limit moral hazard and to maintain a level playing field, and it should be managed at arm’s length to avoid the risk of politicization of day-to-day management decisions. To ensure strong accountability, there should be transparency on the extent and cost of the public support (and of recovery), as well as a clear plan for exit.106 The arrangements should also be buttressed by ensuring that resolution regimes, funding arrangements, and contingency planning build in sufficient flexibility to enable scope for later recovery of resources from the banking industry in the event of a deficit. Improving frameworks to address troubled banks will pay dividends because greater flexibility in the crisis management policy toolkit, combined with strong contingency planning and the development of robust recovery and resolution plans for major firms, will reduce the need for additional support and minimize the costs.
Conclusion Dealing promptly and comprehensively with distressed assets and problem banks is essential for a well-functioning banking system and healthy, sustainable growth. History has shown that a strong initial response prevents problems from festering, maintains the capacity of the banking sector to finance the real economy, fosters market and public confidence, and reduces the risk that countries become trapped in an equilibrium of low growth and lackluster financial sector performance. Avoiding such a scenario should be a top priority. Replicating the full range of policies discussed in this chapter may be particularly demanding for countries that face a combination of institutional constraints and serious preexisting financial sector vulnerabilities. Under these circumstances, some sequencing of measures is likely to be necessary, while some of the more complex reforms may need to be simplified. Whatever the situation, effective resolution of the banking sector must begin with an accurate understanding of the scale of the problem. The starting point is full transparency about bank exposures to troubled assets, supported by a robust regulatory and supervisory framework so that banks properly identify NPLs and provision for credit losses. Supervisors must ensure that banks have sufficient capital buffers to support lending growth and economic recovery, while absorbing credit losses to minimize the risk that insolvency problems materialize and become a threat to financial stability. Encouraging banks to use favorable global financing conditions to strengthen capital and balance sheet resilience can support this process. Some countries, however, entered the pandemic with lax regulatory definitions and ineffectual supervision. In these countries, it is critical that regulators and supervisors do not succumb to pressures to further dilute regulatory standards and soften supervisory enforcement. Instead, they should consider reversing any recent dilution of asset classification definitions and developing and implementing a plan for gradually introducing internationally agreed-on definitions for NPLs and forborne exposures to ensure rigorous monitoring of banks’ asset quality. That effort should be buttressed by ongoing efforts to strengthen the effectiveness of supervision. Supervisors should require banks with excessive NPL exposures to adopt NPL resolution strategies and reinforce their operational readiness to resolve rising volumes of bad loans. The creation of dedicated workout units tasked with handling problematic exposures is a good starting point. Banks will also need to implement internal policies to manage and resolve NPLs and to assess the viability of distressed borrowers. The latter is vital to avoid questionable loan restructuring that delays the recognition of inevitable credit losses. At the national level, the government should coordinate the participation of public and private sector stakeholders and civil society representatives in resolving banking sector problems. Such institutional coordination would be particularly useful in jurisdictions where efforts to accelerate NPL resolution face
108 | WORLD DE VELOPMENT REPORT 2022
