Banking Crises With enough leverage, a small shock can move the whole world ---- with apologies to Aristotle

1. Banking CrisesWith enough leverage, a small shock can move the whole world----with apologies to Aristotle Michael Smitka Economics 102 Winter 2003

2. 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?

3. 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

4. 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

5. LDC Bank CrisisLatin 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

6. Rapid Growth: Supply • On supply side due to: • Petrodollars after first oil crisis • OPEC had lots of revenue and needed to "recycle" • Disintermediation • big firms shifted to direct or non-bank financing • E.g., commercial paper • Banks thus were flush with funds but had lost traditional big customers • Japanese banks, too -- new entry led to thin margins

7. 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

8. Then came 1980…

9. Systemic shock • Fed President Volcker decided to cut US inflation: interest rates jumped • Second oil crisis boosted import prices • World-wide recession led to falling prices • Now + 20% nominal interest rates - (-20%) inflation = +40% real interest rates • LDCs couldn't pay back debt

10. And debt there was! • Brazil, Mexico, Venezuela & Argentina: $176 billion • Some 27 LDCs together owed $239 billion • Citibank alone had about $1 billion in exposure to Brazil • Most of this was in "Eurodollar" syndicate loans with floating

11. 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…

12. 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

13. Jamaica, Nicaragua in 1980 • Jamaica, Nicaragua both hit by interest rates and export price collapse • Hurricane, tourism collapse also hit Jamaica • Somoza emptied coffers, then fled war-struck Nicaragua for Paraguay • Bankruptcy not possible • Couldn't start over, even if loan proceeds stolen • Instead had to shrink GDP to generate export surplus • Bottom line: massive poverty / economic collapse • I saw firsthand as representative for Japanese banks to the IMF-led consultations for Jamaica

14. 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 problem! • until the Bank of Thailand ran out of dollars • When the baht fell by 50%, the banking system was immediately insolvent • Companies could repay, but that still left banks 50% short of what they needed to repay foreign banks

15. 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

16. 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

17. Japan • Various economic shocks encouraged rapid money creation by BOJ • Excess savings (paradox of thrift) underlay this • 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!

18. 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 would surpass the US soon

20. 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

21. Is the US safe? • Consumers have dipped into home equity to support their lifestyle • Are real estate prices set to fall? • How many more Enrons are out there? • But direct finance (stocks, bonds) greater than in other economies • Consumers -- pension funds -- take the "hit" more than bankers. Maybe.

22. EOF