Chapter 4 - Banking Crises – Part II

Financial Crisis in Emerging Economies- Fall 2023

LAU Beirut

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 IX- Origins and Causes of Banking Crises
• Empirical work in the area of origins and causes of banking crises has focused on a combination
of:
• microeconomic causes (bank specific),
• structural causes (structure of the banking system), and
• macroeconomic causes
for which emphasis has varied from one research to another.

• Much of the research relates to a single country experience while others involve a panel of
country.

• Studies on the possible causes of banking system problems and the conditions under which
banking crises are likely to occur identified a list of potential determinants of crisis and these are
interrelated or induce one another and could commonly be responsible for amplifying the severity
of the problem or crisis.
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 Potential Determinants of Banking Crises

Domestic
macroeconomic
instability
Poor and
inadequate External
bank macroeconomic
management, volatility
regulation and
supervision

Banking
Problems/Crises

Improper Unfavorable
Structure of economic
the banking policy changes
system and reforms
Inadequate
government
safety net

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 1-Domestic Macroeconomic Instability

Affects the activity and profitability of Lower real value of capital and force
businesses and causes them to incur losses, portfolio adjustments from high income
implying high ratio of non performing loans at activities to lower ones
banks and rising losses
Demotivate borrowing and lending
Leads to a drop in the demand for loans, thus activities thus less business and lower
reducing the income and profitability of banks Sharp profitability for banks
contraction in
High inflation
economic
rates
activity and
output

Can reduce banks’ profitability or cause losses if Can impact negatively the value of the
interest paid on deposits increase faster than collateral underlying the loan and weaken
interest charged on loans the solvency of banks
High interest Collapse in asset
Make loan repayments more difficult for rates prices
borrowers and increase the share of loan losses May raise fears about the safety and
at banks soundness of banks and encourage bank
Exacerbate the moral hazard and adverse runs
selection problems and lower the quality of
loan portfolios

Can reduce domestic liquidity and lead to a 4

sharp fall in asset prices
Factors behind the increase in short term interest rates

The need to defend the

exchange rate against a Increase in international
Inflation stabilization policies
speculative attack on the interest rates
currency

Financial liberalization and An increase in the rate of Weak or insolvent banking

the removal of interest rate inflation and a the pursuit of institutions offering high rates
control restrictive monetary policy in competing for funds

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 2-External Macroeconomic Volatility
Large capital inflows and credit booms
induced by low international interest rates, financial
liberalization or government guarantees of the exchange rate
or FX deposits, tend if not sterilized to increase fast bank
deposits and loans most of which low quality.
(given the limited number of creditworthy projects and
limited capacity to assess and monitor projects and banks)
Problems arise when the credit boom bubble collapses or
under capital inflow reversal causing output contraction and
liquidity problem for banks
4 main factors
Real exchange rate appreciation
Deteriorates international competitiveness in tradeable
sectors and reduces their profitability and thus their ability to
pay back bank debt.
Increases domestic real interest rates and incites locals to
borrow in foreign currencies, meaning more trouble to banks
if the currency mismatch is large and unanticipated exchange
rate movements occur.
The fixed exchange rate regime and currency crises
A fixed exchange rate decreases the exchange rate risk ,
encourages banks to rely on external funding, and promotes
capital inflows and subsequent lending booms, excessive risk
taking at banks, and low asset quality .
Unexpected currency devaluation in the presence of currency
mismatch make domestic currency denominated earnings
finance less foreign currency denominated debt. This could
be problematic to individuals, firms, and banks
Shocks to the terms of trade
Worsening terms of trade (decline in the relative price of
exportable to importable goods) affects negatively the
profitability of commodity exporters and impair their ability
to honor debt obligations.
Banks will be hit if they devote a large share of their loans
portfolios to firms in the exports sector
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 3-Unfavorable Economic Policy Changes and Reforms

Sharp shifts in monetary and

fiscal policies
Expansionary policies stimulate a Financial liberalization and
credit boom and increases asset prices deregulation
Then a tightened policy to fight
Can generate lending booms and
resulting inflation pierces the asset
asset price bubbles and breed a
price bubble and make it harder for
banking crisis
borrowers under higher interest rates
to settle debt and refinance their This applies to countries with weak
positions institutional environment and
ineffective prudential regulation and
This would increase non performing
supervision as these factors increase
loans at banks
the opportunity for banks to take on
Falling collateral value with declining additional risks
asset prices reduces lending activity
and tighten credit further and lower
more asset prices

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Financial Repression vs. Financial Liberalization
Financial repression
• Created by the government when forcing banks
and other financial institutions to acquire funds at
low and negative real interest rates, thus reducing
domestic savings and decreasing the availability of
resources to finance investment.
• It involves direct government intervention in the
economy, of which, forcing banks to fund
government fiscal imbalances and subsidize
priority sectors at low and negative real interest
rates.
Financial liberalization
• Many countries started as early as the 1970s to
liberalize and deregulate their financial systems to
reduce direct government intervention in the economy,
on the believe that this liberalization would promote
financial development and economic growth.
• Liberalization and deregulation involve lifting or easing
bank interest rate ceilings, foreign financial entry
barriers, and government interference in credit
allocation decisions.
• Can take also the form of lowering compulsory reserve
requirements at banks and privatizing many depository
and insurance institutions.
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Mechanisms through which financial liberalization increase banking
sector problems and drive banks to assume more risk
• Financial liberalization grants easier access of local
banks to new domestic and foreign markets and
sectors, where banks can over-lend to a given
sector, firm, individual and risky borrower as
interest rates are now market-determined.
Previously banks could not charge a high or
market determined risk premium to high risk customers
and that would have affected their risk/ return trade off
and probably induced banks to better diversify their
portfolios and/or reduced the extension of such risky
loans.
• The involvement of domestic banks in new risky
activities such as derivatives’ contracts.
• The competition coming in with the lifting of
barriers to entry and the removal of ceilings on
deposit interest rates. Increased bank competition
contributes to moral hazard and increased risk
taking.
• The lack of necessary skills and experience of non-
trained bank staff to evaluate and monitor the risk
of a bank loan portfolio and manage interest rate
risk in this new environment of less regulated
financial system.
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 4-Inadequate Government Safety Net

Too Big To Fail Policy

Deposit Insurance
Inadequate deposit insurance can
increase moral hazard and encourage
banks to take excessive risks that may
lead to a crisis.
Because depositors know that their
deposits are guaranteed in case of bank
failure, they tend to not impose market
discipline on banks (through
withdrawing deposits) when banks
take too much risk.
It follows that banks have in the
presence of a safety net/deposit
insurance an incentive to take on
greater risks.
Governments may support selected
large banks through the too-big-to-fail
policy where they guarantee insured
depositors, uninsured depositors and
other creditors of these banks to
prevent the occurrence of a major
financial disruption.
Such a policy can increase moral
hazard incentives for banks as
uninsured depositors and other
creditors have no incentive to monitor
big banks under such a government
guarantee.
Large banks may therefore take larger
risks than smaller ones and that could
make bank failures more likely.
Lender of Last Resort Facility
Where the lender of last resort, the
central bank, stands ready to lend
directly financial institutions in trouble
or inject liquidity into the financial
system to maintain financial system
stability.
A badly specified lender of last resort
facility may create incentive for banks
to take on excessive risk and thus
increase the probability of bank failure
rather than promoting stability.

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5-Improper Structure of the Banking System and Government
Ownership of Banks
Concentration of State Owned Banks
State owned banks have traditionally been
considered inefficient, overstaffed and non- profit –
driven
Their activities are often dictated or influenced by
political objectives and personal interests of those in
the public sector and therefore borrowers'
creditworthiness plays only a minor role in the credit
decision. This is to say that many of these loans
would become non- performing.
State owned banks have also less incentive to
innovate, identify early problem loans and manage
efficiently their cost as losses are covered by the
government.
Crony Capitalism
When the interests of banking
institutions, large companies and
political leaders become mixed
together
“Crony" capitalism was a
characteristic of Korea, Indonesia,
Malaysia and Thailand before the
onset of their crises. In those countries
banks were required and even forced
to allocate a certain share of their loan
portfolios to particular sectors.
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 6-Poor and Inadequate Bank Management, Regulation and
Supervision
Poor management and internal governance
Over-extension of lending relative to the bank equity or deposit
base, domestically and abroad,
Dealing with sophisticated risky instruments and contracts
Aggressive lending with less stringent criteria or through aggressive
deposits collecting highly remunerated,
Poor lending manifested by loan concentration in a small number of
borrowers or a given segment of the economy, in addition to
connected lending and term /currency mismatching,
Inadequate bank regulation
Inappropriate compliance with international capital, loan
classification and accounting standards
Inappropriate disclosure rules and provisioning for non performing
loans
Inadequate restrictions of foreign exchange exposure and insider
lending
Not ensuring that the right owners, managers are in place and that
the quality of risk management and control systems is high
Not promoting the disclosure of financial information by banks to
the public and allowing market discipline
Poor management and internal governance
Poor internal controls such as poor credit valuation and follow up
systems, internal audit mechanisms and management information
systems,
Poor disclosure comprising hiding the truth from the public and the
supervisors by the means of inadequate provisioning and reporting
on loan losses and other practices,
Diverse fraudulent activity
The inability or unwillingness to set appropriate rules, procedures
and policies for controlling risk and minimizing the organizational
hazards, …
Poor bank supervision
Lacking power and speed to take actions and carry out the mission
Supervisory laxity and forbearance ( lack of supervisory firmness in
enforcing rules and regulations)
Incapacity of supervisors to fulfill efficiently the required work
(problem with the availability of the necessary human and financial
resources)
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X- The Economic Effects of Banking Sector Weaknesses and Crises

1-Real sector impact

Banking system fragility and crises can slow economic growth and contribute to a sharp
fall in output.

The economic slowdown or recession is attributed to credit contraction and misallocation

induced by bank failures and expensive and inefficient financial intermediation of a weak
banking system.

Credit contraction can arise from the supply side in response to an increased regulatory
tightening or oversight and deterioration in bank assets or profitability.

Credit contraction can also stem from weak demand for credit.
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Supply of vs. Demand for Credit

Less willingness & ability of banks to Reduced demand for loans

lend
• Credit scarcity if bank failure is widespread • High real interest rates resulting from banks less
willing to lend.
• Contraction in lending as a result of bank losses
• In times of financial panic and crises, an attitude of
• If depositors decide to shift part of their assets
“wait and see” or reluctance to undertake new
portfolio out of banks, due to an increase in the
projects or expand already existing ones is more
degree of uncertainty about the future, in times of
likely to develop.
banking panics or crises.
• Shortage of bank capital necessary to support asset
expansion (credit expansion)
• The expected inflation rate. High inflation rates are
associated with greater uncertainty and in such an
environment banks may be reluctant to lend.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

On the issue of credit misallocation, illiquid and poor performing banks tend to behave
differently than their sound counterparts. As their capital position is weakened and
depositors are inclined to avoid dealing with these “weak institutions”, illiquid and poor
performing banks often recourse to the following:

 They first lend high risk profile borrowers and projects at high lending rates to raise
badly needed liquidity and

 Second widen their interest spreads to cover their mounting operating costs,
particularly, non-performing loans.

Their behaviour could encompass also continued lending to insolvent debtors to prevent
their defaults.
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X- The Economic Effects of Banking Sector Weaknesses and Crises

Such behaviour could harm in many ways:

 First, there could be a misallocation or under-utilization of credits to its best use in

addition to credit discrimination (against some creditworthy borrowers).

 Second, the cost of intermediation will rise and eventually the cost of investment.

This is to say that the behaviour of troubled or weak banks could penalize some
creditworthy borrowers and productive economic activities from receiving adequate
funds at the usual market rates.

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 Banking crisis
leads to:

• Lower number of
operating banks
• Large losses
• Less resources to Credit Contraction
extend loans
• Lower capital level • Higher cost of financial
to support loans intermediation and
• High uncertainty investment
• Fall in economic activity
and output
• Slow economic growth
• Risky lending and
high interest Credit
spreads by poor misallocation
performing banks
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X- The Economic Effects of Banking Sector Weaknesses and Crises

2-Impact on the Fiscal balance

A fragile banking system can compound fiscal problems through reducing government
revenues and rising government expenditures, thus increasing budget deficits.

Depending on the scale and intensity of this fragility, large budget deficits could pose
a threat to any undertaken stabilization policies and programs.

Large-scale government bailouts accompanied by lower revenue levels complicate

therefore fiscal consolidation and budgetary control efforts, influencing possibly
interest rates, prices, the exchange rate and ultimately macroeconomic stability.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

Lower revenues are mainly attributed to a drop in the overall economic activity (less
aggregate tax and non-tax revenues), banks’ rising expenses (less net profit and less
corporate tax income), and central bank’ declining profits (lower profit transfers to the
treasury) all caused by banking system distress.

On the other hand, cost on the public sector can be incurred when the government has to
bail out insolvent banks, particularly state owned, or honour their obligations towards
deposit/credit guarantee institutions or schemes for these latter to perform adequately
their duties when crises occur.

Another fiscal cost is rising cost of deficit financing and debt servicing. This is the case
when the amount of finance to the government i.e. subscriptions in the treasury securities
is substantially altered by the presence and performance of systemic bank weakness.
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X- The Economic Effects of Banking Sector Weaknesses and Crises

To sum up, government assistance of banks in distress can take different forms depending
also on the different stages of this distress.

Assistance could be through short to medium term liquidity and credit support, re-
capitalization programs or schemes, government acquisition of bad loans and assisted
mergers.

Related costs could add up and increase the public deficit and public debt.

Estimated fiscal costs due to banking crises have ranged worldwide from 2 to 30 percent
of GDP.

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Banking crisis may result in :

Lower government revenues

Higher government expenditures

Larger budget deficits

Higher Public debt

Macroeconomic instability

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X- The Economic Effects of Banking Sector Weaknesses and Crises

3-External balance implications

Banking system problems are capable of exercising or inducing undesirable effects on the
exchange rate and the balance of payments, as banks are major importers and exporters of
capital.

These effects could be manifested by speculative attack on the currency, exchange rate
deterioration and capital outflows.

However, it is not always clear whether these implications are a direct response to
banking sector problems and the associated inefficient cross border banking and loss of
confidence in this sector or to macroeconomic imbalances in general.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

There are many channels through which banking system fragility contributes to the
depreciation/ devaluation of the exchange rate and to capital outflows.

Pessimistic expectations about the solvency and soundness of the banking system drive
locals and overseas depositors and investors to shift resources at banks to cross border
markets. In this respect, large outflows could have a major impact on the value of the
domestic currency.

The shift in confidence of foreign investors in the domestic currency can also lead to the
same result of capital outflows or drive investors to sell domestic assets or equity and
exchange domestic for foreign assets, thus pressuring the exchange rate.

The adverse effects of banking sector weakness on the exchange rate and balance of
payments could come therefore from the loss of confidence.
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X- The Economic Effects of Banking Sector Weaknesses and Crises

There are other ways banking system fragility plays a role also in initiating currency
attacks and accelerating the depreciation of the currency.

Banking problems may signal potential future large government bailouts that would be
inconsistent with defending the currency under a pegged exchange rate mechanism,
initiating speculative attacks on the currency.

Large scale banking problems can even accelerate the devaluation of the currency. This is
the case when the currency within a fixed exchange rate regime gets under attack and the
central bank finds itself constrained in defending the currency by raising interest rates
fearing of the potential negative effects on the weak banks balance sheets.

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 Banking crisis
may lead to:

• Pessimistic expectations
about banks and the
economy
• Shift in confidence of Large capital • Pressure and attacks on the
local and foreign outflows exchange rate
investors • Exchange rate
deterioration
• Balance of payments
problems

• Expectations of large
government bailouts
and expansionary
policies inconsistent
with maintaining the
fixed exchange rate
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X- The Economic Effects of Banking Sector Weaknesses and Crises

4-Monetary Policy Impact

Banking fragility influences the supply of and demand for money and credit and
complicates the task of the monetary authority in regulating monetary aggregates for
policy goals of price and economic stability.

In fact systemic vulnerability constrains the capacity of the monetary authority to devise,
control and implement adequate policies as input from the banking market may become
less reliable and the fear that certain policies may hurt banks.

It also undermines the effectiveness of the monetary instruments, mechanisms of policy

transmission and policy goals.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

Complications in controlling monetary policies may come from improper accounting

practices and behaviour undertaken by troubled or weak banks.

The reliability and accuracy of financial banking data, on which part of the policy
formulation and control is based, become increasingly questionable as there is a tendency
from the part of unsound banks ( more than the others) to incorrectly provision and
misclassify non performing loans, capitalize unpaid interest ( to consider them new loans)
,or inflate assets.

Illiquid and insolvent banks have in general interest in doing that to prevent information
driven loss of confidence and associated costs for banks.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

These practices of improper accounting bewilder the accurate assessment of the true
credit volume and growth in the economy and provide misleading indicator variables and
low usefulness policy guide contributing to potential error making at policy levels (of
concern targeted growth rate in monetary aggregates).

Because fragile banks are inclined to get involved also in lending high risk projects and
widening their spread to cover the cost of their operations, any interest rate rise may not
reflect anymore the overall market stance and changes in the supply of and demand for
funds, thus adding to the complication in controlling policies.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

What could happen also is the witnessing of segmented interest markets in the economy
depending mainly on depositors’ behaviour and the presence investment opportunities for
banks.

For it has been reported ( Venezuela 1994) that depositors were transferring their assets in
huge amounts from unsound banks to sound ones. In reaction to this massive inflow of
funds that could not be deployed by sound banks, these latter had to reduce the interest
rate to avoid attracting further deposits or place the excess liquidity in the central bank or
in government securities, leading again to a drop in interest rates.

Thus, interest market segmentation also complicates the task of the monetary authority.

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• Improper accounting
practices Complicating the task of
the monetary authority in
Distort the actual money
• Less reliable and controlling the monetary
and credit volume and
accurate banking data aggregates or the interest
growth
rate and in devising
• Higher spreads and appropriate policies to
Send misleading signals
rates not truly achieve its objectives of
for policy makers
reflecting supply of and price and economic
demand for funds stability

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X- The Economic Effects of Banking Sector Weaknesses and Crises

Fragile banks introduce complications also to the implementation of monetary policies.

Implementing policies perceived adequate for a given situation may also not take place,
fearing that they will contribute to worsening the financial conditions of the already
troubled banks.

It has been observed that the Central Bank may be no more at ease in raising the interest
rates, for example, to defend the currency for the adverse short term negative
consequences of high rates on banks’ balance sheet (a larger portfolio of non performing
loans).

The central bank may not be able even to pursue properly its stabilization policy through
a monetary tightening, especially in two situations.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

 First, if it is committed to support ailing and illiquid banks through extending them
overdrafts on their accounts at it premises, reducing the discount rate, accommodating
any shortfalls in reserves and purchasing short term treasury bills from banks in the
secondary market.

 Second, if it has concerns about the effects of money tightening, mainly high interest
rates and reduced liquidity, on the asset portfolio of banks and the cost of raising
money (case of Mexico and Venezuela).

In all these cases a rapid monetary expansion could be the result.

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X- The Economic Effects of Banking Sector Weaknesses and Crises

Large-scale banking problems affect also the efficiency of monetary policy instruments in
stimulating the anticipated response. Conventional monetary relationships, even if they
hold, could no more be perceived as efficient and predictable.

A deliberate interest rate change by the Central Bank through its open market operations
may not translate into credit expansion or contraction for reasons related to the
performance and behaviour of unsound banks as well as the public preferences and
expectations.

Given the erratic performance of banks in distress, the quality and structure of their
portfolios (high volume of risky loans) and their increasing insensitivity to market interest
rates (increase in the cost of funds), it becomes difficult for these depository institutions
to quickly adjust their balance sheet items (specifically loans and reserves) in response to
policy action.
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X- The Economic Effects of Banking Sector Weaknesses and Crises

This difficulty or even inability to respond, delays the on-time achievement of intermediate
targets such as contraction or expansion in monetary growth, or simply impairs specific
policy signals transmission to the market carried either through the interest rate or credit
channel (reserve money – money multiplier mechanism).

The public’s choice on how much money to hold and in what financial instrument to invest
in panic times influences also the efficiency of the monetary policy. The demand for money
could rise or fall substantially and large portfolio shifts would become a reality with
systematic banking fragility.

In fact, banks in distress can generate an environment characterized by high uncertainty and
asset liquidations which drives people to adjust their demand for money and/or turn into
other perceived safer instruments such as foreign currency assets, government securities
and others.
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X- The Economic Effects of Banking Sector Weaknesses and Crises

That is the interest elasticity of demand for currency and deposits would be altered in
these situations, where fears of suffering losses on deposits, should banks collapse, or
paying a high premium on currency, in the event of suspension of payments, are there.

Structural changes in currency to deposit ratio, bank reserve holdings and currency in
circulation influence in turn the monetary base, the money multiplier process and
ultimately the overall money creation in the economic system. Where people want to hold
more currency relative to deposits, the rise in this ratio would then imply implicitly a fall
in the broadly defined money supply.

Deposits are “destroyed” also when banks reduce their loans and increase their reserves-
deposit ratio to improve their liquidity position. A reduction in the money stock is
determined as well by bank failures of themselves.
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