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Banking Crises Regulation & Performance Economics 102 Early Regulation • Scams ==> bank licensing by late 1800s • Minimum capital requirements • Attempt to exclude criminals • But US had 20,000+ banks – In much of midwest, branch banking prohibited – Interstate banking prohibited • Federal Reserve System from 1913 • Smooth interest rate swings • Foster national market Great Depression • Big swings in prices: deflation – Debtors hurt, many default – Real GDP fall likewise leads to defaults • Banking “panic” – Fears lead to bank runs • Sum – Illiquidity issues – Insolvency issues Regulation • Promote “sound” banking practice • More below... • Depositor insurance (FDIC, 1933) • Restores confidence • But insurance has side effects – Moral hazard • Encourages risk taking • Heads I win … tails you lose Safe Banking • Sound practice – Glass-Steagall (1933): segment services • Insurance - banking - securities - underwriting • NOW DEFUNCT cf. Enron issues – Bank supervision (gradual, state & federal) • Inspection • Case study: Bank of Tokyo NY, 1979 – Regulation Q (1933) • Prevent competition for deposits • Help guarantee margins – Federal Home Loan Bank Act (1932) • Set up S&L framework: some perks, but only mortgages Banking Crises • Structural change is the enemy of sound banking – Managing risk is undermined – Mix of products / operations undermined 1970s shifts • 1970s – Inflation rose ==> disintermediation – MMMFs developed • Donahue and money market funds • Incentive to pull money from term savings accounts • Also could buy bonds directly …. – Regulation Q broke down • Banks were freed to pay market interest rates in 1980 for S&Ls S&Ls • Savings & Loan Institutions – State-chartered banks • Most deposits guaranteed by FSLIC – Restricted in general to nearby housing – Typical product fixed-rate 30 year mortgage • Core of business – Borrow short – Lend long – “Maturity transformation” Demise of S&Ls • 30 year mortgages – Collecting 4% • Short-term deposits – Paying 10% • Paul Volcker Fed Chairman 1979 ==> raised “i” sharply • Entire sector rendered insolvent – In 1981 3,300 out of 3,600 S&Ls were losing money – By mid-1982 S&Ls in the aggregate were insolvent Further deregulation • So rechartered as federal institutions • Freed S&Ls to lend to new business – 1980, esp 1982 • Allowed to do new, “ profitable” types of loans – Commercial real estate 40%, including outside state – Consumer loans 20%, also credit cards – Could accept brokered deposits: phone banks calling people across the country, and insured up to $100,000 S&Ls in the New Age • • • • But the same old regulators And the same old bankers In a brave new world California S&Ls in Texas … ….. Dentists as Bankers?! • No ability to practice or assess sound banking • Outright fraud – Over $1 billion in fraud at one S&L in Colorado with Neil Bush as director – More at Keating’s Irvine CA Lincoln S&L, bought 5 US Senators to protect themselves, but $3.4 bil in losses to taxpayers – Included Sen. McCain, Glenn and 3 who didn’t run for re-election (1 censured) Riegle DeConcini Cranston (censured!) Bottom Line • $250 billion cost to taxpayers • Lots of bad assets – Lots of unmitigated waste – Local business cycle accentuated (Tx, Fl, La) • Ultimate total elimination of S&L segment • Commercial banks alternatives • floating rate mortgages • so it’s still possible to finance a home purchase More recent crises • 1980s Latin America Debt Crisis • Japan • Thailand • Argentina Latin American Debt • Big “petrodollar” recycling – Banks - where to lend? – Latin America is growing strong • Esp Brazil • Commodity prices rising faster than interest rates – 10% i - 20% π = -10% real i so stupid not to borrow! – Citibank along lent $1 billion • But then commodity prices fell, interest rates rose – 20% i - (-)20% π [deflation] = +40% real I – Bankrupt! Japan • Traditional business disappeared – Growth slowed from 10% pa to 5% pa – Less Investment • business borrowing fell by 10% of GDP • savings (deposits) continued to rise • So need new business – Small firms (60% of economy) – Real estate (good collateral, prices always rise) Japan’s Crisis • New business plan a failure • Good small businesses already had bankers • Real estate prices could fall, too • Began shift in a boom, hiding bad practices • Banking crisis from 1992 • Real estate prices fell • Stock-market based financing backfired • Japan in 2001 is back in recession, with only one year of good growth since 1990. Thailand, Argentina • A supposedly fixed foreign exchange rate – But domestic interest rates high! – Answer? • Borrow in US $ from foreign / offshore banks • But the exchange rate depreciated – Suddenly instead of owing B20,000 you owe B40,000 – And interest payable doubles too • Widespread defaults / bankruptcies Tomorrow’s crisis? • Citicorp etc – Can megabanks handle the menu of new products that they’re trying to peddle, on a global basis? I wonder… • Why worry? – Structural change, but management change? – Expansion in up cycle when hard to lose money • Housing bubble • Hedge funds with new and thus unknown risks. • Note: most of the above was written in March 2002 Summary • Leverage: – a little is very powerful – Try to move too much and something will snap – Institutional change: both regulators & lenders find hard to handle • Regulation – Regulations generate side effects • Moral hazard – Heads I win, Tails you lose