PSI and policy adjustment by the crisis country
Note that the external financing gap is endogenous, thus there is a role for catalytic IMF financing in some cases.
Trade-offs in PSI
There is some trade-off between the amount of bail-in versus the amount of bailout given an external financing gap: more of one means less need of the other. Ideally, one would want to keep official support to the minimum necessary (to avoid moral hazard) but also to avoid more coercive forms of PSI (as they may negatively affect private flows of capital to emerging markets) For example, Kohler speaks of “constructive engagement” and wants small IMF packages and no coercive PSI
But there is some partial tension in this view: smaller IMF packages may mean more PSI and more PSI of a more coercive form. While less coercive PSI may mean the need for larger official packages. The new US administration faces a similar tension between the Meltzerite views of some (no more large bailouts and allowing for more restructurings and defaults) and the Wall Street and national security interest groups (who tend to prefer bail-outs to bail-ins). The catalytic approach, when successful, can partly obviate this tension as official financing together with policy adjustment will restore investors’ confidence and market access and thus avoid the need for more coercive forms of PSI.
PSI in the 1980s versus the 1990s
The 1980s developing countries’ debt crisis had its own PSI (suspension of payments on syndicated bank loans, concerted loans rollovers, new money) and eventually led to debt reduction (the Brady Plan)
So, what is new in the 1990s?
1.Instruments (bonds and short term interbank lines rather than syndicated medium-long term bank loans)
2.Creditors (bondholders in addition to banks)
3.Debtors (private debtors in addition to sovereign ones)
In the 1980s the challenge was to restructure medium and long term syndicated bank loans. In the 1990s the challenge was to restructure sovereign and private bonds and short-term interbank lines.
There are a number of flawed arguments on how easy was to do PSI in the 1980s versus the 1990s. It has been argued that in the 1980s it was easy to restructure loans of a small number of homogeneous regulated banks pliant to forbearance while in the 1990s it would be impossible to restructure bonds (without collective action clauses) held by thousands of creditors. Also, it would be hard to restructure interbank lines as investors would rush to the door before the concerted rollovers could be arranged. The 1990s reality instead had been that there has been lots of PSI, both bond restructurings and interbank rollover arrangements.
Moreover, in the 1980s PSI was not that easy to arrange as there were:
1. Collective action problems of coordinating many different creditors
2. Hundreds of banks with different interests
3. Holdout problems especially among smaller banks
4. Non-homogenous syndicated loans that had to be restructured in more homogenous instruments.
Conversely, the 1990s experience has been that:
1.sovereign bond restructurings are possible even without collective action clauses (CACs):; see the cases of Pakistan, Ukraine, Russia, Ecuador (and Argentina);
2.the bail-in of interbank lines is also possible: see Korea, Indonesia, Thailand, Russia, Brazil…and Turkey.
In general the 1990s crises were addressed with a combination of partial bailouts and bail-ins in spite of the superficial perception among some that international financial crises were mostly dealt with large bailouts.
Current G7 PSI doctrine and 1990s experiences with PSI
Rationale for PSI
The rationale for PSI is pretty straightforward:
1. If there is a crisis, it is likely that there will be an external financing gap even after policy adjustment by the country
2. Official support can help to fill the gap but not fully. Not enough official money under normal circumstances
3. Exceptional financing is not only not feasible but also not desirable apart from few special cases as large bail-outs may lead to creditor and debtor’s “moral hazard”
Given 1-3, there is a need for “appropriate” PSI that will help to fill in the external financing gap.
Current G-7 PSI Doctrine
The current G-7 PSI doctrine, as evolved from the G-7 Kohl Summit architecture report through the April 2000 G-7 operational guidelines and the September 2000 IMFC statement, can be summarized as follows:
•Case by case approach rather than strict, rigid rules
•But discretion constrained by principles, considerations, tools, criteria and guidelines
•I.e. “constrained discretion”
•Rigid rules initially deemed not realistic because of complexity and novelty of the issues to be solved.
•Idea of case studies leading eventually to “case law”
•Some fuzziness and ambiguity on large systemic liquidity cases with preference for catalytic IMF financing when deemed likely to be successful.
•Still open debate on when access should be high or low and when PSI should be concerted or catalytic.
•Cooperative solution to be preferred to coercive ones when possible
The G-7 preference for “constrained discretion” rather than rigid rules in the 1999 Architecture Report derived from the fact that, in the absence of case law, there was a set of complex and difficult questions on how to do PSI that had no clear ex-ante answers in the absence of actual experience with cases studies:
•When to do PSI and when not?
•Which type of PSI (coercive, voluntary)?
•Which claims to include?
•Which creditors?
•What do to in liquidity cases?
•What to do in systemically important cases where contagion is possible?
•How to distinguish insolvency from illiquidity?
•How much adjustment versus financing?
•How to divide the burden sharing between private and official creditors?
•How to measure comparability?
•Allow reverse comparability?
•What is the appropriate sequencing btw Paris Club and private sector claims restructuring?
•Which process to follow for debt restructuring? Unilateral exchange offers or a more formal process with use of CACs, formal creditor committees and negotiations between the debtor and creditors?
Thus, the case-by-case approach with principles and tools and criteria combined clear guidelines with necessary discretion and flexibility to address appropriately each case.
There were two other elements of the G7 PSI doctrine:
1. “Appropriate PSI”
2. Try “cooperative, voluntary solutions” rather than coercive ones as much as possible to avoid hurting long term capital flows to emerging markets.
“Appropriate” PSI partly depended on:
•a. Where a country stands in the spectrum going from illiquidity to insolvency cases
•b. Whether the country is large and systemically important or not, i.e. whether the crisis may lead to “international contagion”
Evolution of Cases Studies in the Last Decade
• The Mexican peso crisis of 1994-95 was the closest to a full “bail-out” case as enough official money was provided to allow the exit of those investors who did not want to rollover their holdings of Tesobonos.
•Asian Crisis in 1997-98: in Korea, Thailand and Indonesia concerted rollovers of interbank lines were arranged. No sovereign bonded debt restructurings as these were “de minimis” in Asia. But in Indonesia there was a suspension of payments by private corporates and financial institution as the collapse of the rupiah led to the near bankruptcy of a large section of the corporate sector
•Paris Club comparability applied for the first time to bonds in Pakistan in 1999
•Brazilian crisis, monitoring of interbank lines in 1999 and commitment to maintain interbank exposure after partial roll-off of such lines
•Romania and Ukraine piecemeal restructurings of sovereign bonded and quasi-bonded liabilities in 1999
•Russia default and restructuring of bank and bonded debt liabilities (1998-2000)
•Ecuador Bradies default and restructuring in 1999-2000
•Sovereign bond exchanges in Russia, Ukraine, Pakistan and Ecuador in 2000.
•Turkey: monitoring of cross border interbank lines exposure in 2000-2001
•Argentina’s mega swap in 2001: effectively a voluntary market solution.
Open Cases Studies and Issues
•Cote d’Ivoire and Nigeria: Bradies restructurings in the near future?
•What to do if Argentina and Turkey’s rescues do not work? More concerted PSI and/or more official finance?
•How to deal with contagion if - as likely - Argentina and Turkey get in serious trouble again?
•In case of contagion, ring-fence the “well-behaved” (CCL for Brazil for example?) with official finance or involve somehow the private sector?
Evolution of the G-7/G10 debate on PSI and G-7 doctrine[1]
•The Rey Report. The G-7/G10 debate on PSI began when the G-10 organized a working group after the Mexican crisis bail-out. Some Europeans were concerned that the high levels of access and absence of a bond restructuring in Mexico would set a negative precedent and cause moral hazard. The Rey report recommended the adoption of bond clauses and called for the IMF to modify its policy of lending into arrears (LIA). But the report recommendations were not made into policy.
•Private sector resistance to the Rey Report. The private sector, namely the Institute for International Finance, strongly objected to both the bond clause recommendation and the LIA recommendation.
•The G22 working group on financial crises. The next official initiative was the G22 working group on financial crises. This group tried to bring emerging market debtors into the discussion and, unlike the Rey report that had stressed the problems deriving from bonded debt driven crises, it also addressed the question of interbank rollover crises such as those observed in Asia. In addition to the question of collective action clauses in bonds it covered new issues and recommendations: contingent credit lines from private banks to provide emergency liquidity, a call for better insolvency regimes, and a suggestion that in some cases, after receiving indications about the amount of official financing that would be available, debtor countries would approach their creditors for a restructuring. Such restructuring would ideally allow a country to avoid default and a suspension of payments, but such a positive outcome could not be guaranteed. But note that the G22 did not call for restrictions on the availability of official financing or indicate that some form of debt restructuring would always accompany the provision of official finance.
•Lending into arrears policy change by the IMF. The G22 also recommended that the IMF needed to make it clear that if country was working with its creditors in good faith and taking appropriate reforms, it would lend into arrears. The IMF subsequently amended its policy on lending into arrears to allow lending into arrears on bonded debt.
•Contagion and creation of the CCL. In the aftermath of the Russian crisis and its contagion to Brazil and other emerging markets, the G-7 leaned towards developing improved mechanisms to ward off contagion, such as the IMF’s CCL.
•The Kohln Architecture report: PSI principles, considerations and tools (“constrained discretion”). The G-7 directly took up the PSI issue in the debate on architecture in spring and summer of 1999. This was a framework of considerations, principles and tools that basically introduced a set of principles and considerations, presented a list of ways the private sector could be involved, and said that the right approach would depend on the circumstances of a given case. The official sector also made clear that it did not consider bonds to be inherently privileged relative to banks. This framework can be described as a “case by case” approach constrained by principles, considerations and tools, i.e. a “constrained discretion” approach to PSI.
The G-7 framework for PSI was partly a response to several concerns:
- concern that large bailout packages in Mexico and Asia were leading to moral hazard;
- concern that new official forms of financing such as the SRF, the CCL and the renewal of IMF quotas should be accompanied with rules restricting excessive official financing;
- concern that the application of PSI in specific case studies in Asia and afterwards did not follow clear rules and was thus a source of uncertainty and confusion for market participants.
•Paris Club comparability principle applied to sovereign bonds. In early 1999 for the first time ever, the Paris Club applied the comparability approach to sovereign bond by asking Pakistan to restructure a set of bonds that were coming due at the end of 1999 and early 2000. This case and that of Ecuador opened the issue of whether the Paris Club, the IMF and the G-7 were forcing the countries to default and restructure their bonds.
•The April 2000 operational guidelines. The G-7 attempted to give operational substance to their Kohln report principles - also taking stock of the lessons from experience of bond restructurings- in their April 2000 “operational guidelines” for PSI. The G-7 statement considered three types of cases – cases where the emphasis should be placed on catalytic official financing (Mexico), cases where official action could help overcome coordination problems (Korea, Brazil) and “restructuring cases” (Ukraine, Ecuador). It then laid out a set of guidelines for official action in such restructuring cases. Intentionally, the statement did not address the controversial issue of the right level of official financing, i.e. when exceptional financing is needed or not. Thus, the hard questions of what to do in large, systemic semi-liquidity cases were largely finessed again.
•G-7’s Central Banks support for standstills and coercive PSI. The G10 central banks have been generally more sympathetic to the idea of standstill and the necessity to limit exceptionally large official packages to limit moral hazard. The Bank of England and Bank of Canada argued in a paper that limited official financing and payments standstills might be the right approach, even in systemic liquidity cases. Support for standstills and limited official finance in crises has also been expressed by the Bank of Italy and Bundesbank in documents and official statements. Quite interestingly, central banks have expressed greater sympathy for standstills and limited official money than finance ministries and treasury departments. There may be a principal agent problem here: the closer is an agent to decisional power (as central banks in monetary policy and bank regulation) the greater its sympathy for qualified benevolent discretion and aversion to rules (thus the finance ministries preference for discretion in PSI issues). The farther is an agent away from direct decisional power (as central banks on PSI issues) the greater their sympathy for rules and aversion to discretion.
•The IMF’s attempt to frame operationally PSI guidelines. The IMF did not find the G-7 “guidelines” neither very operational nor helpful—as they clearly finessed the most difficult PSI issues, i.e. the right amount of official financing in crises and whether or not private creditors should be involved in liquidity cases. In response to the guidelines, the IMF produced two papers that provided a more precise and clear, if controversial, set of operational guidelines. The first presented an IMF’s operational “framework” which effectively reduced the possible contingencies to a two by two matrix: official finance could either be exceptional or not, and “PSI” could either by “catalytic” or “concerted.” The second paper discussed the pros and cons of standstills. The G-7 were somewhat critical of the IMF framework. The Europeans, being more wary than the US of the use of large packages, were skeptical of the IMF’s framework matrix box that allowed “exceptional access” to be combined with “catalytic” PSI in some cases. While the U.S. objected to narrowing down to a binary distinction between catalytic and concerted the wide range of possible actions that the private sector could take to contribute to crisis resolution.