Transcript Selected Crises - Jamaica Deposit Insurance Corporation

THE CAUSES OF FINANCIAL
CRISES: What We Know and What
We Can Do About It
Antoinette McKain
Chief Executive Officer
Jamaica Deposit Insurance Corporation (JDIC)
Global Association of Risk Professionals
October 2016
The views expressed in the following material are the
author’s and do not necessarily represent the views of
the Global Association of Risk Professionals (GARP),
its Membership or its Management.
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Definition of Financial System Crisis
A financial system crisis can be considered to exist where there is a severe loss value of the
assets of corporate and financial institutions; loss of access to funding; and significant
diminution of their customer’s trust - to the point of endangering the financial system’s
sustainability.
The systemic crisis occurs where financial institutions’ or other corporates business are so
interconnected with that of other each other and /or the performance of the macro economy such that
the insolvency of one so adversely impacts either the balance sheets or perception of the others
causing contagion effects where short term funding is pulled from the institutions or becomes
unavailable.
A pure banking system crisis can be caused by a run on a bank where depositors fear the loss of their
funds and which so adversely affects the confidence of the depositors of other banks that they in turn
run on their banks. The business model of banking being fractional , the institutions cannot withstand
the run and consequently can go into insolvency.
Individual corporate entities and financial institutions can experience insolvency and be closed in the
course of ordinary commercial activity with the development, growth and contraction of markets.
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Causes of Financial System Crises
Unlike what is often believed, when the memory of a financial crisis wanes, they
have been relatively common, in the context of their impact on national and global
economies.
 One of the more modern financial crises was the Wall Street Crash of 1929 and the Great Depression
of 1933 in the United States. The analysis of this became important again because of the recent
Global Financial Crisis of 2008 and 2009. The latter has been compared in terms of the magnitude
of the impact to the global financial system. Comparisons allow for the assessment of the respective
policy actions of the monetary and fiscal authorities in crisis periods to better identify and manage
future ones.
 Financial crises have been recorded since the 17th Century. The recurring causes have been:
-
Boom and bust cycles (bubbles)
Economic recessions
Shortsighted monetary and fiscal policies
Financial deregulation and liberalization
Poor and unresponsive regulatory oversight
Inexperienced management of financial institutions and where there are incentives for excessive risk taking,
Inadequate risk identification, management and controls
The herd mentality and “irrational exuberance” of market participants who overestimate existing and future
market values in particular after innovations in technology
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Important Rudiments of The Bubble Phenomena
The definition of an economic bubble can be restated in a number of ways but the
basic conditions are appropriately defined in a Financial Times Article:
“A bubble is considered to exist where the price of an asset that may be freely
exchanged in a well-established market first soars then plummets over a
sustained period of time at rates that are decoupled from the rate of growth of
the income that might reasonably be expected to be realized from owning or
holding the asset.”
 Colloquially it is argued that bubbles emerge because each trader hopes to pass the asset on to
some less rational trader (greater fool ) in the final trading rounds. Similar patterns emerge when
investors have no resale options and are forced to hold the asset to the end. Bubbles are due to the
combination of declining fundamental value – which leads to mispricing-and an increasing cash-toasset-value ratio – the overvaluation. [Bubbles, Financial Crises, and Systemic Risk – Brunermeier
and Oehmke – Handbook of Economics and Finance, Volume 2]
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Selected Crises – All Kind of the Same
Wall Street Stock Market Crash 1929
 The pre-crisis period was characterized expansionary monetary policy actions resulting in surplus
growth fueled by real estate and stock market growth and significant innovations in electrical and
transportation technologies. Heavy stock market activity fueled even more investment making these
investments seem more and more valuable. Stock purchasing was also made cost effective through
the ability for margin purchases, then borrowing the price of the stock at low interest rates to finance
the purchase with the securities used as collateral for the loan. When prices rose dividends were
available. Any potential drop in the price of stock was covered by the expectation that the stock prices
would rise again. There was the incentive to mimic the behavior of others in the purchasing of stock
(the herd mentality). Even when the market dropped sharply (September 3, 1929) it rose again even
stronger and a precipitous decline began again by October 21, 1929. There was so much margin
purchases by 1929 the debt was $6 billion. By the end of the market decline $30 billion had been
lost. This was two times the national debt. The country slipped into the Great Depression.
[Summary from “The Wall Street Crash,” EyeWitness to History, www.eyewitnesstohistory.com
(2000). Reference Allen, Frederick, Lewis, Since Yesterday: the 30’s in America (1972)].
 The Great Depression was characterized by high consumer debt, where badly regulated markets
permitted the writing of bad loans and lack of new growth industries which caused a downward
economic spiral. The period was characterized by bank runs. By 1933 nearly 11,000 of the 25,000
banks had failed and 9 million savings accounts were lost. In addition the decision was for tight
monetary policy reducing the potential for fuelling a speedy recovery.
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Selected Crises – All Kind of the Same
The dot com bubble 2001
 The early 1990’s was characterized by the start up of several internet based companies referred to as
dotcom. Companies could raise the price of their stock by adding the prefix “e-“ or the suffix “.com”
There was therefore a combination of rapidly increasing stock and market confidence that the
companies would turn future profits; speculation and available venture capital that would create an
environment where investors overlooked the traditional P/E ratios, basing confidence on technological
advancement. These companies could make a great deal of money through the stock markets
without actually showing a profit. The “Silicon Valley” effect was sought to be replicated in other parts
of the United States outside of Silicon Valley and in Europe.
 It is argued that much of this speculation was facilitated by loose monetary policy actions by the
Federal Reserve Bank of the USA, often referred to as Greenspan’ Bubbles.
 It is also argued that the unnaturally rapid growth in the dotcom internet companies was also fuelled
by tax policies on capital gains tax cuts under the Taxpayer Relief Act of 1977, as growth companies
would not ordinarily pay dividends.
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Selected Crises – All Kind of the Same
Mexican Financial Crisis of 1994 – 1995
 In the second half of 1980 Mexico undertook large scale reform and deregulation of its economy
consistent with economic reforms made conditional on multilateral support. Trade liberalization and
capital flows were seen as integral to Mexico becoming a part of the developed world. This new
approach came out of a balance of payments crisis and caused the Mexican Government of the day
to seek a less protectionist development model.
 There was deregulation and privatization of a number of government owned industries. Foreigners
were now allowed to invest in the Mexican Stock Market and Mexican companies began to finance
expansion through foreign currency loans.
 The Mexican Peso was pegged to the US dollar to encourage borrowings on the international capital
markets and to facilitate expected trading with the United States in particular. It was expected that in
order to deal with inflation monetary policy would fluctuate according to balance of payments
considerations. There is a presumption of macroeconomic stability and investor trust in the currency.
 The largest banks were privatized, facilitating a credit boom. Unfortunately the privatization was an
inefficient process with the Government concentrating on the highest bidders without taking into
account experience of the bidders except some groups with experience in the stock market. The
privatized banks then began competing for larger market share making risky mortgage and consumer
loans and borrowed in US dollars to make some loans.
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Selected Crises – All Kind of the Same
Mexican Financial Crisis of 1994 – 1995
 International best standards were not adopted simultaneously and the risks in banks balance sheets
were underreported . Banks would lend or buy securities without keeping proper reserves against
losses:
- Risky loans were underreported and accounting rules allowed that where loans were non-performing only
the interest was counted as being in arrears.
- In addition bank regulators were inexperienced and lacked sufficient legal authority and autonomy to
properly supervise the banks. [Musacchio, Aldo. “Mexico’s Financial Crisis of 1994 – 1995” Harvard
Business School Working Paper, No. 12 -101, May 2012]
 Investors now saw Mexico as a great place to invest with higher interest rates (than the US) and
safety. A bubble effect was created as investors moved money to Mexico for the purchase of
Mexican assets causing the value of these to rise along with the high returns to investors. The
actual growth rate of the country did not reflect this. In 1992 the growth rate was 3% but in 1993 it
was approximate 2%. Households were not increasing savings and the country’ s GDP fell to 15%
by 1994 down from 18% in 1989 before the lead up to the crisis. Foreign borrowings were not
increasing the wealth of the country or its people.
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Selected Crises – All Kind of the Same
Mexican Financial Crisis of 1994 – 1995
 The bubble burst in 1994 when in-fighting with rebel groups and a series of political assassinations
caused investor disquiet. Along with this US interest rates began to rise and the dollar peg no longer
had investor confidence. As easily as capital had come in it left notwithstanding Government efforts
of issuing debt indexed to the value of the US dollar.
 With investors leaving the country interest rates began to rise causing defaults from consumers and
businesses. A banking crisis ensued with the Government bailing out the Mexican banks and the US
and multilateral agencies having to come to Mexico’s aid.
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Selected Crises – All Kind of the Same
Jamaican Financial Crisis of 1996

Liberalization of the Jamaica economy started in1986 in an attempt to create an environment more
conducive to efficient financial intermediation and the strengthening central bank ability to influence
money and credit variables. Interest rate policies reform and the development of money and capital
markets were also two areas of focus at the time.

There was rapid asset expansion and deepening of the financial system with conglomeration among
banks and non-bank operations. By the end of 1997 three large banks accounted for 75 percent of
the banking system which assets accounted for 50% of the total assets of the banking sector. Nonbanks also increased from 8 in 1985 to 25 in 1993.
 Financial institutions conglomeration was usually undertaken by insurance companies which were
taking advantage of financial arbitrage where there was beneficial cash reserve ratio differential
relative to banks.
These conglomerated entities also branched out into the acquisition of
agricultural and tourism ventures, increasing risk and contagion causing the entire sector to become
vulnerable to financial instability.
 Commercial bank balances grew 55 per cent from 1993 to 1995 and the category referred to as
merchant banks grew by 200 percent. Foreign currency loans increased by over 100 percent each
year from between 1992 and 1994.
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Selected Crises – All Kind of the Same
Jamaican Financial Crisis of 1996
 The liberalization was also characterized by rapid depreciation of the exchange rate moving form
US$1.00:$7.90 to US1.00:J$27.38 in less than two years. Whereas private sector credit grew by
almost 70 percent in 1993 it slowed to 25 percent growth in 1996 and actually declined in 1998. The
flaws began to show up with declining profitability of the banking sector and a reduction on the return
on assets of the commercial banks and capital adequacy ratios then 8 percent by international
standard was below 3 percent in Jamaica.

These problems were also reflected in the non-performing loan ratios (NPLs’). NPL’s as a
percentage of total loans in commercial banks grew from 7.4 percent in 1994 to 28.9 percent in 1997
with evidence of high levels of problematic related party loans a significant portion of which was
associated with relationship between the insurance companies and commercial banks. In the early
1990’s life insurance companies aggressively marketed short-term equity-linked products by offering
high rates of return.
 Although there was legislative reform in 1992 the rules did not address consolidated supervision and
whereas there was no requirement for senior bank officers to have any special educational
background or actual competence to run a bank. There was no expressed powers for either the
Minister or the regulator to deal with a bank that had, or was about to become insolvent. The local
banks were characterized by poor management.
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Selected Crises – All Kind of the Same
Japanese Financial Crisis 1990s

Japan is considered a developed country and in the 1970’s and 1980’s was considered one of the
strongest in the world. In the middle 1980’s economic growth was above trend with near zero
inflation. The country’s risk premium was low and marked upward adjustment in growth
expectations, boosting asset prices and fueling rapid credit expansion.

In the second half of the 1980’s there was financial liberalization and deregulation which saw:
relaxation of interest rate controls and capital market deregulation. Price competitiveness reduced
banks’ risk-adjusted interest margins causing them to seek expansion through assuming riskier
segments in their loan portfolios. Consumer lending and lending to the real estate market and to
small and medium sized enterprises increased sharply. Credit standards were loosened while
banks focused on market share with increased risk as lending was based on collateral rather than
on cash flows. It was noted that banks’ preoccupation with market shares was a vestige of the
interest rate control regime where banks’ lending spreads were more or less fixed and they derived
most of their income from their interest earning. This meant that their outstanding loans would
determine the size of their net income.
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Selected Crises – All Kind of the Same
Japanese Financial Crisis 1980s

The collapse of the bubble was described as occurring in 1990 when the Japanese stock markets
collapsed having now become overvalued from the previous period of expansion and the Bank of
Japan had successive increases in its discount rates. To contain rising land prices, the Ministry of
Finance introduced guidelines limiting total bank lending to the real estate sector. This caused a
leveling off of asset growth in banks. There was a subsequent slowdown in economic growth,
together with drastic declines in stock and real estate prices which weakened the health of banks
and other financial institutions. The weakening, among other things saw the quality of loans to the
real estate sector deteriorated rapidly with the value of collateral eroding; and the decline in the
value of banks’ equity holdings putting pressure on bank capital. With the deceleration in economic
growth the ability of debtors to continue to service their loans was greatly reduced.

With the consequent downgrading of Japanese banks by the ratings agencies their marginal costs
of funding rose above those of many of their borrowers. This, together with the incremental lifting of
restrictions on the access of Japanese corporation to the domestic and euro bond markets, led to
acceleration in bond issues which put further pressures on banks.

Corporate governance practices of banks was also poor where there existed a symbiotic
relationships between shareholder, employees and managers and governing boards causing self
interest to cover up the impending failures of banks. Bureaucrats from the Ministry of Finance and
the Bank of Japan on retirement would take senior positions in banks resulting in conflict of interest
and slow action by supervisor.
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Selected Crises – All Kind of the Same
Japanese Financial Crisis 1980s
•
In terms of compliance with international best practice standards, Japan had fully implemented the
Basel Capital Accord for the fiscal year 1992 but the international standard of 8 percent for capital
adequacy was only applied to banks with international operations while regional banks were
permitted to hold only 4 percent. It was noted despite the sharp decline in stock prices many banks
could be deemed to meet the Basel capital standards partly because book values of the stocks
were well below the market values. Loan loss classification was designed not to send signals to the
markets about the performance of banks and consequently provisioning for problem loans and loan
losses was poor.
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Selected Crises – All Kind of the Same
Icelandic Financial Crisis 2006-2008
 A small economy which had relied primarily on financial services where financial institutions were
mostly nationally owned. There was financial sector deregulation in the early 1990’s. The banking
sector was dominated by 3 main commercial banks and a large fringe of savings banks and pension
funds that offered other financial services. After privatization of the banking sector in 2003, assets
increased from 100 percent of GDP to 1000 percent of GDP with the take off of internet banking in
2006. They used internet banking to attract foreign deposits using the cost savings from on-line
banking to offer higher savings to customer. This level of deposit base and heavy concentrations was
seen as the Icelandic banking systems key fragility.
 By 2006 ratings agencies had noted high levels of debt and large exposures of financial institutions to
house prices, share prices and the exchange rates with the Krona and share prices falling by about
20 percent. From as early as 2006 Icelandic economy had been downgraded by the ratings agencies
because of its current account deficit with rising global interest rates and tightening liquidity. Iceland
had begun to see large capital outflows which had repercussions throughout the world as traders
needed to liquidate profitable positions to fund Icelandic losses. By the onset of the global financial
crisis in 2008 the regulatory authorities had taken control of the largest bank as a rescue measure
and legislation passed allowing the government to intervene in Iceland’s banking system.
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Global Financial Crisis 2008
 IMF research on the cause of the Global Financial Crisis has noted four
underlying conditions:
-
Particular structural changes within the macroeconomy such as economic and financial
liberalization and/or weaknesses in financial regulation where financial innovations are not
adequately understood or regulated
- Ensuing asset price bubbles, credit booms and economic expansion not supported by
underlying real sector fundamentals
- Institutional weakness in governance of financial institutions and breakdown in their delegated
monitoring functions
- Too slow regulatory responses. Internationalization of financial institutions and systems provide
channels for these crises to cross borders and assume global proportions
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What We Will Do About Averting Crises
Post Crisis International Standards
 Prudential Standards
– Basel III
• Minimum Capital Requirements - tighter capital requirements in comparison to Basel I and Basel II
• Countercyclical Measures - new requirements with respect to regulatory capital for large banks to
cushion against cyclical changes on their balance sheets
• Leverage and Liquidity Measures - safeguard against excessive borrowings and ensure that banks
have sufficient liquidity during financial stress
• Counterparty Credit Risk Exposures
• Risk‐Based Regulatory Capital Framework for Securitization Exposures
 Financial Stability Board Total Loss Absorbing Capacity (TLAC) for global systemically
important banks - Failing G-SIBs will have sufficient loss-absorbing and recapitalization capacity
available in resolution for authorities to implement an orderly resolution that minimizes impacts on
financial stability, maintains the continuity of critical functions, and avoids exposing public funds to
loss.
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What We Will Do About Averting Crises
 Macro prudential Policies
- IMF Research notes that having recognized the causes of crises is now growing consensus of the
need for macro prudential policies and regulation which has financial stability objectives and that
they should work with micro prudential policies and monetary policies and fiscal policies to deal
identify and deal with systemic issues.
- Macro prudential policies should also address the issues in competition policy. These policies
recognize that there are key externalities within an economy and the financial system that can
lead to excessive pro-cyclicality and the build up of systemic risk which might occur from micro
prudential regulation and from monetary policy applications. These externalities can be
described as those relating to:
•
Strategic Complementarities - the interaction of banks and other financial institutions and agents
and which cause build up of vulnerabilities during the expansionary phase of financial cycle
•
Credit crunches and fire sales that arise when there is a generalized sell-off of assets cause
decline in asset prices and drying up
•
Interconnectedness caused by the propagation of shocks from systemic institutions or financial
market or networks (contagion)
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What We Will Do About Averting Crises
 Macro prudential Policies
- Some macro prudential policy tools include caps on loan to value ratio, limits on credit growth and
other balance sheet restrictions and counter cyclical capital and reserve requirement and
surcharges and Pigouvian levies. The costs of these tools need to be analyzed.
- Macro prudential policy and monetary policy must work synergistically or they can negate the
effectiveness of each other. Monetary policy concerned with price stability and liquidity while macro
prudential policy focused on systemic stability might not be immune from political pressures and
time inconsistencies. The authorities for the use of the tools must be clearly defined in law.
- Systemic Risk Measurement
- There should be methodologies for systemic risk measurement which should identify individually
systemically important financial institutions (SIFIs) that are so interconnected and large that they
can cause negative spillovers on others. In addition it should identify institutions that are systemic in
the context that they are part of a herd. The second point is important because of a group of 100
institutions that act in a correlated fashion can be dangerous to a system as one large entity. This
also means that splitting a SIFI into 100 smaller institutions does not stabilize the system as these
100 smaller ‘clones’ continue to act in a perfectly correlated fashion. Source: “Bubbles, Financial
Crises, and Systemic Risk: Markus K. Brunnermeier, Martin Oehmke”
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What We Will Do About Averting Crises
 The IADI Core Principles for an Effective Deposit Insurance Systems, November 2014 states:
“Resolution” refers to the disposition plan and process for a non-viable bank. Resolution may include:
liquidation and depositor reimbursement, transfer and/or sale of assets and liabilities, the establishment
of a temporary bridge institution and the write down of debt or conversion to equity. Resolution may also
include the application of procedures under insolvency law to parts of an entity in resolution, in
conjunction with the exercise of resolution powers.”
 The Financial Stability Board (FSB) Key Attributes for an Effective Resolution Regime, October
2014 states:
“The objective of an effective resolution regime is to make feasible the resolution of financial institutions
without severe systemic disruption and without exposing taxpayers to loss, while protecting vital
economic functions, through mechanisms which make it possible for shareholders and unsecured and
uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.”
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Some New Aspects of the Jamaican Regulatory Framework
The Banking Services Act 2014, now gives the Supervisor, in addition to the general prudential
regulatory powers over banks, power over bank holding companies and the powers to take prompt
corrective action where capital ratios are compromised below prescribed limits. These actions include
taking temporary management of the financial institution and in the case where non-viability of the
institution is determined the Minister with responsibility for finance can through the Accountant General
of Jamaica vest the shares of the institution to undertake a private sector solution for the resolution of
the institution.
The Central Bank through the Bank of Jamaica Act now has the express power for financial stability and
for macro prudential regulation and emergency liquidity funding for the purposes of maintaining financial
stability.
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THE CAUSES OF FINANCIAL CRISES: What We Know and What We Can Do
About It
QUESTIONS?
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THE CAUSES OF FINANCIAL CRISES: What We Know and What We Can Do
About It
THANK YOU
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