Models of Financial Crises, Reforms in the

International Financial Architecture and

Determinants of Financial Crisis in India from
1971-72 through 2008-09

S.K.Mathur,PhD
AP,HSS,IITK(www.iitk.ac.in)

1
Definition of Crises and
Links
• Sachs(1997) classified financial crises as fiscal crises,
exchange crises( currency crisis and currency crashes)
and banking crises according to their field. First a fiscal
crisis means the situation where the government gets
into debt restructuring or default as it cannot postpone
a debt or get a new loan. Second, an exchange crisis
means depletion of the central bank’s foreign
exchange reserves as market participants switch
domestic currency denominated assets into foreign
currency denominated assets. Lastly a banking crisis
hits the commercial banks when they face liquidity
shortage or insolvency as they cannot roll over debt
any longer or face a sudden withdrawal of deposits.

2
Links between Crises
• Banking Crisis can cause a Currency
Crisis( Interventions to increase credit can lead to
inflation and devaluation of currency)
• Currency Crisis can cause Banking Crisis( through
decrease in reserves and credit (money supply) and
commercial banks have to give up loans even to
profitable entities
• Sudden Capital Outflows can cause a banking crisis
and a currency crisis(IMF,1997).

3
Impact of Financial Crises
• A collapse in housing prices in the United States in the middle of 2007 led to a rise in defaults in loan repayments
and then rapidly to major losses in financial institutions ACROSS THE WORLD. Contagion Effect prevalent.
Governments and Central Banks are now rethinking about the organizational structure and the incentives given
to executives to promote profits at all costs. Reasons ranging from moral hazard( on part of investment bankers),
adverse selection (of borrowers of mortgage loans), global financial imbalances and low interest rate, monetary
policy of the US after dot com trouble in 2001, inadequate regulation of investment banks( forays into capital
markets), Chinese undervalued exchange rate.
• Five independent investment banks disappeared during the recent US sub prime lending crisis; two went
bankrupt, one was taken over by the commercial bank and two converted into financial conglomerates. Shadow
Banking system at fault. US States Nevada and California affected the most. 40% reduction in stock value. Loss of
More than 6 lakhs jobs in California from 2007(total 7 million job lost). Unemployment rate 12.5%(short of 20%
figure during the great depression, 1929). US fiscal stimulus 5.6% of GDP.
• In India stock prices declined by 40%, exchange rate declined by 25%, loss of reserves about 40-50 billion in
reserves in two months, tightening of credit lines abroad led indian firms to turn to indian banking system for
credit and demand for foreign exchange
• $ 150 billion moved out of the 5 East Asian Countries which the World Bank Defined as the ‘East Asian Tigers’ in
the month of June 1997 leading to deceleration in economic growth rates and heavy depreciation of the
exchange rate( currency crashes). Contagion effect prevalent. Non banking institution lacked supervision for their
lending for real estate, margin loans for equity, consumer finance and equity finance.
• Probably more of such crisis in future because of risk taking behaviour of market players for increasing growth
and forays into rural areas in India. Need to have correct diagnose and resolution at national, regional and
international level (international financial architecture)

4
 Financial Crisis and Factors
Leading to Crisis
• Financial Crisis is a regular phenomena of the 20 the Century
(Kaminsky and Reinhart,1999),Important ones: Latin America
Crisis(1982, petro dollars available), EMU Crisis(1992), Mexican
Peso Crisis(1994, CAD/GDP 8%), East Asian(1997), Argentinian
Crisis(2001), Turkey(2000, sale of government securities by banks
triggered action by creditors),Russian(1998) among others, India
(1991, mortgage gold abroad to borrow) more than 150 episodes
of banking and currency crisis since 1970s. Precise figures 124
banking crisis, 208 currency crisis and 63 sovereign debt
crisis(IMF,2008) Fiscal cost ranging from 3% to 20 % of the GDP.
18 bank centered financial crisis from post war period (Reinhart
and Rogoff, 2008)

• While each financial crisis is distinct they also share striking

similarities in the run up of asset prices, in debt accumulation, in
growth patterns, in current account deficit (Boom and Bust
Phenomena, V shaped), Reinhart and Rogoff(2008)

5
 Impact on India
Key Macro Indicators
Indicator Period 2007-08 2008-09
Growth, per cent
Real GDP Growth April-December 9.0 6.9

Industrial April-February 8.8 2.8

production
Services April-December 10.5 9.7
Exports April-March 28.4 6.4
Imports April-March 40.2 17.9
GFD/GDP April-March 2.7 6.0
Stock Market April-March 16,569 12,366
(BSE Sensex)
Rs.per US$ April-March 40.24 45.92

6
Models of Financial Crises
• Krugman(1979) Model of Macroeconomic Imbalances
Created through high fiscal deficit and inadequate
reserves (First Generation)
• Self Fulfilling Models by Radelet and Sachs(1998),
Obstfield(1996), Ozkan and Sutherland(1995),
Wyplosz(1998): Second Generation Models
• Models Of Moral Hazard and Adverse Selection by
Krugman(1998), Dooley(1997), Radelet and
Sachs(1998):Third Generation. US Subprime crisis due to
moral hazard( role of credit agencies and complex and
toxic assets not priced accurately) and adverse selection
• Fourth Generation Models By Bhagwati(1998) and
Radelet and Sachs(1998):Creditors Actions

7
8
Reasons of Financial Crises
• Macroeconomic imbalances( inflation, budget deficit, government debt, interest rates)
financial instability (markets, Institutions, infrastructure:Mathur,2003), and Microeconomic
Imbalances/ Instability( how are banks generating and investing funds, borrow short and
invest long, corporate governance issues, hedging instruments leading to speculation)
• Speculation and Self Fulfilling Tendencies
• Moral Hazard and Adverse Selection
• Creditors actions
• Investment Banks( underwriters and price determination of new stocks) in the US sold toxic
assets with perverse incentives( including innovations in derivative instruments) with the
hope that investors will buy them by making available easy funds through sub prime loans.
Decline in housing prices made the whole investments in mortgage based (loans) securities
unprofitable leading to bursting of the ‘ asset bubble’( deceleration of asset prices) and hence
shortage of liquidity and capital in the banking system first and then in the entire system.
Interlinkages in financial markets compounded the problem( global supervisory and
regulatory standards required).
• Global Financial Imbalances, Nth Country Problem, Impossible Trillema between Monetary
independence, perfect capital mobility and fixed exchange rate system, Exchange Rate
Distortions, Monetary Policy Volatility( low interest since the dot.com trouble in the US)
• Factor Accumulation leading to Diminishing marginal Productivity

9
 Global Financial Crisis
Current Account Balance
Country 1990- 1995- 2000- 2005 2006 2007 2008
94 (per
99 cent
04 to GDP)
China 1.4 1.9 2.4 7.2 9.5 11.0 10.0
India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8
Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1
Saudi -11.7 -2.4 10.6 28.7 27.9 25.1 28.9
Arabia
United Arab 8.3 4.6 9.9 18.0 22.6 16.1 15.8
Emirates
United -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7
States
Memo:
Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7
Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8
Source: World Economic Outlook Database, April 2009, International Monetary Fund.
Note: (-) indicates deficit.
10
 Global Financial Crisis
US Monetary Policy

•Volatility in monetary policy in advanced economies

•Large volatility in capital flows to EMEs
•Again very loose MP in US – likely surge in capital flows to EMEs? 11
 Global Financial Crisis
US Monetary Policy
Taylors rule which determines nominal interest rate as a function of
differences in actual and target inflation rates and growth rates and potential
growth rate

•US Monetary policy too loose during 2002-04; aggregate

demand exceeded output; large current a/c deficit;
mirrored in large surpluses in China and elsewhere. 12
 Global Financial Crisis
Capital Flows to Emerging Market
Economies

•Very large capital flows to EMEs –– now outflows in 2009 - large

volatility - implications for monetary management and financial stability
13
 Global Financial Crisis
Worsening Global Economic
Outlook
Growth Forecast of IMF (per cent)
Region April July 2008 October April 2009
2008 2008
  20082009 200 2009 20 2009 2008 2009
8 0
8
Advanced 1.3 1.3 1.7 1.4 1.5 0.5 0.9 (-)3.8
countrie
s
EMEs 6.7 6.6 6.9 6.7 6.9 6.1 6.1 1.6
World 3.7 3.8 4.1 3.9 3.9 3.0 3.2 (-)1.3
Global Trade Volume (Goods and Services)
World 3.7 3.8 4.1 3.9 3.9 3.0 3.3 -11.0
14
Research
• Index of Crises=Fn(M2 Multiplier, Domestic Credit/GDP,
Real Interest rate, lending/deposit rate ratio, Excess M1
Balances,M2/Reserves,Bank Deposits, Real Exchange
rate, Short term debt/reserves( trade credit and NRI
deposits in banks with exchange guarantees), Current
ac deficit/reserves, Fiscal Deficit/GDP, Government
debt/GDP, stock returns, terms of trade, Budget
deficit/GDP, short term flows/GDP, index of financial
liberalization among others
• Time series data of Country and Logit Analysis

15
Identification of Crisis (reserve loss and appreciation
of foreign currency) and its Determinants in India

• I created an index of crisis( like in Edwards,2004) based on weighted average of

exchange rate( both rupees to US $ and rupees to basket of currencies and sdr ) and
reserves rate of change where in the weights are the standard deviation of rate of
change of exchange rate and reserves. The data came from the Handbook of Statistics,
RBI. Years considered were 1971-72 through 2008-09.
• If the index in any year was greater than equal to mean of the index +one standard
deviation we called it the crisis year and gave a value one and o otherwise. Using our
first index (weighted average of reserve rate of change and us rupee exchange rate)
we found 07 years where we had crisis out of 38 years. These are 1981-82,84-85,88-
89,89-90,91-92,92-93,2008-09.
• Using my second crisis index (weighted average of reserve rate of change and
appreciation of basket of currencies and SDR) i found that in 10 years we had crisis
since 1971-72. These are 72-73,86-87,87-88,88-89,89-90,91-92,92-93,95-96,99-
00,2008-09.
• I further regressed the two crisis indices on its determinants using time series data
namely short term debt/ reserves, trade balance, FDI flows, SBI Advance lending rates,
loans and advances, total financial assistance,M3 Growth, deposit rates, call rates,
current account deficit/ GDP,a among others. Logit regression was used for the work.
Coefficients to be interpreted in terms of probability. Marginal effects on probability are
worked out by multiplying the coefficients with value of PDF depending on values of all
the explanatory variables.

16
 indexus indexweighted

mean -0.64009 1.327

median -0.34169 -0.25

max 24.4028 23.36

min -28.2775 -24.4

sd 13.32411 12.89

skwe -0.01017 -0.13

kurto 2.651387 2.399

jbstatistics 0.193079 0.685

pvalue 0.907974 0.709

38

17
1IF CRISIS O OTHTERWISE Dependent Variable: SER01

Method: ML - Binary Logit

Date: 12/22/09 Time: 17:16

Sample: 1 38

Included observations: 38

Convergence achieved after 12 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

C -17.472 8.909341 -1.96108 0.0499

SHORT TERM DEBT/RESERVES SER03 0.025521 0.013535 1.885587 0.0594

FDI FLOWS SER05 0.000135 6.71E-05 2.013808 0.044

SBIADVANCE RATE SER15 0.888661 0.519142 1.711788 0.0869

Mean dependent var 0.184211 S.D. dependent var 0.392859

S.E. of regression 0.318481 Akaike info criterion 0.757899

Sum squared resid 3.448636 Schwarz criterion 0.930277

Log likelihood -10.4001 Hannan-Quinn criter. 0.81923

Restr. log likelihood -18.1533 Avg. log likelihood -0.27369

LR statistic (3 df) 15.50643 McFadden R-squared 0.427097

Probability(LR stat) 0.001431

Obs with Dep=0 31 Total obs 38

Obs with Dep=1 7

18
 Dependent Variable: SER02
Method: ML - Binary Logit
Date: 12/22/09 Time: 17:25
Sample: 1 38
Included observations: 38
Convergence achieved after 10 iterations
Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

C -3.545018 1.083501 -3.271819 0.0

ORTTERMDEBT/RESE SER03 0.032139 0.013958 2.302595 0.0
NSANDADVANCES SER14 7.96E-05 4.53E-05 1.759255 0.0
DEBALANCE SER13 -1.48E-05 1.63E-05 -0.912317 0.3

Mean dependent var 0.263158 S.D. dependent var 0.446

S.E. of regression 0.373049 Akaike info criterion 1.045
Sum squared resid 4.73163 Schwarz criterion 1.217
Log likelihood -15.86643 Hannan-Quinn criter. 1.106
Restr. log likelihood -21.9007 Avg. log likelihood -0.41
LR statistic (3 df) 12.06854 McFadden R-squared 0.275
Probability(LR stat) 0.007152

Obs with Dep=0 28 Total obs

Obs with Dep=1 10
19
Conclusion of Regression
Exercise
• High Short term
debt/reserves( generally greater than
25%), net capital inflows more of the
nature of portfolio investment) ,low and
excess liquidity in the system through
various channels( monetary policy, loans
and advances and financial assistance,
Lending rates) can create vulnerabilities
in the system and financial crisis.

20
 Response of SER10 to One S.D. Innovations Response of SER02 to One S.D. Innovations
12 20

Impulse Response
10
15
8
10
6

4 5

2
0
0
-5
-2

-4 -10
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

SER10 SER03 SER10 SER03

SER02 SER04 SER02 SER04

Response of SER03 to One S.D. Innovations Response of SER04 to One S.D. Innovations
30000 1.5

1.0
20000
0.5

0.0
10000
-0.5

-1.0
0
-1.5

-10000 -2.0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

SER10 SER03 SER10 SER03 21

SER02 SER04 SER02 SER04
 Response of SER10 to One S.D. Innovations Response of SER02 to One S.D. Innovations
15 100

50
10
0

-50
5
-100

-150
0
-200

-5 -250
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

SER10 SER03 SER10 SER03

SER02 SER04 SER02 SER04

Response of SER03 to One S.D. Innovations Response of SER04 to One S.D. Innovations
800000 20

600000 10

0
400000
-10
200000
-20
0
-30

-200000 -40

-400000 -50
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

SER10 SER03 SER10 SER03

SER02 SER04 SER02 SER04

22
Variance Decomposition of Crisis Index(ser10) (see
14 period onwards)
Ser02(short term debt/reserves), ser03(FDI inflows)
and ser04(SBI lending rate)
• Variance Decomposition of SER10:
• Period S.E. SER10 SER02 SER03 SER04
• 1 10.89255 100.0000 0.000000 0.000000 0.000000
• 2 11.47911 90.85825 0.491326 5.816073 2.834348
• 3 11.95784 85.94474 2.429590 7.010690 4.614977
• 4 12.36843 80.87034 4.882181 7.274282 6.973199
• 5 12.62156 79.11475 6.203067 7.098214 7.583974
• 6 12.76926 77.45298 7.458554 7.265468 7.823001
• 7 12.90372 75.89369 8.422976 7.115942 8.567390
• 8 13.00137 74.77232 9.057181 7.276772 8.893722
• 9 13.05441 74.16621 9.424705 7.362394 9.046691
• 10 13.10872 73.63288 9.663538 7.579985 9.123595
• 11 13.15754 73.13279 9.813163 7.864468 9.189580
• 12 13.22732 72.42589 9.881788 8.538001 9.154322
• 13 13.33020 71.45207 9.889375 9.607735 9.050818
• 14 13.51499 69.77280 9.811177 11.58476 8.831257
• 15 13.84006 66.94216 9.610974 15.00459 8.442274
• 16 14.43643 62.23530 9.209942 20.77965 7.775104
• 17 15.49713 55.18069 8.560183 29.49489 6.764233
• 18 17.34114 45.84385 7.662793 41.07157 5.421786
• 19 20.39794 35.56333 6.649899 53.84511 3.941668
• 20 25.23001 26.28188 5.718558 65.39688 2.602685

23
Granger Causality Tests
SBI lending rate have two way causality with crisis index while

short term debt/reserves causes crisis

• Pairwise Granger Causality Tests

• Date: 12/27/09 Time: 14:00
• Sample: 1 38
• Lags: 2
• Null Hypothesis: Obs F-Statistic Probability
• SER02 does not Granger Cause SER10 36 2.60406 0.09008
• SER10 does not Granger Cause SER02 0.50195 0.61018
• SER03 does not Granger Cause SER10 36 1.24463 0.30205
• SER10 does not Granger Cause SER03 0.63031 0.53911
• SER04 does not Granger Cause SER10 36 3.57110 0.04021
• SER10 does not Granger Cause SER04 3.30854 0.04985
• SER03 does not Granger Cause SER02 36 0.17217 0.84263
• SER02 does not Granger Cause SER03 0.00379 0.99622
• SER04 does not Granger Cause SER02 36 1.10885 0.34267
• SER02 does not Granger Cause SER04 1.59652 0.21881
• SER04 does not Granger Cause SER03 36 0.56976 0.57147
• SER03 does not Granger Cause SER04 2.29824 0.11730

24
Conclusions
• Innovation accounting shows that short term debt/reserves and Capital
inflows do have impact on crisis index dynamically in future time
periods (after 14time period inflows of capital have significant
explanation to crisis index ). SBI lending rate have two way causality
with crisis index while short term debt/reserves causes crisis.
• Limitation: Does Financial Liberalization precede a financial crisis.
Looking for an financial liberalization index( over the years) which can
capture: interest rate deregulations, removal of entry barriers,
reduction in reserve requirements, easing of credit control,
implementation of prudential rules, stock market reform, privatization
of state owned banks, external liberalization,M2Multiplier,deposit
lending ratio, real interest rate, private sector credit/GDP).
• More Involved econometric work should have an index of banking
regulation, stock returns as well as an index of financial liberalization as
right hand side variables as potential determinants of crisis.

25
Reforms in International Financial
Architecture (official mechanisms
which facilitate financial stability) to
Reduce Vulnerabilities of Countries
Transparency in reporting of Macroeconomic and Microeconomic Indicators, not merely
•
information but methodology as well
• Strengthening of Financial Institutions including Banks : BIS Basel II Norms on Capital
Adequacy and Internal Risk Assessments through Value At Risk Models( Market Risk but
limitations). Curb other risks like Operational Risk, Credit Risk regulations( capital asset
ratios, credit expansion, maturity mismatches) in boom and recessionary conditions, More
IMF Money like SDRs and liberal disbursement policy, Global Supervisory Standards
required,G-20(FINANCIAL STABILITY BOARD to Unite Regulators and IMF in providing early
warnings of potential threat
• Nationalization vs Private Sector Bail In at the time of Crisis. Bailouts do not make sense
when there are excessive involved. Measured risks promotes stability and long run
growth( Rao,2009)
• Adequate Supervision and prudential Regulations to Curb Distortions Created by
Asymmetric Information
• Coordination of Fiscal Policies and Monetary Policies across Countries to Curb ‘Excessive’
Surplus and Deficits in the Balance of Payments
• Invest the Surplus (foreign exchange in Infrastructure, Social Sector), Questions to be
answered is What are Adequate Level of Reserves( ft of volatility in export receipts, GDP,
population, REER volatility, imports); three months of reserves are adequate and
instruments of financial intermediaries (SPVs)? Cost of maintaining reserves( sterlization
and investment in low interest liquid debts )

26
Reforms
• Growth of Manufacturing Sector so that excessive money does not
chase too few goods
• Total Factor Productivity growth instead of Factor accumulation( leading
to diminishing marginal productivity)
• Controls on Movement of Financial Capital and keeping currency
competitive so that adequate reserves can be build up, REDUCING
SHORT TERM DEBT AND VOLATILITY IN CAPITAL INFLOWS,
STERLIZATION IS IMPORTANT
• Coordinated approach of regulation moving away from pillars
approach(Mathur,2001). Take care of regulatory arbitrage.
• Capital provisioning and regulation of shadow banking
• Tax at good times and spend it at bad times (R Rajan)
• Boring Banking (Krugman)

27
India’s Approach to Managing
Financial Stability

– Financial sector, especially banks, subject to prudential regulation

• both liquidity and capital.
• prudential limits on banks’ inter-bank liabilities in relation to their net
worth;
• asset-liability management guidelines take cognizance of both on and off
balance sheet items
• Basel II framework: guidelines issued.
• Dynamic provisioning
• NBFCs: regulation and supervision tightened - to reduce regulatory
arbitrage.
• NPA (reduced from 15% of loans disbursed in 1997 to less than 5% today),
short term debt/ Reserves 19%,cad/gdp 2.6 IN 2008,FISCAL DEFICIT/GDP
6.14, Most of the external debt is long term debt for India, debt/GDP
below 60%(Masstricht Criteria).
• CAMELS APPROACH TO BANKING( CAPITAL ADEQUACY, ASSET QUALITY,
MANAGEMENT,EARNINGS,LIQUIDITY AND SYSTEMS AND
CONTOLS);BANKING REFORMS(PRUDENTIAL REFORMS AND STANDARDS,
SUPERVISION, LEGAL FRAMEWORK)

28
References
• Bhagwati, J(1998),” Asian Financial Crisis Debate: Why? How Severe?”.
Paper presented at the international conference on Managing the Asian
Financial Crisis, Asian Strategic Leadership Institute and Rating Agency,
Malaysia(2-3 November), Kuala Lumpur
• Edwards Sebastian(2004),” Public Sector Deficits, Macroeconomic Stability,
and Economic Performance”, in A Krueger and S Chnoy edited book entitled
Reforming India’s External, Financial and Fiscal Policies, Oxford University
Press,
• Dooley, M(1997), “ A Model of Crisis in Emerging Markets, NBER Working
Paper No. 6300, Cambridge,MA
• Kaminsky, G.L and Reinhart Carmen M(1999),” The Twin Crises: The Causes
of Banking and Balance of Payments Problems”, AER,Vol 89,pp 473-500
• Reinhart and Rogoff(2008),” Is the 2007 US Sub Prime Financial Crisis So
Different? An International Historical Comparison,AER,98:2
• IMF(2008),” Systemic Banking Crises: A New Databse, WP/08/224 by
Laeven and Valencia
• Krugman(1979),” A Model of Balance of Payments Crises,” Journal of
Money, Credit and Banking, Volume II,August, pp 311-25

29
References
• Mathur, SK(2001), “ Insurance Regulation: Some Issues”,Geneva Papers on Risk
and Insurance, Blackwell Publishers, Oxford, UK, Vol 26, No1, Jan
• ----------(2003),” Prudential Practices and Financial Stability: Some Conceptual
Issues, Geneva Papers on Risk and Insurance, Blackwell Publishers, Oxford, UK
Volume 27, No 3,July
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European Economic Review, Vol 40, April pp1037-47

• Ozkan, F and Alan Sutherland(1995),” Policy measures to avoid a currency crisis”,

The Economic Journal, Volume 105, March pp 510-19
• Radelet and Sachs(1998),” The East Asian Financial Crisis: Diagnosis, Remedies
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Policy”,Paper presented at the 11 Conference on Money and Finance,IGIDR,Jan 23-
24,2009
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30