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Book Summaries Business

Banking Crises (This Time is Different)

Banking Crises, Inflation, and Currency Crashes

Countries can outgrow a history of repeated bouts with high inflation, but no country yet has graduated from banking crises.

Banking Crises and Bank Runs

Banking crises has plagued both rich and poor countries alike – the authors of the book make this conclusion based on a historical analysis of banking crises that date back to Denmark’s financial panic during the Napoleonic wars.

Banking crises always lead to sharp declines in tax revenues and surges in government spending. Government debt, on average, rises by 86 percent during the three years following a banking crisis. These indirect fiscal consequences are much larger than the usual costs of bank bailouts.

Often, highly indebted governments or banks seem to be merrily rolling along for a while, until suddenly, confidence collapses, lenders disappear, and crisis hits. The simplest example of this is a bank run.

Banks play a key role in effecting maturity transformation – transforming short-term deposit funding into long-term loans—this makes them uniquely vulnerable to bank runs.

Banks borrow short in the form of savings and demand deposits (which can, in principle, be withdrawn at short notice). At the same time, they lend at longer maturities, in the form of direct loans to businesses, as well as other longer-dated and higher-risk securities. When times are good, banks hold liquid resources that can handle any surges in deposit withdrawals. But during a “run” on a bank, depositors lose confidence in the bank and withdraw in mass. As withdrawals increase, the bank is forced to liquidate assets under duress.

The prices received are usually “fire sale” price – especially if the bank holds highly illiquid loans. The problem of having to liquidate at these prices can extend to broader range of assets during a systemic banking crisis.

Different banks hold similar asset portfolios. If all try to sell at once, the market can dry up quickly. Relatively liquid assets during normal times can suddenly become highly illiquid just when the bank needs them most. So, even if the bank would be completely solvent absent a run, its balance sheet may be destroyed by having to liquidate assets at low prices.

In this case, the bank run is self-fulfilling. In practice, banking systems have many ways of handling runs. If the run is on a single bank, that bank may be able to borrow from a pool of other private banks that effectively provide deposit insurance to one another. But, if the run affects enough institutions, private insurance pooling will not work.

The U.S subprime financial crisis in 2007 is an example of such a run, because problematic mortgage assets were held widely in the banking sector. Exchange rate crises, as experienced by so many developing economies in the 1990s, are another example of a systemic financial crisis affecting almost all banks in a country.

The banking system will absorb a real shock in either situation, but this shock can be managed if confidence in the banking sector is maintained. But if a run occurs, it can bankrupt the whole system, turning a bad problem into a devastating one.

Bank runs are simply an important example of the fragility of highly leveraged borrowers, public and private. The implosion of the U.S. financial system during 2007–2008 came about because many financial firms outside the traditional and regulated banking sector financed their illiquid investments using short-term borrowing.

Why Recessions Associated with Banking Crises Are So Costly

Severe financial crises rarely occur in isolation. They do not usually trigger a recession but are an amplification mechanism of it. Declining output growth leads to defaults on bank loans, forcing a pullback in other bank lending, which lead to more output declines and repayment issues. Banking crises are often accompanied with exchange rate crises, domestic and foreign debt crises, and inflation crises.

A collapse in a country’s banking system can have huge implications for its growth trajectory. It is easier to escape a sovereign debt crisis.

Living with the Wreckage

Countries may “graduate” from serial default on sovereign debt and recurrent episodes of very high inflation (or at least go into remission for extremely long periods), as the cases of Austria, France, Spain, and other countries appear to illustrate. But History tells us that graduation from recurrent banking and financial crises is much more elusive.

Out of the sixty-six countries in our sample, only Austria, Belgium, Portugal, and the Netherlands managed to escape banking crises from 1945 to 2007. During 2008, even three of these four countries engaged in massive bailouts. Indeed, the wave of financial crises that began with the onset of the subprime crisis in the United States in 2007 has dispelled any prior notion that acute financial crises are either a thing of the past or have been relegated to the “volatile” emerging markets.

The this-time-is-different syndrome has been alive and well in the United States, where it first took the form of a widespread belief that sharp productivity gains stemming from the IT industry justified price-earnings ratios in the equity market that far exceeded any historical norm.

This delusion ended with the bursting of the IT bubble in 2001. But the excesses quickly reemerged, morphing into a different shape in a different market. The securitization of subprime mortgages combined with a heavy appetite for these instruments in countries such as Germany, Japan, and major emerging markets like China fueled the perception that housing prices would continue to climb forever. The new delusion was that “this time is different” because there were new markets, new instruments, and new lenders. Specifically, financial engineering was thought to have tamed risk by better tailoring exposures to investors’ appetites.

Derivates contracts in the meantime offered hedging opportunities.

One striking finding is the huge surge in debt that most countries after a financial crisis – with central government debt usually increasing by around 86 percent on average during the three years following a crisis.

"Silence is the best expression of scorn" - G.B. Shaw

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