Macroeconomic Causes of Banking Crises

1. The World Bank Washington Area Finance Association Conference Catholic University November 10, 2000 Macroeconomic Causesof Banking Crises Pierre-Richard Agénor

2. Definition of a banking crisis. • Recent evidence on banking sector problems. • Macroeconomic causes of banking crises. • A brief review of the evidence.

3. Definition of a Banking Crisis

4. 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.

5. Problems • 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.

6. 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.

7. “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 (either to the regulator or the public).

8. Banking Sector Problems:Recent Evidence

9. Systemic banking crises Episodes of non-systemic banking crises No crises Insufficient information Banking Problems since Late 1970s Source: Caprio and Klingebiel (1999).

10. Banking Sector Problems:Why we Should Care

11. 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).

12. 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.

13. 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.

14. 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.

15. 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.

16. Causes of Banking Crises

17. Causes of Banking Crises Microeconomic Distortions and Institutional Failures • 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 • Domestic and exogenous shocks. • Lending booms. • The exchange rate regime.

18. Macroeconomic Factors

19. Domestic and External Shocks Domestic Shocks • 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).

20. External Shocks • 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).

21. 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!

22. 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).

23. Lending Booms • 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).

24. 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.

25. 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.

26. 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.

27. 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 end-Dec 1994 and end-March 1995 and prime interest rates tripled over the same period, reaching 50% in March 1995. • Central bank did intervene subsequently.

28. 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.

29. The Evidence

30. 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.