WHAT ARE THE MAIN FACTORS BEHIND BANKING CRISES

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WHAT ARE THE MAIN FACTORS BEHIND BANKING CRISES?

• To understand the phenomenon of banking crises,
  we must examine the factors that lie behind it.
  Banking crises have many origins, and both
  macroeconomic and microeconomic issues are among
  their main causes.
• Banks are presumed to know the creditworthiness
  of their borrowers and that is why they decide to
  hold illiquid assets. They borrow short and lend
  long they operate with low capital and keep only
  a fraction of their deposits in the form of cash.
  These aspects of the banking business make banks
  particularly vulnerable to volatility in relative
  prices and to losses of confidence.
• In the case of emerging markets, volatility is a
  major factor behind banking crises. That is
  because emerging markets face a more volatile
  environment than industrial countries.

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• Volatility in emerging markets can be both
  external and internal. It can affect the terms
  of trade, the cost of borrowing on international
  markets, private capital flows, real exchange
  rates, and growth and inflation rates.
• By terms of trade, we define the relative price
  of our importables with respect to our
  exportables (PM/PX). For example, this ratio
  could increase due to a decrease in demand for
  our exportables. More specifically, if our
  economys primary exports are agricultural
  products or raw materials (metals, etc.), which
  are imported by several industrial countries, a
  slowdown in economic activity in these economies
  will decrease the demand for our exports and
  lower their price. As a consequence, our
  exporters experience a decrease in their income.
  

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• Exporters are bank customers and, when they
  experience a decrease in their income, their
  ability to service existing loans is likely to be
  impaired. The consequence for banks is an
  increase in the number of nonperforming loans,
  which will require funds to cover for these
  losses. These funds will come from the banks
  capital, thus decreasing that capital and making
  the bank less solvent.
• Studies of banking crises in developing countries
  have found that, in most of the cases, the
  economy had experienced an adverse change in the
  terms of trade prior to the crisis. This change
  has been at least 10, with the average around
  17. This volatility in the terms of trade is
  particularly the case for economies with low
  export diversification.

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• Furthermore, volatility in international interest
  rates in another external factor of banking
  difficulties. If, for example, world interest
  rates and, more specifically, interest rates in
  developed countries, increase, then investing in
  emerging markets is relatively less attractive.
  Volatility in interest rates also affects the
  cost of borrowing for many developing countries.
• The volatility of world interest rates affects
  capital flows in both developed and developing
  countries. Net private capital flows to
  developing countries have been particularly
  volatile during the past 15 years.
• In addition, if an economy does not sterilize
  capital inflows, then the additional funds
  increase bank deposits and encourage banks to
  increase lending at the expense of lower credit
  quality.

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• If a change in investors beliefs leads to a
  sudden reversal of these inflows, meaning that
  capital starts flowing out of the country, then
  the sudden withdrawal of bank deposits will
  result in a fire sale of bank assets (loans).
  Therefore, when the boom in capital inflows
  collapses, the banking system can experience
  serious problems.
• Another external factor is real exchange rate
  volatility and, in particular, a real exchange
  rate appreciation. Many developing countries
  that maintain a fixed nominal exchange rate
  experience real exchange rate appreciation during
  periods of high output growth. A real exchange
  rate appreciation can create problems for banks
  either directly, as in the case of currency or
  maturity mismatches between their assets and
  liabilities, or indirectly, as in the case when
  the real exchange rate appreciation creates
  losses for bank customers (such as exporters).

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• In terms of the domestic economy, volatility in
  growth and inflation rates are among the factors
  that facilitate the emergence of banking crises.
  During periods of volatile inflation rates, banks
  experience difficulties in assessing the
  creditworthiness of potential borrowers. For
  example, a firms credit history during a period
  of hyperinflation may not be a good guide to its
  performance in a more stable environment.
  Economies in Latin America have experienced
  higher volatility in inflation rates compared to
  industrial countries during the period 1980-1996.
• Also, volatility in growth rates is among the
  main reasons for banking crises in emerging
  economies. The empirical work on banking crises
  has shown that sharp contractions in economic
  activity increase the probability of banking
  crises.

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LENDING BOOMS AND ASSET-PRICE BUBBLES

• Besides the increased volatility, both external
  and domestic, economists believe that banking
  crises in many countries are caused by excessive
  lending during periods of economic expansion.
  The excessive lending pushes asset prices up,
  thus creating a bubble. This affects mainly the
  real estate and equity markets. When the bubble
  bursts, the banking crisis is triggered.
• There are three features of the recent experience
  with banking crises that support the above
  argument. First, both bank lending booms and
  declines in equity prices have often preceded
  banking crises. Second, those emerging economies
  that received the largest net private capital
  inflows have also been those that experienced the
  most rapid expansion in their commercial banking
  sectors.

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• Third, part of the increase in capital inflows in
  emerging markets during the 1990s could be due to
  an over-optimism about the effects of policy
  reform in host countries.
• However, the evidence from several banking crises
  regarding the above arguments has been mixed. In
  some cases, such as the Venezuelan banking crises
  or the recent troubles in the Japanese banking
  system, the crisis was preceded by a boom-bust
  asset-price cycle.

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INCREASES IN BANK DEPOSITS AND MATURITY/CURRENCY
MISMATCHES

• Growing economies also experience an increase in
  the ratio of broad money supply to GDP. In other
  words, there is more money in the economy during
  periods of economic growth. In many developing
  economies, the ratio of M2 to GNP increased
  sharply over the period 1980-1993. This can be
  attributed to technological innovation and
  deregulation in the financial sector.
• However, such increases may create problems for
  the banking system. More specifically, if bank
  deposits increase rapidly, if there exist
  liquidity, maturity and currency mismatches
  between bank assets and liabilities, if banks do
  not expand their capital and/or loan-loss
  provisions to compensate for the volatility of
  bank assets, and if the economy is subject to a
  change of confidence, then the banking system
  will be more fragile.

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• In many cases, advances in technology and
  financial deregulation make it easier for
  depositors in emerging economies to change the
  currency composition of their bank deposits.
  Economies in Latin America have experienced more
  deposit runs during the early stages of a banking
  crisis compared to industrial economies.
• Even allowing depositors to keep deposits in
  foreign currency, such as the dollar, will not
  necessarily solve the problem of bank runs.
  Depositors will choose to keep their money in the
  domestic banking system only if they are
  confident that the system has sufficient access
  to international reserves to cover liquidation
  into dollars.
• In addition, banks have an incentive to
  denominate their debt, meaning borrow funds, in
  foreign currency when domestic interest rates are
  high and the central bank attempts to maintain a
  fixed nominal exchange rate.

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• That was the case with several banks in Thailand
  before the banking and financial crisis in 1997.
  Banks attempt to borrow short-term in foreign
  currency through the interbank market, in order
  to fund long-term loans. A speculative attack on
  the fixed exchange rate will lead to a
  devaluation of the domestic currency, which will
  create significant difficulties for domestic
  banks to repay their foreign-currency-denominated
  loans.
• Also, banks in developing economies face higher
  risks from maturity mismatches between their
  deposits and their loans because they have less
  access to longer-term sources of funding
  (depositors are less willing to put their money
  in long-term savings accounts) and cannot
  increase their liquidity (have money available)
  through the securities markets (for example,
  issue corporate bonds).