Banking Crises

With enough leverage, a small shock can

move the whole world
----
with apologies to Aristotle

Michael Smitka
Economics 102
Winter 2003
 Issue: Viability
• Leverage means that banks have very little
capital to set against their loans (or, more
generally, "risk assets")
• Hence there's not much to separate them
from bankruptcy if something goes
seriously wrong with their loans
• The wonder, then, is:
Why is the financial system sound?
 Answer
• Experience
– A century-plus of accumulated lending wisdom
• Regulation
– Banks are prevented, at least historically, from
placing certain types of bets
• Segmentation
– From investment banks, insurance companies
and so on, reinforcing experience & regulation
 What undermines?
• Systemic risk
– Big events that overwhelm even cautious banks
• Structural change
– Negates value of experience in managing risk
– Negates know-how in regulation
– Potential provides perverse incentives
– Rapid growth is the antithesis of sound banking
 LDC Bank Crisis
Latin American Debt in the 1970s
• US$ loans to non-US$ countries
– Exposed to systemic risk of a shock to exports
of Latin America
– Little experience: international banking
declined after 1929
– Little experience in regulating & evaluating
• Economists could theorize, but had little recent data
to make compelling cases to bankers chasing profits
 Rapid Growth: Supply
• On supply side due to:
– Petrodollars after first oil crisis
• OPEC had lots of revenue and needed to "recycl
e"
– Disintermediation
• big firms shifted to direct or non-bank financing
– E.g., commercial paper
– Banks thus were flush with funds but had lo
st traditional big customers
– Japanese banks, too -- new entry led to thin margins
 Rapid Growth: Demand
• Going into the 2nd oil crisis (1979),
commodity prices were rising
– Interest rates were moderate
– 10% nominal interest less 25% nominal revenue
increase meant -15% real rates!
• Petrodollar recycling (trade deficits) and
rapid growth led to strong demand
– No experience on costs of excess borrowing
Then came 1980…
 Systemic shock
• Fed President Volcker decided to cut U
S inflation: interest rates jumped
• Second oil crisis boosted import prices
• World-wide recession led to falling pric
es
– Now + 20% nominal interest rates
- (-20%) inflation =
+40% real interest rates
• LDCs couldn't pay back debt
 And debt there was!
• Brazil, Mexico, Venezuela & Argentina:
$176 billion
• Some 27 LDCs together owed $239 billi
on
• Citibank alone had about $1 billion in e
xposure to Brazil
• Most of this was in "Eurodollar" syndica
te loans with floating
 Regulation
• Well, 10% of capital but
– Different government-guaranteed national firms
weren't aggregated
– Data on aggregate lending was weak, except
perhaps for Brazil [based on first-hand
contemporary observation during my banking
career]
– Brazil was "promising" and well-managed
• Banks felt confident they'd be OK…
 Refinancing
• Default led to extended economic trauma
– US banks profits were depressed profits for
years; none failed directly due to losses
• Regulators did not force quick write-offs, which
would have led to the collapse of several New York,
Chicago & California "money-center" banks
– A few bankers had their careers shortened
– Over 100 million Latin Americans had their lives
disrupted, many thrown into abject poverty;
governments collapsed, too
 Jamaica, Nicaragua in 1980
• Jamaica, Nicaragua both hit by interest rates a
nd export price collapse
– Hurricane, tourism collapse also hit Jamaica
– Somoza emptied coffers, then fled war-struck Nicar
agua for Paraguay
• Bankruptcy not possible
– Couldn't start over, even if loan proceeds stolen
– Instead had to shrink GDP to generate export surpl
us
– Bottom line: massive poverty / economic collapse
• I saw firsthand as representative for Japanese
banks to the IMF-led consultations for Jamaica
 Other Cases
• Asian currency crisis of July 2, 1997
– Thai banks borrowed in US$ but lent in baht,
bearing all the foreign exchange risk
– Thailand had a fixed exchange rate, so no pro
blem!
• until the Bank of Thailand ran out of dollars
– When the baht fell by 50%, the banking syste
m was immediately insolvent
• Companies could repay, but that still left banks 5
0% short of what they needed to repay foreign ban
ks
 Argentina
• Argentina
– A fixed exchange rate that couldn't be
maintained
• Adopted to stop an inflation: an "anchor" linking
domestic prices to stable US prices
– Banks accepted US$ deposits, promising
convertibility
• When Argentina ran out of dollars, domestic banks
collapsed: massive runs on banks
 Burma
• Weak government, poor tax collection
– Printed money to finance government: massive AD
stimulus, since taxes weren't collected
• Led to hyperinflation
• Made worse by inward shift of AS
• Bank interest rates were low
– Everyone wanted to withdraw cash
– Bank runs led to collapse
– Made worse by freezing of US$ accounts
 Japan
• Various economic shocks encouraged rapi
d money creation by BOJ
– Excess savings (paradox of thrift) underlay thi
s
• Structural shifts led to disintermediation
– Big banks tried lending to small firms
– Most tied to real estate or stocks as collateral
• When real estate prices rose
– Banks could lend even more!
 But prices can fall, too.
• Japanese stock market peaked dec 1989
– Had gone from 10,000 to 39,000 in 4 years
• Real estate did the same
– Major urban land prices quadrupled, or more
• Historically prices had never fallen
• But when they did, banks were finished
– Regulators, bankers caught by novelty
• Boom atmosphere accentuated: Japan wou
ld surpass the US soon
 Japan today
• Bad debts mean banking system insolvent
• Economy will never grow again on a
sustained basis
• Unemployment at postwar high
• Growth lowest among OECD for the past
decade
 Is the US safe?
• Consumers have dipped into home eq
uity to support their lifestyle
– Are real estate prices set to fall?
• How many more Enrons are out there?
• But direct finance (stocks, bonds) great
er than in other economies
– Consumers -- pension funds -- take the "hit
" more than bankers. Maybe.
EOF