Transcript Macro Conference IV - University of Manchester

Washington Area Finance Association
Conference
Catholic University
November 10, 2000
Macroeconomic Causes
of Banking Crises
Pierre-Richard Agénor
The World Bank
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Definition of a banking crisis.
Recent evidence on banking sector problems.
Macroeconomic causes of banking crises.
A brief review of the evidence.
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Definition of a Banking Crisis
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Problematic.
Example: (Detragiache and Demirguc-Kunt (1998)).
A distress episode is a crisis when
 Ratio of nonperforming loans to total bank loans
exceeded 10%.
 Cost of the rescue operation was at least 2% of GDP.
 Episode involved a large-scale nationalization of
banks.
 Extensive bank runs took place or emergency
measures (deposit freeze, prolonged bank holidays, or
generalized deposit guarantees) were enacted by the
government.
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Problems
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Information on nonperforming loans: often not reliable
and timely. Evergreening problem.
Cost of rescue operations is often difficult to measure.
Importance of quasi-fiscal costs and contingent
liabilities, and restructuring costs.
 Liquidity provided at below-market interest rates.
 Promise to bail out ailing banks provides an implicit
subsidy.
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Estimating the net costs of banking sector restructuring is
difficult; requires assumptions about
 amount of liquidity support;
 present and future incidence of nonperforming loans
and their recovery rate.
Estimates are often calculated on a gross basis; lead to
overestimation by excluding
 future proceeds from reprivatization;
 loan recovery;
 repayment of the liquidity assistance provided by the
government.
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“Run” or “event” criterion: A crisis can indeed, in some
cases, be dated that way. Examples:
 Massive bank runs in Ecuador, following the currency
crisis of February 1999.
 The crisis in Indonesia, dated in reference to the
closure of 16 banks in late 1997.
Problems
 Runs are often short lived.
 Dramatic “events” rarely represent either the beginning,
or the end, of the crisis.
 In most cases insolvency problems were already present
and worsened over a period of time; event itself is merely
the point at which underlying problems are revealed
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(either to the regulator or the public).
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Banking Sector Problems:
Recent Evidence
Banking Problems since Late 1970s
Systemic banking crises
Source: Caprio and Klingebiel (1999).
Episodes of non-systemic banking crises
No crises
Insufficient information
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Banking Sector Problems:
Why we Should Care
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Key role in the payments system.
High resolution costs. Caprio and Klingebiel (1999):
 Industrial countries. Most severe crises:
 Spain, 1977-85 (17% of GDP); Finland, 1991-94
(11%); Sweden, 1991-94 (4%).
 U.S. Savings and Loan crisis (1984-91): $175$225 bn. (2.4-3% of 1990 GDP).
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Developing countries. More than a dozen episodes
with resolution costs higher than 10% of GDP.
 Venezuela, 1994-... (more than 20%), Mexico,
1995-... (20%).
 Argentina, 1980-82 (over 55%) Chile, 1982-85
(41%), Côte d'Ivoire, 1988-91 (25%).
 East Asia crisis: large fiscal costs induced by bank
restructuring (recapitalization and guarantees to
depositors).
 In Indonesia, for the bank recapitalization
program and resolution of closed institutions (just
completed), bonds totaling some $71 bn. (around
48-50% of GDP) have been issued.
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In Thailand, total cost of bank restructuring (in
terms of public debt issued) is estimated at 32% of
GDP; for Korea, 15-16%.
Pressure on fiscal deficits, public debt, and domestic
interest rates (default risk premium).
Adverse incentive effects.
 Intervention may reduce private incentives to monitor
the behavior of banks in the future.
 Expectation of future rescues creates incentives for
excessive risk taking.
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Reduction in bank credit and higher interest rates:
adverse supply-side effects (small firms).
During a financial crisis:
 Worsening of information and adverse selection
problems.
 Reason: only the least creditworthy borrowers are
prepared to pay higher interest rates.
 Adverse effect on the quality of loan portfolios.
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Constrains the conduct of monetary policy.
 Limits on the possibility to raise interest rates.
 Problematic when such response is needed to fend
off speculative pressures.
Contraction in output that accompanies (or is
exacerbated by) financial crises: has an asymmetric
effect on poverty rates.
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Causes of Banking Crises
Causes of Banking Crises
Microeconomic Distortions and Institutional Failures
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Mismatches between assets and liabilities.
Government intervention.
Weaknesses in the regulatory and legal framework.
Government guarantees and incentive failures.
Premature financial liberalization.
Self-Fulfilling Panics and Information-Based Runs
Macroeconomic Factors
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Domestic and exogenous shocks.
Lending booms.
The exchange rate regime.
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Macroeconomic Factors
Domestic and External Shocks
Domestic Shocks
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Example: increase in domestic interest rates (to
reduce inflation or defend the currency).
 Slows output growth and may weaken the ability of
borrowers to service their loans;
 may lead to an increase in nonperforming assets or a
full-blown crisis.
Country example: Jamaica (1994-99).
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External Shocks
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Example: a change in terms of trade.
 May affect even well-run banks.
 An unanticipated drop in export prices, for instance,
can impair the capacity of domestic firms (those in
the tradable sector) to service their debts.
 This can result in a deterioration in the quality of
banks' loan portfolios.
 Adverse shock to domestic income associated with a
decline in the terms of trade: may slow output and
raise default rates.
Country examples: Côte d'Ivoire (1986-90), Ecuador
(1998-99).
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Example: capital outflows induced by an increase in
world interest rates or loss of confidence.
 If these flows are intermediated, to begin with, via the
banking system:
 drop in deposits;
 may force banks to liquidate long-term assets to
raise liquidity or cut lending abruptly.
 May entail a recession and a rise in default rates.
Country examples: too many to count!
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Clearly, the impact of these shocks on the banking
system depends on their duration.
But volatility matters also. With highly volatile shocks,
it is more difficult for banks to assess project quality
and credit risk (distorted price signals).
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Lending Booms
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Rapid increases in bank credit growth to the economy.
Source of increase in banks' capacity to lend: often
large capital inflows.
Often at the expense of credit quality.
Distinguishing between good and bad credit risks is
harder when the economy is expanding rapidly because
many borrowers are temporarily profitable and
liquid.
Boom is often accompanied by asset price bubbles
(stock market, real estate).
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Banking crisis may occur when the bubble bursts.
Collapse in equity prices:
 affects overall confidence.
 reduces profitability of bank debtors.
Collapse in real estate prices:
 may also affect confidence.
 reduces the value of collateral.
Crisis often exacerbated by a high degree of loan
concentration (to groups and sectors).
Examples: East Asia, Latin America.
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The Exchange Rate Regime
Pegged exchange rate regime: two issues.
 A credibly-fixed exchange rate provides an implicit
guarantee (no foreign exchange risk) which may lead to
excessive (and unhedged) short-term foreign
borrowing. Example: East Asia.
 This increases the fragility of the banking system to
adverse external shocks, particularly if the degree of
capital mobility is high.
 Example: adverse shift in market sentiment that leads to
capital outflows.
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Lowers (without full sterilization) the money supply
and leads to higher interest rates.
 Higher cost of credit: increases the incidence of
default and leads to a deterioration in the quality of
bank portfolios.
Thus: under any pegged rate regime, capital outflows
affect the financial system through an expansion or
contraction of bank balance sheets; they can lead to
instability in the banking sector.
Additional problem with a rigid regime (e.g. currency
board): it also constrains the lender-of-last-resort
function of the central bank; prevents it from reacting
quickly to stop a bank run by injecting liquidity.
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Example: Argentina, 1995 (Tequila crisis).
Bank deposits fell by 16% (more than $7.5 billion)
between mid-Dec 1994 and end-March 1995.
Foreign currency withdrawals translated into
contractions of the monetary base and, via the money
multiplier, into declines in domestic credit and a sharp
rise in domestic interest rates.
Foreign exchange reserves fell by 40% between endDec 1994 and end-March 1995 and prime interest rates
tripled over the same period, reaching 50% in March
1995.
Central bank did intervene subsequently.
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Flexible exchange rate regime: may also create problems.
 An abrupt outflow of capital can lead to a sharp
depreciation of the nominal exchange rate.
 The depreciation may raise the domestic-currency value
of foreign-currency liabilities, for banks and their
customers.
 Large, unhedged foreign-currency positions increase
risk of default on existing loans and vulnerability to
adverse (domestic or external) shocks.
 The fall in borrowers’ net worth may also lead to a rise in
the finance premium and to increased default rates;
 higher incidence of nonperforming loans may lead to a
banking crisis.
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The Evidence
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Take it with a grain of salt!
Serious measurement problems; but also endogeneity and
misspecification problems.
Nevertheless: suggests that external shocks (movements
in world interest rates and induced capital flows) and
lending booms are important determinants of financial
crises in developing countries.
But further research is needed to understand interactions
between (domestic) micro and macro factors.
Macroeconomic shocks are often the triggering factors
that reveal underlying microeconomic weaknesses.
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