Fundamentals of Banking Crises
Causes of Banking Crises
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Banking crises can be caused by inadequate
governmental oversight, bank runs, positive
feedback loops in the market and contagion
Key Points
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A bank occurs when many people try to withdraw their deposits at the same time. As much of the
capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the
consumer demand.
Due to the mass interdependence of economies across the globe, a banking crisis in one nation is
likely to dramatically affect other international economies.
The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came
in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs.
Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure
to listen to economists predicting this over the past decade, caused the 2008 stock market crash
and subsequent depression.
Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure
to listen to economists predicting this over the past decade, caused the 2008 stock market crash
and subsequent depression.
Key Terms
Bank Run: A large number of customers withdraw their deposits from a financial institution at the
same time due to a loss of confidence in the banks.
leverage: The use of borrowed funds with a contractually determined return to increase the ability
of a business to invest and earn an expected higher return, but usually at high risk.
• In light of recent market and banking failures, the economic
analysis of banking crises both historically and presently is a
constant source of interest and speculation. Banking crises
are when there are widespread bank runs: an abnormal
number depositors try to withdraw their deposits because
they don’t trust that the bank will have the deposits for
withdrawal in the future.
• Banking crises are not a new economic phenomenon, and
similarly are not the only source of financial crises. Over the
course of the past two centuries there have been a
surprisingly large number of financial crises, as
demonstrated in the attached figure. In understanding
banking crises over time, it is useful to identify the causes
in context with historic examples of banking collapses.
Causes of Banking Crises
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Banks can fail for several different reasons:
Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As
much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to
meet the consumer demand. This can quickly induce panic in the public, driving up withdrawals as
everyone tries to get their money back from a system that they are increasingly skeptical of. This
leads to a bank panic which can result in a systemic banking crisis, which simply means that all of
the free capital in the banking system is withdrawn.
Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a
similar positive feedback loop effect in the stock markets, which was a much more dynamic factor
in more recent banking crises (i.e. 2007-2009 sub-prime mortgage disaster). John Maynard Keynes
once compared financial markets to a beauty contest, where investors are merely trying to pick
what is attractive to other investors. There is a profound truth to this, creating an interdependent
and potentially self-fulfilling investment thought process. This can create dramatic rises and falls
(bubbles and crashes), which in turn can throw banks with poorly designed leverage into huge
losses.
Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of
governmental oversight. As noted above, banks often leverage themselves to capture gains despite
extremely high risks (such as over-dependence on derivatives).
Contagion: Due to globalization and international interdependence, the failure of one economy can
create something of a domino effect. In 2008, when the U.S. economy collapses, the reduced
buying power and economic output from that economy dramatically damaged all economies
dependent upon it (which includes most of the world). This is called contagion.
The Great Depression
• The Great Depression highlights how bank runs caused a banking
crisis, which ultimately became a global economic crisis. The Great
Depression in 1929 resulted from a variety of complex inputs, but
the turning point came in the form of a mass stock market crash
(Black Tuesday) and subsequent bank runs. As fear began to grip
consumers across the United States, people became protective of
their assets (including their cash). This caused a large number of
people to the banks to withdraw, which in turn motivated others to
go to the banks and get their capital out also. Since banks lend out
some of their deposits, they did not have enough cash on hand to
meet the immediate withdrawal requests (they became illiquid) and
therefore went bankrupt. Within a few weeks this resulted in a
systemic banking crisis
Consequences of Banking Crises
• Banking crises have a range of short-term and
long-term repercussions, domestically and
globally, that reduce economic output and
growth
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Key Points
Banks play a critical role in economic growth, primarily through investment and
lending.
After a banking crisis, investment suffers. When banks lack liquidity to invest,
growing business depending upon loans struggle to raise the capital required to
execute upon their operations.
The fall in liquidity and investment, in turn, drives up unemployment, drives down
governmental tax revenues and reduces investor and consumer confidence.
Imports and exports play an increasingly large role in the health of most developed
economies, and as a result, the relative well-being of trade partners plays an
increasingly critical role in the success of domestic economies.
Key Terms
Economic crisis: A period of economic slowdown characterised by declining
productivity and devaluing of financial institutions often due to reckless and
unsustainable money lending.
liquidity: The degree to which an asset can be easily converted into cash
• Banking crises have a dramatic negative effect on
the overall economy, often resulting in an
eventual financial and economic crisis in a given
economic system. Banking crises have a range of
short-term and long-term repercussions,
domestically and globally, that underline the
severe repercussions of irresponsible banking
practices, poor governmental regulation, and
bank runs. The most useful way to frame the
consequences of bank crises is by observing the
critical role banks play in economic growth,
primarily through investment and lending
Domestic Consequences
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Within a given system, banking failures create a range of negative repercussions from an economic
perspective. Banks coordinate and economy’s savings and investment: the act of pooling money to
capture higher returns for everyone while simultaneously funding business dependent upon
leveraging debt and equity. With this in mind, a banking crises can have a variety of averse
individual and economic consequences within the system.
First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend
upon loans struggle to raise the capital required to execute upon their operations. When these
businesses cannot produce the capital required to operate optimally, sales decline and prices rise.
The overall economic performance of any debt-dependent industries becomes less dependable,
driving down consumer and investor confidence while reduce overall economic output. Banks also
perform more poorly, due to the fact that they have less capital to invest and returns to acquire.
This drives down the overall economic system, both in the short term and the long term, as
companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives
down governmental tax revenues and reduces investor and consumer confidence (damaging equity
markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to
these adverse effects, as each are interconnected in a way that creates a domino effect across the
domestic economic system
Global Consequences
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While these domestic consequences are expected and, in many ways, intuitive, the
global dependency upon foreign trade in modern markets has exacerbated these
effects. Imports and exports play an increasingly large role in the health of most
developed economies, and as a result the relative well-being of trade partners
plays an increasingly critical role in the success of domestic economies.
A good example of this is to look at the way in which the U.S. (and to some extent,
European) banking disasters in 2008 and 2009 led to a complete global financial
meltdown, destroying economies not involved in the irresponsible investing
practices executed by banks in these specific regions. identifies the critical
importance of economic well-being in trading partners, as the U.S. banking and
financial crises spread rapidly (within the course of just one year) across a
substantial portion of the globe (though there are certainly other factors that
contributed to the financial crisis and its consequences). The domestic reduction
of capital for businesses, income for consumers and tax revenue for governments
ultimately results in a reduction of trade and economic activity for other
economies
International Banking
Operations
Banking Crisis from an International
Perspective
I. The Causes of Banking Crises
-Each banking crisis has its own dynamics, most
of the main ingredients are always present.
-Based on their most common causes, Banking
crises can be classified into one of two
categories:
1-Microeconomic (or bad banking),
2- Macroeconomic (or bad operating
environment).
1-Bad banking
• Banking crises often have their roots in poor bank
operations: poor lending practices, excessive risk
taking, poor governance, lack of internal controls,
focus on market share rather than profitability,
and currency and maturity mismatches in the
banks themselves or among their borrowers.
These conditions are aggravated if bank owners
have little at stake in the banks—that is, do not
have enough capital invested in the banks—and if
bank managers carry little personal responsibility
for the risks they take.
• In some emerging countries these conditions may be
worsened when bank ownership is very narrow and
when banks are run as personal "piggy banks" or
pyramid schemes of industrial groups or families.
• In these conditions, connected lending, insider
operations, and outright fraud may go on with
impunity.
• Similarly, state banks may be run as quasi-fiscal
agencies based on political criteria with disregard for
commercial principles, which undermines their
solvency and the soundness of other better-run banks.
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Bad banking can only persist in the absence of proper regulation and supervision,
and of adequate market discipline.
Weak supervisory frameworks may include allowing for concentrated lending,
portfolio mismatches, inadequate loan valuation that overstate bank profits and
capital, incompetent management, etc. Supervision may also lack authority, and
have an insufficient number of skilled staff who may be poorly motivated and
compensated.
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Poor transparency, limited financial disclosure, and poor accounting and auditing
practices mean that the market—that is, bank creditors—will not have sufficient
information to exert discipline on bank owners.
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Market forces are further impeded by weak frameworks for dealing with problem
banks, including weak legal, judicial and institutional frameworks for dealing with
failing banks and companies. Expectations of depositor and creditor bailouts may
overpower any policy to the contrary.
2-Bad operating environment
• Crises can arise from macroeconomic causes that are external to
the banking system.
• Even well-run banking systems operating in a strong legal and
regulatory framework can be overwhelmed by the effects of a poor
macroeconomic environment or inadequate policies.
Macroeconomic difficulties may arise from lending booms, possibly
stoked by excessive capital inflows or changes in tax rules; real
estate and/or equity price bubbles that inflate and burst; slowdown
in growth and/or exports, or the loss of export markets; growing
excess capacity/falling profitability in real sector; lower overall
investment; rising fiscal and/or current account deficits; weakened
public debt sustainability; sharp changes in exchange rates and real
interest rates; and so on. Not all these developments are under
authorities' control—but governments must be ready to adapt
macro policies that take the conditions of a systemically distressed
banking system into account.
Crisis triggers
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As long as the banks remain liquid, banking distress can persist for a prolonged period—until some trigger leads
depositors and creditors to lose confidence in the banking system. These can be market, policy, or political shocks
that become the "wakeup call" for dealing with problems so far ignored, causing dramatic shifts in expectations
and systemic bank runs.
The emergence of illiquidity in one bank can quickly spread to others through contagion, as bank or payment
system weaknesses destroy credibility of all banks, and lead to creditor and depositor runs regardless of the
soundness of individual banks. Contagion is in this case local, but can also be international, when it is caused by
the emergence of a systemic crisis in a country related through financial and trade channels.
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Premature financial liberalization, together with inadequate preparation among bankers and supervisors, has also
in the past triggered banking crises. Bankers may not have the needed skills to manage and price risk, and
supervisors may lack adequate resources and competencies to monitor the more complex new risks. This can
easily create a situation where liberalization unleashes the effects of pure ignorance about the risks involved
among relevant parties.
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A loss of confidence in the government and its ability to implement its macroeconomic framework can trigger a
systemic crisis. Such concerns erode confidence in the banking sector as well as, often, the currency.
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In addition, if the medium-term sustainability of a country's macroeconomic policies, including its external debt,
comes under question, are in doubt, private confidence in the economic outlook can erode, resulting in the
emergence of banking pressures and, in unaddressed, banking distress.
• But maybe the most important issue is not the
specific causes of a banking crisis, but the ability
of the political authorities to come together to
develop a strategy and then implement it.
• Political decision makers must recognize that
there is a problem and make quick and resolute
actions. Developing a political consensus on the
path forward is a critical step. Most importantly,
the process must be seen as fair and transparent.
Bank owners and borrowers must be prevented
from exerting inappropriate interference
Framework for crisis resolution
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By the late 1990s, the Fund had significant experience in addressing banking sector
crises in a variety of economic environments. The experiences of the Nordic
countries were among the first, intensive areas of involvement and, in the late
1990s, the Fund, and MAE in particular, was intensively involved in resolving the
financial crises in Asia.
These crises emerged in an environment quite different from the crises in Latin
America today. The roots of the crises lay, in large part, with the weak financial
sector and were only triggered by macroeconomic difficulties. Our response was to
address those root causes, implementing important legal and regulatory reforms
and strengthening bank supervision. These efforts were supported by reforms to
address the deep insolvencies in the banks and institutional steps to manage the
system's nonperforming assets.
The results of the Nordic and Asian crises have been quite good. The countries
involved have largely emerged from the crises with vibrant financial systems.
However, the lessons learned so well in those countries are now being modified in
light of the new challenges faced in the more recent financial crises in Latin
America.
II. Recent Challenges
• If these issues where not sufficiently difficult
and challenging, recent banking crises have
dealt with a combination of high dollarization
and high levels of government debt that have
imposed particularly hard constraints on crisis
management
1-Dollarization
• Crises have emerged recently in highly dollarized economies such as
Argentina and Uruguay. This aspect raises issues not previously
encountered and special factors must be considered.
• A high degree of dollarization particularly makes banking systems
more prone to runs and makes runs more difficult to stop.
Dollarized economies face liquidity constraints early in the crisis, as
bank runs must be addressed using limited international reserves.
Furthermore, as depositors know that the supply of dollars is
limited, they may be more prone to leave the banking system.
• These conditions—the constraints on liquidity support and on
depositor protection—may make the use of administrative
measures—such as restrictions on deposit withdrawals or
securitization of bank liabilities—more likely. As we all know, both
Argentina and Uruguay were forced to design administrative
measures to contain a run on their banks that could not otherwise
be contained
2-Sovereign debt restructuring
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Another factor that has recently become evident is the constraints on banking crisis
management when this is combined with sovereign debt restructuring. Although we have
limited experience, available evidence suggests that the impact of sovereign debt
restructuring on bank soundness will depend on a large number of issues, including the size
of banks' exposure to the government, the currency of denomination of the debt, and the
terms and modalities of the debt restructuring.
Large-scale restructuring can result in immediate undercapitalization or even systemic
insolvency when banks have sizeable holdings of government debt. At the same time,
policymakers should be aware that the use of fiscal resources to deal with banking problems
are inherently limited when the debt is already unsustainable and needs to be restructured—
hence the government's role as creditor, guarantor, or owner of last resort is severely limited.
For these reasons, any strategy for sovereign debt restructuring must be designed to
explicitly consider the impact on the banking system.
From a banking system perspective, we have come to believe that, if restructuring is
necessary, and if the authorities have a choice, a preferable approach is to avoid nominal
reductions (haircuts) in bank assets. Haircuts would result in reduction of bank capital and,
likely, the imposition of remaining losses on depositors. Instead, the authorities should try to
achieve a restructuring through reductions in interest rates or extension of deposit maturities
that may not entail immediate losses
III. The Case of Argentina
• in 2000, the Argentine banking system was in sound
financial condition following the substantial consolidation,
privatization, and increased foreign entry in the second half
of the 1990s. This strengthening of the system was
supported by a tightening of regulation and supervision.
• The build up of the crisis began in 2001 and emerged in full
in 2002.
• During 2002, progress in stabilizing the financial conditions
was delayed by the lack of basic information on banks'
financial conditions, uncertainties concerning
compensation for policy-induced losses, as well as delays in
issuing necessary prudential and accounting rules.
Banking sector strategy
• The policy agenda for 2003 is both clear and urgent.
• As I mentioned above, the most important challenge now is
for the Argentine authorities—both the Ministry of
Economy and the Central Bank of Argentina—to agree on a
coherent banking strategy and then implement that
strategy as quickly as possible. Further delays will only
increase the costs of restructuring and reduce the already
limited options available.
• Second, as we have seen in numerous other crises, the
policies adapted must be transparent and uniformly
implemented. Special interests will always try to gain in
period of economic distress. The policy challenge is to build
a broad domestic consensus for the difficult challenges
ahead without giving in to limited, special interest groups.
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Third, progress must be made in understanding the true condition of the banking system. While
banks appear reasonably liquid, their solvency remains unclear. This reflects uncertainties about
compensation for policy-related losses as well as concerns about the quality of banks' portfolios.
These issues must be quickly addressed. Specifically:
The mechanism for compensating banks for policy-related losses should be finalized;
The regulatory framework should be updated;
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Banks must provide detailed audits, business plans, and monthly cash flow projections.
Fourth, the central bank must determine the state of the banking system. Using financial
statements and the business plans, viable and nonviable banks should be identified. Viability can be
determined by evaluating banks' capital, the strength and commitment of shareholders to
recapitalize the bank, the business plans, their client base, the quality of the loan portfolio, and
future cash flow.
Fifth, nonviable banks must be resolved, either through recapitalization and restructuring by
shareholders, or through least cost resolution techniques including merger, sale, or liquidation.
Finally, I believe that, regardless of the resolution option chosen, if feasible, additional losses to
depositors should be minimized. If depositors lose confidence further, it will be difficult to prevent
a resurgence of bank runs
Special issues for public banks
• A priority task is to accelerate the restructuring of
the large public banks, which were weak even
before the crisis and have accumulated a
substantial debt to the central bank.
Uncertainties remain about the true condition of
these banks, which must be ascertained through
a detailed due diligence process. After that, a
difficult restructuring process must begin, leading
to a reasonable financial solution to these banks'
problems, and a clear definition of the future role
for public banks in the Argentine system.
Remaining institutional agenda
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I would like to highlight two more issues that should have priority in the emerging
strategy for the financial sector.
We have seen in all countries that progress cannot be made in the restructuring of
the banking system without clear protection for supervisors. Dealing with weak or
insolvent banks touches at the heart of a country's financial system. Pressures can
be put on supervisors to make inappropriate decisions or not to make decisions at
all. Without protection, supervisors will have little ability to withstand such
pressures. Legal protection is a key element of any successful strategy.
Second, the autonomy of the central bank has increasingly become an accepted
international standard. In the region, as well as in Europe and Asia, more and more
central banks are gaining their autonomy. This allows them to act in the best
interest of the country, aiming monetary policy at controlling inflation and
ensuring financial stability. I would urge the Argentine authorities to continue their
movement towards the full autonomy of the central bank.
These are challenging times and I wish the best for Argentina and the Argentine
authorities