ECONOMICS OF FINANCIAL INSTITUTIONS (ECON 3011) UNIT 7 PRESENTATION (Financial Crises)

Introduction In this final Presentation, we examine more closely the matter of financial crises, mainly in relation to the banking sector, which has been the origin of most financial crisis in the last few decades. We recall the matter of regulation and supervision in the previous Presentation. We said then that the majority of modern-day financial crises have been synonymous with the collapse of major banks somewhere across the globe. Countries that are predominantly bank-based are therefore the main victims of bank failures. We also supported this statement by citing statistics from the research of Caprio and Klingebiel (99/03) and Lindgren et al (1996). According to Caprio and Klingebiel (99/03), there were 117 systemic banking crises in 93 countries since the 1970s. Using a less strict definition of a crisis, Lindgren et al (1996) reportedly found that 75% of IMF countries had serious banking problems during the period (1980-1995), with 87 countries experiencing a currency crisis between 1975 and 1995. Here we examine the anatomy of banking crises by addressing the issue of common fundamentals of banking crises. We also explore the cost/consequences of such crises and, of course, review the various policy responses suggested by academic and practicing Economists in dealing with banking crises. Presentation Objectives By the end of this presentation, you should be able to: Explain the main manifestations of financial crises Survey with greater ease the technical literature on financial/banking crises Understand the main causes and key features of financial/banking crises Identify the main repercussion of financial/banking crises

Financial Crises: A General Perspective Financial crises are normally manifested in the following two forms:

Currency Crises: (Balance of Payments or BoP Crises) e.g. Asia 1997-1998. These normally involve an attack on the exchange rate of a currency, which then leads to a devaluation or a sharp depreciation of that currency; and Banking Crises: These normally occur because actual or potential bank runs or failures induce banks to suspend the internal convertibility of their liabilities or require Government intervention.

However, the term financial crisis has also been used to refer to debt crises (sovereign defaults), bursting of asset bubbles or wider economic crises. Definition(s) Popular definitions of a financial crisis include: i. A sudden wide-scale drop in the value of financial assets or in the financial institutions managing of those assets (and often in both); and ii. A disturbance to financial markets that disrupts the markets capacity to allocate capital. The literature also distinguishes between a financial crisis and financial distress. For instance, Carstens et al (2004) in Avoiding Banking Crises in Latin America, defines a banking crisis as a situation in which much or all of bank capital is exhausted and runs on deposits usually occur. However, their definition of financial distress is less severe in that systemic bank runs are not a usual occurrence but assets have low or negative net worth. What are the Main Causes? The literature describes several causes and origins of financial/banking crises. These include: 1. Carstens et al (2004): Avoiding Banking Crises in Latin America

According to them, the main causes of banking crises in Latin America since 1994 were: Credit boom Wholesale financial liberalisation Direct effects of fiscal difficulties in the banking system Contagion and spill-overs from other countries

Terms-of-trade (ToT) shocks (Px/Pm) x100 where Px is export price and Pm is import price. If Px > Pm, then ToT is favourable. The reverse implies a ToT deterioration or simply an unfavourable ToT.

Political instability

And these were exacerbated by: 2. Ineffective and inappropriate prudential regulation policy induced distortions Inefficacy of bank intervention and resolution Poor structure and composition of government finances Inadequate accounting practice, poor property rights and governance Inefficiencies in the judicial system and poor observation and enforcement of laws

Kaminsky and Reinhardt (2000): The Twin Crises: The Causes of Banking and BoP Problems After studying 76 currency crises and 26 banking crises, the authors made the following observations: Problems in the banking sector precede a currency crisis, which then deepens the banking crisis activating a vicious spiral; Financial liberalisation often precedes banking crises Crises occur as economies enter a recession following a booming economy fueled by credit expansion, capital inflows and accompanied by an overvalued currency International Monetary Fund (IMF) 1998 The IMF argued that the causes may be grouped under the following headings (not mutually exclusive): i. Unsustainable macro-economic policies e.g. excessive debt accumulation and overly expansive monetary and fiscal policies Weaknesses in the financial structure Global financial conditions iv. Exchange rate misalignments

3.

ii. iii.

v. 4.

Political instability Inter-American Development Bank (IADB) The IADB groups the determinants into two broad categories: i. ii. Adverse s4election and moral hazard factors Liquidity factors

Reference is also made to terms-of-trade shocks 5. Demirgc-Kunt and Detrigiache (1998): Banking Crises in Developed and Developing Countries

Based on their research for the period 1980-1994, the authors identified the following causes: 6. Weak macro-economic environment (low growth and high inflation) High real interest rates Explicit deposit insurance schemes Weak law enforcement Duttagupta and Cashin (2008): The Anatomy of Banking Crises Authors used a Binary Classification Tree (BCT) model to analyse banking crises in 50 emerging markets and developing countries for the period 1990-2005. This model recognises that a combination of factors rather than a single factor may cause banking crises. It also recognises that a particular threshold must be attained before a single factor can be destructive. The baseline model identifies five candidate variables as the most important determinants of banking crises. These are: nominal depreciation bank profitability Inflation liability dollarisation, bank liquidity

Three crisis prone conditions are then identified; namely: The authors then identified the following three key crisis-prone conditions: i. Macroeconomic instability: High inflation (> 19%) per annum combined with relatively low ToT growth (< 3.25%) increases the probability of a crisis from 5.3% to 21.4% ii. Low bank profitability: A spread between lending and deposit rates (<3%), combined with modest export growth (<12%) increases the probability of a crisis to over 20% iii. High foreign exchange risk: High liability dollarisation (Foreign exchange deposits/official foreign exchange > 140%) combined with either (i) relatively high depreciation (> 9%) increases the probability of a crisis to 25%; or (ii) low bank liquidity (private credit/deposits > 150%) increases the probability of a crisis to 100%. Costs and Consequences This section draws almost exclusively on the work of Reinhardt and Rogoff (2008), The Aftermath of Financial Crises. These authors studied crisis episodes in 66 countries using a data set that spans over 200 years. According to them, the antecedents and aftermath of banking crises in rich countries and emerging markets have a surprising amount in common. Similarities related to housing and equity prices, employment, government revenues and debt. In particular, the research found that: Asset market collapses are deep and prolonged. Real housing price declines an average of 35% over 6years. Equity price collapses an average of 55% over a downturn of about 3 years Profound declines in output and employment. Unemployment rate rises an average of 70% point over the down phase of the cycle, which last on average over 4 years. Output falls an average of over 9% even though the duration of the downturn (peak to trough) averages about 2 years Real value of government debt tends to explode rising an average of 88% in the major post-WW II episodes. The main cause of debt explosion is not the widely cited cost of bailing out and recapitalising the banking sector but instead the collapses in tax revenue associated with the prolonged output contractions as well as the ambitious counter-cyclical fiscal policies designed to mitigate the downturn. The fiscal balance worsens markedly, in some cases moving from a surplus position to huge deficit positions.

Other studies have found cited the following repercussions of banking crises: Decline in credit and economic growth Reductions in investment and consumption Bankruptcies Disruptions in investor confidence Reductions in domestic savings Disruptions to the payments system Negative relationship between cost and duration of crisis i.e. quick action to get results is costly.

Caribbean Experience With the exception of Jamaica (1995), the Caribbean has been spared the wrath of financial/banking crises.
In analysing the cause of the Jamaica financial crisis, it is felt that the Jamaica financial system assumed too much risk, thereby increasing its vulnerability. In 1995, five commercial banks (out of nine) and five insurance companies were intervened. Managerial inefficiencies, weak macroeconomic fundamentals, poor choices of macroeconomic policy, and the combination of these factors explain the crisis.

In recent times, some Caribbean Governments have been making a valiant effort at establishing mechanisms based on early warning signals.

Terry Bascombe Course Coordinator December 01, 2010