Asian Journal of Research in Banking and Finance Vol. 5, No. 6, June 2015, pp. 55-74.

Asian Journal of Research in Banking and Finance

ISSN 2249-7323

www.aijsh.org

Asian Research Consortium

The Financial Crisis and Systemic Risks in Asia Pacific Banks: An Evaluation of Policy Responses Dr. Yongli Luo* *Assistant Professor, Wayland Baptist University.

Dr. Dave O. Jackson Professor of Finance at University of Texas-Pan American, USA DOI NUMBER:

10.5958/2249-7323.2015.00073.5

Abstract This paper examines the effects of the 2008 financial crisis on the Asia Pacific banking system and the policies that the local government authorities implemented in response to the crisis. We use descriptive statistics to examine capital adequacy and loan quality in the Asia Pacific banks. We show that the extent of spillover effects of the crisis on the Asia Pacific banking industry is associated with the trade-off between financial liberalization and financial stability; there is a linear relationship between foreign bank participation and cross-border loans in the Asia Pacific economies. We also conduct an event study to examine the systemic risks in the Asia Pacific banks. Particularly, we find that the CDS spread started to converge in 2009 after the implementation of stimulus packages and assertive policies in the Asia Pacific countries, implying that the policies adopted by the regional governments had at least some immediate effectiveness in helping banks decentralize the international financial shocks.

Keywords: financial crisis; bank; systemic risk; stimulus package; Asia Pacific. ________________________________________________________________________________

1. Introduction The U.S. subprime crisis has great impacts on global financial market stabilities. After several major financial institutions collapsed in 2008, significant disruptions in the flow of credit and assets losses were observed in the banking system in the U.S. and Europe. Nonetheless, the banking sectors in the Asia Pacificseem to be less affected and more immunized to the crisis; most Asia

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Luo& Jackson (2015). Asian Journal of Research in Banking and Finance, Vol. 5, No.6, pp. 55-74.

Pacific banks even maintained comfortable earnings and healthy loan qualities. Why do the banking sectors in the Asia Pacific appear to be relatively immune to the financial crisis? How do the local authorities adjust their economic policies in response to the crisis? This study attempts to answer these questions and evaluate the regional policy effectiveness. Academics generally believe that the soundness of the Asia Pacific banking system is due to several reasons. First, the conventional originate-to-hold (OTH) business model for most Asia Pacific banks determines that their primary funding source is deposits, while the U.S. and European banks depend heavily on whole funds, an originate-to-distribute (OTD) model of lending. The OTD method of mortgage lending is that the originator of a loan sells it to various third parties. It was very popular before the onset of the subprime mortgage crisis (Purnanandam, 2010). Second, compared to the real estate market in the U. S. and Europe, the mortgage backed securities (MBSs) and credit markets in most Asia Pacific economies are relatively under-developed. During the crisis, bond issuers with low ratings from the international rating agencies were almost completely shut out from the market. In 2008, sub-investment grade bond issuance was only 3% of all bonds with international ratings (Shim, 2012). Third, the Asia Pacific market is dominated by emerging economies with relatively high growth rates. In 2010, the average Gross Domestic Product (GDP) growth rate for Asia Pacific economies was 5.547 percent, and the weighted average GDP growth rate was 7.1 percent.*As most Asia Pacific economies were recovering in 2009, the average GDP growth in the region is expected to continue exceeding the average GDP growth in the rest of the world. This paper contributes to the literature in several ways. First, this paperuses the most recent data and investigates the spillover effects of the global financial crisis on the banking system in the Asia Pacific; specifically, we link the spillover effect of the major bank failures (such as Lehman Brothers) to stabilizations of regional financial markets. Second, this paper measures the systemic risks in the banking system using credit default swap (CDS) spreads and we quantitatively illustrates the potential threat and vulnerability in terms of liquidity structure in the Asia Pacific banking system. Third, we comprehensively evaluate the policies implemented by the regional government authorities during the financial crisis and provide further suggestions for bank regulation and prudential supervision. We use hand-collected data from the LEXIS-NEXIS Academic Universe to investigate the policies implemented by regional government authorities and evaluate their policy effectiveness in response to the crisis. These polices include both monetary and fiscal actions as well as several bank-specific reform policies such as deposits guarantee, liquidity support, capital injection, and credit supply. We also use descriptive statistics to analyze the bank performance and loan quality in the Asia Pacific economies. We find that after the Lehman Brothers’ bankruptcy in 2008, the foreign claims on the Asia Pacificbanks increased sharply, with international banks reducing lending activity in the region, resulting in most of the Asia Pacific banks experiencing greater difficulty in obtaining international capital. Importantly, we find that the size and mobility of

*

The average GDP growth rate is measured using constant price in national currencies of selected Asia Pacific economies including Australia, China, Hong Kong, Indonesia, India, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. 56

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international capital flows make it increasingly important to monitor the strength of financial systems; while the spillover effect of major bank failure magnifies the potential vulnerability in terms of systemic risks, liquidity structure and financial crisis contagion in the regional banking system. The analyses have important implications for bank regulation and prudential supervision in the Asia Pacific economies. The structure of this manuscript is constructed as follows: Section 2 presents an overview of the policies implemented in the Asia Pacific economies during the financial crisis. In section 3, data and methodologies are introduced. Section 4 reports the empirical results and summarizes the major findings, and section 5 concludes the paper.

2. A Brief overview of Policy responses in the Asia Pacific during the Crisis In response to the 2008 financial turmoil, the central banks and government authorities in the Asia Pacific enacted various policy measures. We conduct a wide and comprehensive search on the dataset using the LEXIS-NEXIS Academic Universe over 2007-2009. Specially, we investigate the policies implemented by regional government authorities and evaluate their policy effectiveness in response to the crisis. The major monetary policy actions in the AsiaPacific include interest rate cuts, exchange reserve reductions, foreign exchange market interventions, and domestic credit expansions. Other important policies include fiscal actions, such as a wide variety of fiscal stimulus packages, improvement of financial system liquidity, and safety net for private financial institutions. In the following sections, we attempt to examine the major monetary and fiscal policies implemented by the local government authorities in response to the financial crisis in the Asia Pacific. In general, we find that these actions have greatly mitigated the spillover effects of the major bank failures on the Asia Pacific banks. 2.1. Fiscal Policies and Stimulus Packages Since late 2008, many Asia Pacific countries have begun to conduct various forms of stimulus packages and inject liquidity into the financial systems. For instance, China implemented a stimulus plan (US$586 billion) via bank credit in 2008; Japan conducted a stimulus package (US$250 billion) in government spending, bank bailouts, tax cuts and grants to the local governments. Australia, Korea and Malaysia also implemented similar stimulus policies to encourage spending on infrastructure, public facilities and tax cuts for low-income families and small-middle enterprises (SMEs). Table 1 presents a more detailed summary of the Stimulus packages in the Asia Pacific during the crisis. In general, we find that these actions have greatly offset the spillover effects of the major bank failures on the Asia Pacific banking industry. However, such actions also bring about risks of potential asset bubbles and vulnerabilities in the financial and banking system in the Asia Pacific economies. It should be noticed that such huge stimulus packages could be undertaken because most East Asian nations run current account surpluses. During the past decades, trade surpluses have contributed to a significant buildup of foreign exchange reserves across the region. As of December, 2010, China and Japan were ranked as the largest nations in the world with foreign exchange reserves (China,US$1.9 trillion; Japan, US$996 billion) and investments in the U.S. treasury bills. However, the major concern is that these countries may be forced to abandon their 57

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stimulus plan sooner than planned to carry out a restrictive budget policy. For example, China increased interest rates twice in 2010 to cope with higher inflation rates. Korea increased the interest rate twice to 2.75% from 2% in 2009 and 2.25% in early 2010. If the government authorities withdraw their stimulus plans too soon, the forecasted economic growth rate may not be realized, since private demands in the local economies are still very weak. Moreover, public demands are usually short-term in nature and not being able to support sustainable business developments. In addition, stimulus packages will introduce long-term effects on fiscal imbalance in the Asia Pacific economies.

Table 1 Stimulus Packages in the Asia Pacific during the Crisis Country Australia

Country code AU

Announced date 1/26/2009

Size ($billion) 35.2

Size/GDP (per cent) 4.68

China

CN

11/10/2008

586

13

Hong Kong

HK

10/2/2008

2.4

5.2

India

IN

12/8/2008

4

3.5

Indonesia

ID

1/28/2009

6.32

1.4

Japan

JP

12/13/2008

250

4

Korea

KR

11/3/2008

14.64

2.14

58

Descriptions $7 billion to assist low and middle income earners. $28.2 billion for infrastructure, schools, housing and budget deficit. Low-income housing, water, electricity, rural infrastructure, health care, tax deduction in environmental protection and technological innovation. One-time tax-relief measures, loan guarantees for companies and the suspension on a wide range of government fees. Finance exports of textiles and handicrafts; value added tax rate cut. Public works spending including: housing, automobile, infrastructure, power, and SMEs. Duties reductions. Tax incentives for companies' innovational spending, reductions in fuel, electricity prices, and cost on infrastructure. Increase in government spending, financial system stabilization (bank bailout and credit crunch), tax cuts, and grants to local government. Infrastructure (including roads, schools, and hospitals; funds for SMEs, and low income families) and tax cuts. Construction industry financing.

Luo& Jackson (2015). Asian Journal of Research in Banking and Finance, Vol. 5, No.6, pp. 55-74.

2/9/2009

37.87

5.54

Malaysia

MY

11/30/2008

1.93

8.35

New Zealand

NZ

2/10/2009

2.6

4.04

Philippines

PH

1/21/2009

7.01

4.54

Singapore

SG

1/22/2009

13.7

8.78

Thailand

TH

1/29/2009

3.35

1.26

Investment in eco-friendly projects including the construction of dams; “green” transportation networks, and other public transportation systems. Infrastructure projects including roads, schools, and housing. Government budget in deficit. State housing, road and education sector projects; five new schools and five major state highway developments. More spending on infrastructure, agriculture, education, and health, cash for poor households, and tax cuts. Tax cuts; subsidies for lowincome workers; public sector hiring; social welfare, government pensioners, and students; invest in infrastructure. Cash for low earners, tax cuts, expanded free education, subsidies for transport and utilities.

Source: LEXIS-NEXIS Academic Universe and news from various issues of government press releases. The GDP values are calculated as at the end of 2008. Some announced stimulus plans may be spread over multiple years. Not including infrastructure spending plans of THB 1.43 trillion for Thailand over the 2010–2012 period.

2.2. Monetary Policies and Interest Rates Cuts Table 2 shows that reductions in policy rates and reserve requirements are substantially helpful to boost liquidity and capital adequacy in the banking system. After the Lehman Brothers’bankrupt, most Asia Pacific economies began to experience difficulties in international financing. To reduce the cost of borrowing, most central banks in the Asia Pacific announced significant policy rates drops. For instance, the policy rate in Korea was cut by 3.25%in 2009; the interest rates in Australia and India were cut by 4 % and 4.25%, respectively; the policy rate in New Zealand was reduced by 5%. Following the common monetary policies in the region, the central banks of Indonesia and the Philippines cut their policy rates about 200 base points as well. At the end of 2009, Hong Kong, Japan, and Singapore all kept zero-rate policy; the policy rates in these economies were maintained as close to zero as possible. Meanwhile, the reserve requirements for major commercial banks were significantly reduced by the central banks in the Asia Pacific. For example, the Philippines and China lowered their reserve requirements for large banks by 2%; Malaysia lowered its statutory reserve requirements by 3%; the central banks in India and Indonesia cut their reserve requirements for 59

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major financial institutions by about 4%.As a result, the local economies began to show signs of recovery in late 2009, with much faster growth rate than international average GDP growth. The injection of liquidity in the Asia Pacific banking system leads to fast growth in these economies by facilitating increased business activities and private borrowing, although the size and swiftness of the rate cuts may reflect a consideration of potential tail risks.

Table 2 Monetary Policy changes in the Asia Pacific during the Crisis Country Australia

Total -425

China

-216

Hong Kong

Changes in Policy rates specific event and date -25(04/07/2009),100(02/03/2009),100(12/02/2008),-75(11/04/2008),100(10/07/2009),-25(09/02/2008) -27(12/22/2008),108(11/26/2008),-27(10/29/2008),27(10/08/2008),-27(09/15/2008)

Changes in reserve requirement Total specific event and date n.a.

-200

n.a.

India

-425

Indonesia

-225

Japan

-40

Korea

-325

Malaysia

-150

New Zealand

-575

Philippines

-200

Singapore

n.a.

Repo: –25 (04/21/2009),–50 (03/05/2009),–100 (01/05/2009), – 100 (12/08/2008), –50 (11/03/2008),–100 (10/20/2008); Reverse repo: –25 (04/21/2009),– 50 (03/05/2009), 200(01/02/2009). –25 (07/03/2009),-25 (06/03/2009),–25 (05/05/2009),–25 (04/03/2009),–50 (03/04/2009),–50 (02/04/2009), –50 (01/07/2009), – 25 (12/04/2008), +25 (10/07/2008),+25 (09/04/2008). –20 (12/19/2008),–20 (10/31/2008) –50 (02/12/2009),–50 (01/09/2009),–100 (12/11/2008),– 25 (11/07/2008),-75(10/27/2008),– 25 (09/10/2008). –50 (02/24/2009),–75 (01/21/2009),-25(11/24/2008). –50 (04/30/2009),–50 (03/12/2009),–150 (01/29/2009),– 150 (12/04/2008), –100 (10/23/2008), –50 (09/11/2008),– 25 (07/25/2008). –25(07/09/2009),–25 (05/28/2009),–25 (04/16/2009),–25 (03/05/2009),–50 (01/29/2009), – 50 (12/18/2008) n.a.

60

-400

-158

For large banks: -50(12/22/2008),100(11/26/2008), -50(10/08/2008); For other banks: -50(12/22/2008),200(11/26/2008), 50(10/08/2008);-100(09/15/2008). -100(12/17/2008),50(10/30/2008),-150(10/09/2008). –50 (01/17/2009),–50 (11/03/2008), –50(10/25/2008),– 250 (10/24/2008).

-158(10/09/2008)

n.a. n.a.

-300

–100 (02/24/2009),– 150(01/21/2009),–50 (11/24/2008). SRR adjusted to 1% effective 1 March 2009 n.a.

-200

-200(11/14/2008)

The SGD shifted to a modest and gradual appreciation currency

Luo& Jackson (2015). Asian Journal of Research in Banking and Finance, Vol. 5, No.6, pp. 55-74.

Thailand

-250

–25(04/08/2009),–50 (02/25/2009),–75 (01/14/2009),– 100 (12/03/2008).

stance within the target band (10/10/2008). n.a.

Source: LEXIS-NEXIS Academic Universe and news from various issues of government press releases. Values are expressed as basis points and the event dates are presented in parentheses. “n.a” denotes unavailable data.

2.3. Banking Reforms and Credit Market Restructuring Policies Other policy changes duringthe crisis in the Asia Pacific include comprehensive banking reforms and credit-market restructurings. The developments of structured credit markets in the Asia Pacific were far behind their counterparts in the U.S. and Europe. When the financial turmoil started, most Asia Pacific banks were not engaged in asset securitizations and the collapse of the U.S. credit market did not have a significant impact on their balance sheets. For those more structured credit markets, such as Australia and Japan, the impact is greater; forthe rest of other Asia Pacific economies, the structured credit markets began to develop as a way to match local investors’ preference for highly-rated debt with local issuers’ average credit quality (Remolona and Shim, 2008), therefore, the creditworthiness of the financial markets was not severely affected, since the MBSsare mainly dominated by prime mortgages with better quality assets. In other words, most banks in the Asia Pacific were not under the threat of structured products held by their counterparts in the U.S. and Europe. Since the MBS and credit markets in the Asia Pacific are less developed, local investment banks began to put continuous pressure on domestic currency prices through asset sales after the Leman Brothers’ bankruptcy. As regional currency liquidity pressures spread to domestic financial markets, almost all the Asia Pacific governments took various measures to support the provisions of credit market restructuring. These measures include domestic currency liquidity support, depositary guarantees, and asset purchases. Most importantly, the central banks injected capital into the banking systems and made rules to restrict short sales and provide debt insurances. For example, to eliminate financial distress in the banking system, the central banks in Australia and New Zealand offer guarantees on nondepository wholesale liabilities and provide grace periods to extend the maturity of borrowing from the central banks. Capital injection into financial institutions was also widely used by other Asia Pacific central banks. For example, the practices on the recapitalization of state-owned banks were widely accepted by the governments in Australia, Hong Kong, India, Indonesia, and New Zealand (Ma, 2007). As a lender of last resort, the central banks of both Hong Kong and Malaysia introduced credit guarantee schemes for SMEs during the crisis, while the Korean central banks expanded the provisions of credit guarantees to SMEs through government agencies. Moreover, many central banks in the Asia Pacific broadened the eligibility of collaterals for their lending activities, enhancing the ability of local banks to increase currency liquidity for their fund needs. For example, many central banks in the Asia Pacific took various measures including purchase of assets and suspension of mark-to-market accounting rules. Contrary to the market value method, fair value approach allows for reclassification of assets held at fair value into amortized costs, resulting in substantial changes in estimations of prior incurred losses. In 61

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September 2008, the International Accounting Standards Board (IASB) relaxed mark-to-market rules for transactions in distressed markets in order to mitigate the impact of the crisis on bank statements. Under this framework, fair value is used as the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. When the bond markets collapsed in Indonesia and the Philippines, both countries modified their accounting rules to comply with the new regulations.

Table 3: Time Table of Banking reforms and Credit Markets Restructuring The table reports the timing of the introduction of the major instruments taken against credit booms and major measures in banking reforms in the AsiaPacific before and after the crisis. LVR = loanto-value ratio; Capital = capital requirements; Provision = loan provisioning rules; Credit limit = limit on credit growth; Lending criteria = limits on debt repayment-to-income, debt repayment-todebt or credit line to- income ratio; Exposure limit = credit exposure to a sector. The years indicated refer to the timing of the introduction of the measure. A year after a dash refers to the timing of the lifting or relaxing of the measure. Data Source: The International Monetary Fund (IMF) and the Bank for International Settlements (BIS). Monetary instruments Credit Reserve limit requirement

China Hong Kong

India

2003, 2004, 2006-08 1994

2003

LVR 2001, 2005, 2006 1991, 1997

2006

Malaysia Thailand

1994-98

2003, 200608 199598 2003

Lending criteria

2004 1994-98 2005, 2008, 2009

2004, 2006, 2007-08

Korea

Prudential instruments Exposure Capital Provision limit

2005, 2006, 2007

2006

2007

2006 2005

1997-98

1995 2004-05

In summary, we conduct a wide and comprehensive search on the major policies that were implemented by the local government authorities in response to the financial crisis in the Asia Pacific. Typically, these measures help mitigate financial distress during the time of financial crisis, particularly in the banking sector. These policy measures are mainly designed to achieve the following goals: (1) mitigate spillovers to the financial sector and stabilize regional financial markets; (2) provide sufficient liquidity and solvency assistance to regional financial institutions; (3) restructure bad loans and reevaluate distressed assets to stabilize the regional financial system; (4) abandon traditional accounting rules and apply fair market approaches in risk management; (5) undertake credit easing to avoid future economic recession(Shim and Von Peter, 2007).

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3. Data and Methodologies 3.1.Data We collect data from three major sources: the LEXIS-NEXIS Academic Universe, the World Development Indicators (WDI) database, and various issues of the Bank of International Settlement (BIS) reports. The policies in response to the financial crisis are drawn from the LEXIS-NEXIS Academic Universe. The events date is determined using the official announcement date published either by the central banks or the government authorities. If the official announcement date is not available, we use the first publication date of the event in the newspaper. We also conduct a wide range of Google search for similar news using keywords, such as “ monetary policies, fiscal policies, stimulus packages, bank reforms, credit markets” for a specific country from various issues of international press releases. We collect more than 2000 relevant information and read through all the events for accuracy. The selected countries or regional authorities are coded as follows: AU=Australia; CH=China; HK=Hong Kong SAR, China; IN=India; ID=Indonesia; JP=Japan; KR=South Korea; MY=Malaysia; NZ=New Zealand; PH= the Philippines; SG=Singapore; and TH=Thailand. To examine the bank performance and resilience for each country, we use the ratio of bank capital to assets, a measure of bank solvency and resiliency, to show the extent to which banks can deal with unexpected losses. We also use the ratio of bank nonperforming loans to total gross loans to measure bank health and efficiency and identify problems with asset quality in the loan portfolio. The yearly data for the aforementioned ratios are retrieved from the WDI database available at the World Bank official website. Other data on lending activities and cross-border loans in the Asia Pacific were collected from various issues of the BIS reports. 3.2. Methodology We first use descriptive statistics to analyze the bank performance and loan quality in the Asia Pacific economies. We use both the capital adequacy ratio and the non-performing loan ratio as proxies for bank performance and efficiency. Specifically, we define the capital adequacy ratio as the total market value of bank capital and reserves divided by total bank assets at the end of each year. Capital includes tier 1 capital (paid-up shares and common stock) and total regulatory capital. Total bank assets include all the assets used for both financial and nonfinancial purpose. We define the non-performing loan ratio as the bank’s value of nonperforming loans (also called gross value of the loan in each bank’s balance sheet) divided by the total value of the loan portfolio at the end of each year. Particularly, we focus on how the aforementioned ratios changed during and after the financial crisis. We also use ordinary least square (OLS) regression to detect whether there is a linear relationship between foreign bank participation and cross-border loans for each economy in the Asia Pacific. Since the international banks began to reduce lending activity in the Asia Pacific after the crisis, we measure the local claims by bank liquid reserve to bank assets ratio, and the foreign claims by international financing ratio. The data are incomplete for all the selected countries; they are only available for Indonesia, Japan, Malaysia, the Philippines, and Thailand. Specifically, the liquid reserve ratio is defined as the year-end total bank liquidity as a percentage of total bank 63

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assets (%). The international financing ratio is defined as the year-end gross inflow via international capital market as a percentage of national GDP (%). Most importantly, we conduct an event-study to examine the systemic risks in the Asia Pacific banking system. Following the methodology of King (2009), we calculate the “Implied” probabilities of defaults (PDs) from the U.S. dollar-denominated CDS spreads, and compare them with the “Actual” PDs, which are calculated using Moody’s KMV method. The event period is a period 20 days prior to and 20 days after the announcement date. Examining the relationship between a bank’s CDS spread and a market benchmark would help us draw conclusions on policy effectiveness.

4. Empirical Results 4.1. Capital Adequacy and Non-performing loan of the Asia Pacific Banks Table 4 reports the capital adequacy ratio and the non-performing loan ratio in the Asia Pacific banking industry over year 2001-2010. The ratio of bank capital to assets, a measure of bank solvency and resiliency, shows the extent to which banks can deal with unexpected losses. Panel A of table 4 shows that the capital adequacy ratio for Hong Kong, India, and Philippines are all over 10% over the past several years, and several other economies such as Indonesia, Korean, Singapore, and Thailand also maintain a high level of capital adequacy with ratios close to 10%. For the top three large economies--China, Japan and Australia, the banking capital adequacy ratios are relatively lower, but they are all greater than 5% in most years. On average, the capital adequacy ratios for Asia Pacific banks are relatively higher than those of their counterparts in the U.S. and Europe. Therefore, we can conclude that, prior to the financial crisis, the Asia Pacific banks were quite resilient relative to their counterparts in the U.S. and Europe. The implication is that robust financial systems can increase economic activity and welfare, but instability can disrupt financial activity and impose widespread costs on the economy. Panel B of table 4 reports the ratio of bank nonperforming loans to total gross loans ofthe Asia Pacific banks over 2001-2010. The value of nonperforming loans (gross value of the loan as recorded on the balance sheet) divided by the total value of the loan portfolio (including nonperforming loans before the deduction of loan loss provisions) is a measure of bank health and efficiency. International guidelines recommend that loans be classified as nonperforming when payments of principal and interest are 90 days or more past due or when future payments are not expected to be received in full, thus the bank nonperforming loan ratio is an indicator to identify problems with asset quality in the loan portfolio; thus, a high bank nonperforming loan ratio may signal deterioration of the credit portfolio. It shows that most AsiaPacific economies have relatively low nonperforming loan ratio during the financial crisis, except for Malaysia and Thailand. Especially, the non-performing ratio recorded a significant drop in China and India when the financial crisis occurred in 2008. One contributing reason is that most Asia Pacific banks rarely use investments such as derivatives and sophisticated financial instruments. Another reason might be that most Asia Pacific banks use conventional OTH model, which implies that the risk management and supervisory schemes in the Asia Pacific banks enable to keep pace with business practices. On the other hand, the U.S. and European banks depend heavily on wholesale funding, and their OTD

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business model is often associated with distortions in incentives and financial vulnerabilities (Knight, 2008).

Table 4: Capital Adequacy and Nonperforming Loan of the Asia Pacific Banks Country 2001 2002 2003 2004 2005 2006 2007 Panel A: Bank Solvency--Bank capital to assets ratio (%) 7.1 5.3 5.2 5.1 5.2 5.2 5 AU 4.1 4.1 3.8 4 4.4 5.1 5.7 CH 9.8 10.1 10.6 10.8 13.3 13 10.4 HK 5.3 5.5 5.7 5.9 6.4 6.6 6.4 IN 5.2 8.8 10.4 10 9.8 10.1 9.2 ID 3.9 3.3 3.9 4.2 4.9 5.3 5.3 JP 4.9 7.2 7 8 9.3 7.38 8.23 KR 8.3 8.7 8.5 8.2 7.7 7.6 7.4 MY 13.6 13.4 13.1 12.6 12 11.7 11.7 PH 7.4 10.7 10.7 9.6 9.6 9.6 9.2 SG 8.9 6.1 7.4 8 8.9 9.2 9.8 TH Panel B: Bank Efficiency--Bank nonperforming loans to total gross loans 0.6 0.4 0.3 0.2 0.2 0.6 0.6 AU 29.8 26 20.4 13.2 8.6 7.1 6.2 CH 6.5 5 3.9 2.3 1.4 1.1 0.8 HK 11.4 10.4 8.8 7.2 5.2 3.3 2.7 IN 31.9 24 6.8 4.5 7.4 6.1 4 ID 8.4 7.4 5.2 2.9 1.8 1.5 1.5 JP 3.4 2.4 2.6 1.9 1.2 0.8 0.7 KR 17.8 15.9 13.9 11.7 9.6 8.5 6.5 MY 27.7 26.5 16.1 14.4 10 7.5 5.8 PH 8 7.7 6.7 5 3.8 2.8 1.5 SG 11.5 15.7 13.5 11.9 9.1 8.1 7.9 TH

2008

2009

2010

5.4 6 11.2 7.3 9.1 4.5 6.3 8.1 10.6 7.2 10.1

5.7 5.6 12.9 7 10.1 3.6 7.3 9 9.5 9.2 11

5.7 6.1 12.3 7.1 10.7 4.7 7.5 9.4 10.2 9 11.3

1.3 2.4 1.2 2.4 3.2 1.4 1.1 4.8 4.5 1.4 5.7

2 1.6 1.6 2.4 3.3 1.6 1.2 3.6 3.5 2 5.3

2.2 1.1 0.8 2.5 2.5 2.5 1.9 3.4 3.4 1.4 3.9

The table reports the capital adequacy ratio and non-performing loan ratio of theAsia Pacificbanking sector over 2001-2010. The capital adequacy ratio is defined as the total bank capital and reserves divided by total bank assets at the end of the year. The non-performing loan ratio is defined as the year-end bank value of nonperforming loans divided by the total value of the loan portfolio. The country codes are as follows: AU=Australia; CH=China; HK=Hong Kong SAR, China; IN=India; ID=Indonesia; JP=Japan; KR=Korea, Rep.; MY=Malaysia; PH=Philippines; SG=Singapore TH=Thailand. The missing values are computed using three years moving average. Data Source: World Development Indicators of the World Bank.

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4.2. Retreat of Foreign Banks from the Asia Pacific after Major Bank Failures The size and mobility of international capital flows make it increasingly important to monitor the strength of financial systems. After the Lehman Brothers’ bankruptcy, international banks began to reduce lending activity in the Asia Pacific, and most AsiaPacific banks immediately experience difficulties in obtaining international capital. According to the BIS statistics, foreign claims by banks from major industrialized economies to non-Japan Asia fell dramatically in the second half of 2008. In the fourth quarter, foreign claims on emerging Asia dropped by 12% to US$870 billion. The retreat of foreign banks from the Asia Pacific forces all banks in the region to face intensifying pressure, with such pressures not only due to the deteriorating performance of the real economy but also due to a general loss of confidence and potential risk aversion in financial markets. Table 5 reports the local claims changes as well as the foreign claims changes over 20012010. The local claims are reflected by bank liquid reserve to bank assets ratioin Panel A of Table 5. It shows that local claims are relatively stable recording only marginal changes during the financial crisis. However, the foreign claims have increased significantly since 2008. In Panel B of Table 5, it shows that the international financing ratios for most Asia Pacific economies have substantial declined after the crisis. For example, the capital inflows into Malaysia have dropped 5.55% from 2007 to 2008, and the Philippines’ capital inflows dropped have 4.64% over the same time period. In sum, almost all the Asia Pacific economies have experienced reductions in capital inflows during the crisis. Starting from early 2000, international claims on the Asia Pacific countries began to increase steadily and reacheda peak just prior to the onset of the 2008global crisis. Specially, the short-term shares of claims reached at almost 60% in early 2005 with a subsequent rise in early 2008; while after 2008, such claims dropped sharply and then plummeted in 2009. Compared to the normal years prior to the crisis, real domestic credit growth slowed substantially in Australia, Hong Kong, India, Indonesia, Korea, New Zealand, and Singapore, while stronger credit growth was observed in Malaysia, the Philippines, and Thailand. In sum, the major bank failures in the U.S. have significant spillover effects on the Asia Pacific capital markets and bank asset liquidities, resulting in substantial drops in international financing activities.

Table 5: Liquid Reserve and International Financing of the AsiaPacific Banks The table reports the bank liquid reserves to bank assets ratio and the bank financing via international capital markets for major Asia Pacific countries over the period 2001-2010. The liquid reserve ratio is defined as the year-end total bank liquidity as a percentage of total bank assets (%). The international financing ratio is defined as the year-end gross inflow via international capital market as a percentage of national GDP (%). The country codes are expressed as follows: AU=Australia; CH=China; HK=Hong Kong SAR, China; IN=India; ID=Indonesia; JP=Japan; KR=Korea, Rep.; MY=Malaysia; PH=Philippines; SG=Singapore TH=Thailand. Values are expressed as %. Data Source: World Development Indicators Database of the World Bank.

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Country 2001 2002 2003 2004 2005 2006 2007 Panel A: Local claims--Bank liquid reserves to bank assets ratio 0.35 0.37 0.40 0.36 0.29 0.39 0.40 ID 0.02 0.03 0.04 0.04 0.04 0.02 0.02 JP 0.12 0.15 0.19 0.23 0.26 0.30 0.29 MY 0.11 0.11 0.10 0.09 0.12 0.24 0.27 PH 0.07 0.06 0.09 0.09 0.09 0.11 0.12 TH Panel B: Foreign claims--Financing via international capital markets 0.48 0.53 0.63 1.30 1.81 2.30 2.08 CH 0.31 0.58 2.00 1.86 2.28 2.37 2.15 ID 0.53 0.25 0.62 1.73 1.84 3.03 4.14 IN 5.90 9.28 5.43 8.21 4.66 5.89 7.77 MY 3.59 7.54 7.72 6.87 7.52 8.33 6.08 PH 0.35 0.88 2.22 1.85 2.69 2.55 0.83 TH

2008

2009

2010

0.24 0.02 0.26 0.24 0.18

0.31 0.03 0.23 0.25 0.22

0.31 0.03 0.21 0.35 0.23

0.48 3.10 2.10 5.78 4.33 0.51

1.04 2.35 1.59 2.22 1.59 0.26

0.87 2.13 1.53 3.27 3.37 1.13

4.3. Foreign Bank participation and Cross-border Loans in the Asia Pacific We also illustrate that there is an explicit linear relationship between foreign bank participation and cross-border loans in each of the Asia Pacific economies in 2008. The estimated results can be expressed by the following equation: Yi=5.254+1.1586Xi

(1)

whereYi is the rate of foreign bank participation, and X i is the percent change in crossborder loans. We depict such a linear relationship in Figure 1. It illustrates that the declines in crossborder loans are remarkably significant after the crisis. The highest percentage change in crossborder loans occurs in China, dropping more than 25% in the fourth quarter relative to the third quarter in 2008.The exception of China suggests that the capital inflows are more affected by the global capital markets when their foreign-bank participation rate is low. In the last quarter of 2008, the share of foreign-owned banks’ total assets in the Chinese banking system was only 1.6%. The results are consistent with the BIS reports that the foreign-bank participation rate in China was relatively low. However, for other countries with a higher share of foreign bank participation, such as Hong Kong and Singapore, cross border loans were less affected by the crisis, dropping only about 5%.A possible reason is these economies are generally more developed and integrated with the global economies, and thus are more immunized to the crisis. Our conclusion is that the extent of spillover effects of the international crisis on the Asia Pacific banking industry is associated with the trade-off between financial liberalization and financial stability in a specific economy.

Figure 1: Foreign Bank participation and Cross-border Loans in the Asia Pacific The figure depicts the linear relationship between foreign bank participation rates and changes in cross-border loans for each country in the Asia Pacific in 2008. The selected countries are coded as follows: AU=Australia; CH=China; HK=Hong Kong SAR, China; IN=India; ID=Indonesia;

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JP=Japan; KR=Korea, Rep.; MY=Malaysia; PH=Philippines; SG=Singapore TH=Thailand; TW=Chinese Taipei. The values are expressed in percent.

90 HK

Foreign bank participation

80 70 SG

60

y = 1.158x + 50.25 R² = 0.165

50 40

MY

ID

30 KR

20

IN

TH

10 CN

0 -30

-25

-20

-15

-10

-5

0

5

Change in cross-border loans 4.4. Systemic Risks in the Asia Pacific Banking System To measure the systemic risks, we use a sample of 23 major banks in China, Hong Kong, India, Indonesia, Korea, Malaysia, Singapore, and Thailand. Follwoing Tarashev and Zhu (2008), we calculate the “Implied” probabilities of default (PDs) from the U.S. dollar-denominated CDS spreads, also known as the risk-neutral default rates. We also calculate the the “Actual” PDs using Moody’s KMV method, an estimate of actual one-year default rates for each individual bank. Because the default risk premium is incorporated, the implied PDs are typically higher than the actual PDs. We use forward-looking measures to estimate both PDs. The specific model specification can be described as follows. Firstly, we assume that the market value of a firm’s assets is A, and the total liabilities of the firm is D. As suggested by Merton (1974), we can construct a call option on the firm’s total assets with a strike price equal to the total liabilities. If at the maturity date when the firm’s liabilities expire, the market value of the firm’s assets A is greater than the value of its debt D (A>D), the shareholders of the firm will exercise the call option. For example, the shareholders repurchase the company’s assets to pay off the debt. However, if at the maturity date, the market value of the firm’s assets is less than the value of its debt (A
Luo& Jackson (2015). Asian Journal of Research in Banking and Finance, Vol. 5, No.6, pp. 55-74.

expiration of the call equal to the probability that the option will not be exercised. Assume that the maturity date of the firm’s pure discount debt is one year, the market value of the call optionis the firm’s value of assetsA and σAis the volatility of the firm’s assets. If the firm’s liabilitiesD have to be repaid at a given time of period, the firm’s Distance to Default(DD) can be expressed as follows in Equation (2):

DD 

A D A * 

(2)

The DD can be transferred into the “actual” PD through KMV estimates. Since the KMV’s default rates are often denoted as expected default frequency (Dwyer et al., 2004), the KMV estimates can simply convert DD into a probability to default using the historical default experience, assuming that the firm’s assets values are normally distributed. †Further we calculate the “Implied” probabilities of defaults (PDs) from the U.S. dollar-denominated CDS spreads.Therefore, the systemic risks can be observed through the gap between “Implied” PDs and “Actual” PDs. Figure 2 plots the weighted averages of individual banks’ PDs over the entire sample period. It shows that gap between “Implied” PDs and the “Actual” PDs began to increase in the middle of 2007 with a slight drop in early 2008, and then peaks up in the 3rd quarter of 2008, suggesting that the potential risk rises in the Asia Pacific after the major bank failures occurred in the U.S. and Europe. In general, we find that the systemic risks in the Asia Pacific banks have increased remarkably since the major bank failures occurred in 2008 (Filardo et al., 2010). However, with the implementation of stimulus packages and assertive policies in the Asia Pacific countries, the spread started to converge in 2009. The gap became narrower from early 2009, implying that the policies adopted by the regional governments had at least some immediate effectiveness in helping banks decentralize the international financial shocks.

Figure 2: Systemic Risks in the Asia Pacific Banking System The figure plots the weighted averages of individual banks’ probabilities of default (PD) during the financial crisis period 2007-2009 for the major banks in China, Hong Kong, India, Indonesia, Korea, Malaysia, Singapore and Thailand. The “Implied” probability of default (PD) is calculated from the U.S. dollar denominated Credit Default Swap (CDS) spreads by using the method of Tarashev and Zhu (2008). The “Real” PD isestimated by using Moody’s KMV method.

†

Merton (1974) assumes that the firm’s asset values may be log-normally distributed rather normally distributed as suggested by the KMV method. An alternative approach to convert DD into PD is proprietary structural model. 69

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8

Possibility of default (%)

7 6

Implied PD Real PD

5 4 3 2 1 0

4.5. The Impact of Deposit and Debt Guarantee Announcements on CDS Spreads To evaluate the effectiveness of the major policies implemented in the Asia Pacific economies, we conduct an event-study methodology to examine the relationship between a bank’s CDS spread and a market benchmark over the sample period 20 days prior to and 20 days after the announcement date of guarantee measures. Following King (2009), we use the iTraxx index as the market benchmark and use the historical relationship between an individual bank’s CDS spread and a corresponding CDS index to calculate the CDS spreads. We extract the abnormal changes in the CDS spreads of individual banks using a sample period of one year up to the bankruptcy of Lehman Brothers. Figure 3 shows the cumulative average abnormal changes in CDS spreads. The time period is calculated for the 20 trading days preceding and following the announcement date of guarantee measures. We focus on five Asia Pacific economies including Australia, Hong Kong, Korea, Singapore and Thailand. Noticed that Australia did not have any formal deposit insurance system until a blanket deposit protection system is introduced in October 2008, we use the announcement date of the blanket guarantee on deposits for Australia, since the debt issuance guarantee was introduced in Australia on the same day. We can see that the CDS spreads for major banks dropped substantially and stayed low after the announcement of deposit and debt issuance guarantees in Australia. In contrast, Hong Kong, Thailand, and Singapore already had a partial deposit guarantee scheme before they introduced a temporary blanket guarantee. Figure 3 shows that in Hong Kong, Singapore, and Thailand, the announcement appeared to be less effective after adjusting for the movement of their banks’ CDS spreads explained by the bench mark. Korea, on the other hand, has only debt issuance guarantee, and has increased the protection limit substantially, but not to the point of issuing a blanket guarantee. Thus, in Korea, we can see that the CDS spreads widened prior to the announcement date, and there is a big drop in about 10 days after the event date. The results suggest that the CDS spreads for major banks in the region have increased after September 2008. The abnormal returns in CDS spreads were largely drivenby the 70

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demand for higher compensation for bearing the default risk premium and for facing liquidity risk premium (Huang et al. 2009, 2010; Kim et al., 2009), and the market confidence weakens as it relates to the strength of Asia Pacific banks (Filardo et al., 2010).

Figure 3: The Impact of Deposit and Debt Guarantee Announcements on CDS Spreads The figure plots the bank Credit Default Swap (CDS) spread changes 20 days prior to and 20days after the announcements of deposit and debt guarantee in Australia (AU), Singapore(SG), Korea(KR), Hong Kong (HK), and Thailand (TH) during the financial crisis period. “t-0” is the announcement date. The numbers on the y-axis represent the cumulative abnormal changes in bank’s CDS spreads. Values are expressed in basis points. 250

TH AU SG KR HK

200 150 100 50 0 -50 -100

-150

5. Conclusions The 2008 financial crisis has highlighted the importance of the government’s capacity to provide assistance to financial institution. Given that the banking sector in the Asia Pacific is relatively sound and resilient, it is important to investigate whether necessary guarantees should be provided by the government authorities to financial institutions. One way to look at the impact of the expansion of deposit and debt issuance guarantees is to examine the reaction of banks’ CDS spreads to the announcement of implementation of these measures. Following King (2009), we conduct an event-study methodology to examine the relationship between a bank’s CDS spread and a market benchmark over the sample period 20 days prior to and 20 days after the announcement date of guarantee measures. In general, we find that the measures in the form of enhanced deposit protection schemes and debt guarantees by the authorities in the Asia Pacific have greatly enhanced

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the ability of the regional banks to deal with the financial crisis. However, these measures have been generally short-term in nature and domestic in orientation. When the retreat of foreign banks from the Asia Pacific occurs, it implies that the role of foreign banks will decline and domestic banks are expected to expand their presence in the region, partially replacing the market share of large international banks. Thus, it is important to recognize the potential home-host issues related to regulation and safety net provisions. Meanwhile, the potential possibility of regional financial institutions to grow into large and complex financial institutions is simultaneously increased; this requires close monitoring of systemic risks in the banking system. Particularly, in the context of financial innovation and securitization, the banking sector in the Asia Pacific should maintain and ensure adequate levels of risk management. The authors suggest that, to maintain confidence in the banking system, implementation of Basel II and maintenance of adequate capital buffers for banks should remain a priority. The financial crisis has clearly illustrated that Basel II is more than a set of rules or quantitative measures; rather, it is a process that ensures capital adequacy with respect to an institution’s overall risk profile (Borio and Zhu, 2008). The extent of spillover effects of the international crisis on the Asia Pacific banking industry is associated with the trade-off between financial liberalization and financial stability. Although there is no consensus regarding the benefits of deregulating financial markets and capital account liberalization, it can be costly to balance this trade-off in terms of increased susceptibility to external financial crises. In 2008, the Financial Stability Forum (FSF) called for coordination between the actions of national and international bodies aimed at strengthening financial systems by increasing prudential oversight of capital, liquidity, and risk management as well as developing robust arrangements for dealing with stresses in the financial system. In April 2009, the Financial Stability Board (FSB) issued further recommendations, guidelines and principles in the areas of reducing pro-cyclicality, modifying compensation systems at financial institutions to prevent excessive risk-taking and enhancing cross-border crisis management. Therefore, it is important to combine financial liberalization process with appropriate framework of sound financial regulation, prudential buffers and internal transparency measures. Although the Asia Pacific authorities have implemented some measures to meet macro- and micro-prudential supervision, the authorities will need to devote further resources and expertise to fully develop suitable tools to address systemic vulnerabilities arising from excess liquidity, leverage, risk-taking, and systemic concentrations across the financial system.

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