The Credit Risk-Contingency System of an Asian Development Bank

Article excerpt

Introduction and summary

During the recent financial and economic crisis in Asia, financial institutions were often found wanting. There is little question that many financial institutions in Asia were mismanaged and poorly regulated prior to the onset of the crisis in the late 1990s. Yet the standards used to make such judgments have been standards appropriate for conventional banks, brought in from the outside, and applied as international best practice more or less uniformly across a variety of local and national institutions. As a result, some institutions have been closed. Alternatively, those same standards have been used to rationalize government intervention in the private sector or greater government subsidies.

Against the backdrop of the Asian financial crisis, we offer an analysis of one financial institution, a government-operated bank in Thailand, the Bank for Agriculture and Agricultural Cooperatives (BAAC). The BAAC offers an example of one of the relatively rare state-owned specialized financial institutions complying with politically mandated lending objectives without recourse to unfettered subsidies, while achieving unprecedented outreach to its target clientele of small-scale farmers. Furthermore, the BAAC has been operating an unconventional and relatively sophisticated risk-contingency system. Indeed, complementary evidence from micro data suggests that this risk-contingency system has had a beneficial impact on the semi-urban and rural Thai households that the bank serves. Unfortunately, the accounts that document the BAAC system, including newly recommended standards from the crisis, are more appropriate for a counterfactual conventional bank, a bank making relatively simple loans with provisions for nonperformance, not for the actual bank, which collects premia from the government if not the households themselves and pays indemnities to households experiencing adverse shocks.

This article ties the actual BAAC operating systems to the theory of an optimal allocation of risk bearing. We recommend accordingly a revised and more appropriate accounting of BAAC operations. That in turn would allow an evaluation of the magnitude of the government subsidy, something that could be compared with the insurance benefit the BAAC offers to Thai farmers, as derived from panel data. The bottom line, and the main policy implication of the article, is a new system for the evaluation of financial institutions, including state development banks which should not be assessed merely on their financial profitability grounds.

Specifically, we proceed as follows. First, we provide a brief review of the theory being used in this type of evaluation of financial institutions and of empirical work in developing and developed economies using that theory. Then, we provide some background information on the BAAC, in the specific context of Thailand. Next, we describe the BAAC risk-contingency system, that is, its actual operating system and how it handles farmers experiencing adverse events. Then, we elaborate via a series of examples on appropriate ways to provision against possible nonpayment, given that underlying risk. We also tie provisioning and accounting standards to the optimal allocation of risk bearing in general equilibrium, inclusive of moral hazard problems. Next, with the costs of insurance well measured, we turn to a more detailed discussion of BAAC accounts and how they might be improved, so as to measure and evaluate better the portion of the Thai government subsidy that is effectively the payment of an insurance premiu m for farmers.

We want to emphasize at the outset that our method of evaluation allows us to attach specific numbers both to the insurance benefit the BAAC may be providing to Thai farmers and to the specific value of the subsidy the government pays to the BAAC. The difference is the bottom-line assessment of the financial institution. In particular, as an illustrative example, Ueda and Townsend (2001) generalize and calibrate a model of growth in which financial institutions provide insurance against idiosyncratic risk, and they estimate the lump sum welfare losses of restrictive financial sector policies that impeded that function at an average of 7 percent of household wealth, up to 10 percent for the middle class. …