Dealing with bank distress: Insights from a comprehensive database

Summary

Focus

Bank distress episodes tend to be followed by recessions, whose severity varies significantly across episodes. There are two interrelated sets of explanations for such variation. One relates to the initial economic conditions, notably the macro-financial imbalances with which countries enter distress. Another relates to the policies deployed. These choices probably influence the severity of the recession. Yet we know little about the effectiveness of the various policies.

Contribution

We present a new database that tracks policy interventions (such as central bank lending, asset purchases, bank liability guarantees and impaired asset segregation schemes) in 29 countries between 1980 and 2016. We then propose a methodology to classify and compare bank distress episodes based on their initial macro-financial conditions. Finally, we assess whether differences in policies can explain the observed variations in GDP growth across comparable episodes.

Findings

Policy interventions help restore GDP growth and normalise the economy when bank distress follows a period of high cross-border exposures. Central bank lending and asset purchase schemes are effective in the first and second years of distress, respectively, and when bank distress follows low asset valuations, high bank leverage and weak bank performance. Overall, our results suggest that swift and broad-ranging policies can lessen the adverse economic effect of bank distress.

Abstract

We study the effectiveness of policy tools that deal with bank distress (i.e. central bank lending, asset purchases, bank liability guarantees, impaired asset segregation schemes). We present and draw on a novel database that tracks the use of such tools in 29 countries between 1980 and 2016. To keep "all else" equal, we test whether different policies explain differences in how countries fared through bank distress episodes that feature observationally similar initial macro–financial vulnerabilities. We find that, altogether, policy interventions help restore GDP growth and normalize the economy when bank distress follows a period of high cross–border exposures. Central bank lending and asset purchase schemes are especially effective in the first and second years of distress, respectively, and when bank distress follows low asset valuations, high bank leverage and weak bank performance. Overall, our results suggest that swift and broad–ranging policies can mitigate the adverse economic effects of bank distress.

JEL Codes: G01, G38, E60

Keywords: bank distress, distress mitigation policy