Financial crises are simply too costly for any country and the ASEAN+3 economies must make every effort to prevent them. An example that greatly resonates with the region is the Asian Financial Crisis (AFC) in late 1990s. During the AFC, ASEAN economies plunged into recessions and shrank at rates of 1 to 13 percent. Prior to the AFC, the region experienced multi-year booms of annual growth rates ranging from 5 to 8 percent.
The most important part about crisis prevention is the ability to identify potential financial risks early before they escalate into a crisis. Authorities will need to be pre-emptive and implement strategies that mitigate risks. Resources would need to be allocated and utilized more efficiently, regardless of whether it is surveillance, assessment, or mitigation of risks.
Banks occupy the center stage in discussions about financial stability, given their pivotal role in credit creation and intermediation. Past episodes, such as the Lehman Brothers triggering the Global Financial Crisis and the insolvencies of savings and loan institutions that led to the 1980s recession in the United States, highlight the importance of ensuring banking sector stability.
The occurrences of bank credit risks are indeed not random events. AMRO estimation shows that a higher leverage, i.e. the ratio of credit-to-GDP for an economy, is closely associated with the probability of financial crisis. One percentage point increase in the credit-to-GDP gap is associated with 0.45 percentage point increase in the probability of crisis in the subsequent three-year period. This aligns with the saying ‘credit booms go bust’, which also corresponds to the guidance provided by the Basel Committee on Banking Supervision. The guidance recommends the raising of countercyclical capital buffers whenever the credit-to-GDP ratio significantly exceeds its long-term trend.
Of course, it does not imply that the other indicators should be ignored. It is advisable to rely on a more comprehensive set of indicators, such as the list of Financial Soundness Indicators (FSIs) provided by the International Monetary Fund. Putting in more effort rather than less should be viewed as prudent for the monitoring and prevention of financial crisis.
Besides looking at the overall balance sheets of banks, there is a need to go deeper as the devils are often found in the details. Corporates merit close attention as they are the main borrowers of the banks. Failure to ensure prudence of the corporate sector could have far-reaching consequences. For instance, in the early 2000s, the downfall of Enron and WorldCom, due to these US giants’ fraudulent and opaque accounting practices, nearly precipitated the collapse of the telecommunications and energy sectors, which in turn created ripples in financial markets across the world.
AMRO’s studies based on machine learning exercises, find that corporate balance sheets are more important than macroeconomic factors as early warning indicators for corporates under stress. Metrics related to profitability and management (including asset and revenue turnover) are most crucial in assessing the resilience of corporate finances. The AMRO findings also show corporate liabilities as a significant predictor of corporate insolvency.
Looking at the banks of the ASEAN+3 economies, the AMRO analyses suggest increased risks for the region. Currently, the bank credit-to-GDP ratio in ASEAN+3 is high and has exhibited a steady increase over the past two decades. The corporate leverage in the region is also found to be elevated compared to global averages. Despite an improvement following the reopening of economies, bank profitability has not fully returned to pre-pandemic levels.
To reduce the likelihood of unfavorable outcomes or even crises, the best practices below should be considered and implemented.
Given the current high bank leverage, there is a need to moderate the pace of debt increase to ensure it does not grow excessively compared to the fundamentals. Amid the current environment of stronger inflationary pressures, higher interest rates imposed by central banks could curb demand, which is likely to dampen borrowings. However, prudential policies should always be the first line of defense, with regulatory oversight on banks in place, to ensure the prudent use of debt.
Fostering a conducive business environment is also critical to enhance profitability. This can be achieved by 1) streamlining regulations to reduce burden for businesses, 2) maintaining stable and non-flip-flopping macroeconomic policies to support investments, and 3) pursuing strong infrastructure developments to improve connectivity and reduce operational costs for firms.
Besides the government-led initiatives, corporates should proactively address new challenges, such as climate change, digitalization, and rapidly aging society. It is likely that firms in the same sector face a similar set of challenges and should work closely with each other on some of these issues by taking advantage of the economies of scale.
In conclusion, reducing vulnerabilities in the ASEAN+3 financial sector requires not only the cooperation of banks, but also across-the-board collaboration among government entities, the banking sector, as well as non-financial businesses. Given the widespread and long-lasting impact of financial crises, preventive measures should be promptly introduced and proactively adopted. History suggests that economies with too much leverage will find ways to deleverage themselves, sometimes abruptly through unwelcomed crises.