FINANCIAL CRISESChap 12 & 13

International Financial Crises• Banking Crisis – Sudden collapse of the domestic

banking system.• Currency Crises – Loss of credibility of fixed exchange

rate system.• Systemic Financial Crisis/Sudden Stops – Breakdown of

system of international capital flows. • Sovereign Debt Crisis – Gov’t unable to pay-off debts

IMF World Economic Outlook, 1998

Prototypical Banking Crises• Event, often deregulation or advance in financial

technology, leads to rapid expansion in credit to speculative borrowers. Borrowers drive up asset prices (usually real estate). Rising asset prices increases the value of collateral which can support further expansion of credit creating a cycle of asset price acceleration and credit extension.

• Eventually, asset prices rise too far above fundamental values and begin to fall. The cycle turns vicious. Asset prices fall, collateral values fall, restrictive covenants bind, speculative borrowers default, banks capital takes a hit, lending is cut back, asset prices fall further.

Sweden & Japan in the 1980s

01.0

3.19

75

01.0

6.19

78

01.0

9.19

81

01.1

2.19

84

01.0

3.19

88

01.0

6.19

91

01.0

9.19

94

01.1

2.19

97

01.0

3.20

01

01.0

6.20

04

01.0

9.20

07

01.1

2.20

10

01.0

3.20

1460.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

140.0

Credit to Private non-finan-cial sector from Banks, total - Market value - Percentage

of GDP

Sweden Japan

Axis Title

01-M

ar-8

6

01-J

un-8

7

01-S

ep-8

8

01-D

ec-8

9

01-M

ar-9

1

01-J

un-9

2

01-S

ep-9

3

01-D

ec-9

4

01-M

ar-9

60

50

100

150

200

250

300

350

Real Estate Prices

Tokyo

Stockholm

Ind

ex 1

981=

100

The cost of cleaning up after financial crises is very high.

Challenges to Monetary Policy Effectiveness

5

Link

Government Intervention

Bank failure can be contagious

1. Interbank Lending

2. Panic conditions

Link

Swedish Model of Crisis Resolution

1. Broad political support. Agreement with the main opposition party….

2. Broad coverage. The guarantee covered all kinds of bank obligations except equity capital and included all banks with subsidiaries, but no other financial institutions.

3. Minimizing the subsidy to the banks and their owners. Support payments should be recovered as far as possible.

4. Only banks deemed to be profitable in the long run should be supported.

5. Bad Bank – Government capitalized institution, Securum, to buy bad loans from major banks

Peter Englund The Swedish 1990s banking crisis

Japanese Model• Implicit Deposit Guarantees• Weak Governance: Banks were allowed to under

provision in order to avoid reporting losses and pay dividends

• Regulatory Forbearance: Japanese banks were allowed to under-report non-performing loans.

• Banks stumbled forward, evergreening loans, but could not make new loans.

Kanaya & Woo Japanese Banking Crisis of the 1990s

1. Bank Risk Taking Channel

• Economic studies suggest that banks respond to persistent periods of low interest rates by taking more risk.

• Yield chasing – Banks may implicitly promise yields to investors, need to earn yields that match those promises. Only by taking on more risk can they do so.

• Evidence suggests that yield chasing is less prevalent in well-regulated banking markets.

9

10

IT and Bank Risk Taking

BIS View (Borio and Wheelock, 2004; Borio and White, 2004)

• Inflation targeting monetary policy passively allows bank credit to expand to fuel the asset price boom general price inflation

• Unless policymakers act to defuse a boom, a crash will follow.

10

Currency Crises• Market believes that exchange rate will be devalued in the

near future.• Lenders demand higher interest rates to lend in domestic

dollars to compensate for loss of value after devaluation.• Central bank must use its foreign reserves to buy domestic

currency and prop up exchange rate. • If pain of interest rates is too painful or loss of reserves too

severe, central bank may be forced to devalue.

Market Expects Devaluation

S

D

iHIBOR

Clearing Balances

iFF

S´

ΔR

iFF +η

η > 0

⓪

ERM Crisis• In 1980’s, European economies constructed a system of

linked currencies called the Exchange Rate Mechanism.• Inflationary German fiscal policy following re-unification

led to high DM interest rates.• To maintain link, other Euro currencies needed to have

interest rates too high for their own situation. • In Sept. 1992, markets expected a delinking/devaluation

of currencies.

Go for the Jugular

Currency Crisis

• Speculation against the pound forced Bank of England to raise interest rates and buy pounds in forex markets.

• Pain of interest rates was viewed as too severe and B of E was forced to abandon the peg.

1992 Jan

1992 Feb

1992 Mar

1992 Apr

1992 May

1992 Jun

1992 Jul

1992 Aug

1992 Sep

1992 Oct

1992 Nov

1992 Dec

0.32

0.33

0.34

0.35

0.36

0.37

0.38

0.39

0.4

0.41

0.42

Pounds/DM

Principal Global Indicators Database

Banking Crisis

Currency Crisis

Fragile banking system makes high interest rates untenable and can lead to fears of devaluation (especially if central bank funds used to bailout banking system)

Exchange rate devaluation can damage balance sheets if balance sheets (deposits or borrowings) are dollarized.

Sudden Stops• International hot money (short-term lending) is subject to

herding behavior from international financial market. • Rapid inflows and rapid outflows.

• When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy. • Domestic firms can no longer finance investment• Demand, GDP, and employment fall. • Devaluation of currency.

Link

Balance of Payments Equation

Current Account

Net Capital Inflows + =

Current Account

Overall Balance(increase in reserves)

Sudden Stop• What if capital flows out?

Current Account

Net Capital Inflows

+Current Account

Overall Balance(increase in reserves)

Money going out of the economy drive foreign exchange payments out of balance.

=

Current Account

Sudden Stop Increase demand for domestic currency causes depreciation.

Net Capital Inflows

+ =

Current Account

Overall Balance(increase in

reserves) = 0

Depreciation leads to currency account reversal.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

-15

-10

-5

0

5

10

15

20

Current Account % of GDP

Indonesia Malaysia Thailand Korea

Foreign Reserves

Measures of Adequate Reserves• Import Coverage: Reserves > Imports for 2-3 Months• Greenspan-Guidotti Rule: Reserves exceed 100% of debt

due within one year.

Link

Buildup Foreign Reserve Assets

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100.000

50000.000

100000.000

150000.000

200000.000

250000.000

300000.000

350000.000

Reserves (excluding gold)

Indonesia Korea, Republic of Malaysia Thailand

Mil

lio

ns

of

US

$

IMF Financial Statistics

Korea

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q10

20

40

60

80

100

120

140

160

180

Short-term External Foreign Currency Debt Korea

Bil

lio

n U

S$

Dealing with Sudden Stops• Modern Approach Swap lines

Link

Link

Final Exam• Monday, December 14th, 08:30AM - 11:30AM. LG5

Multifunction Room. • Cumulative. Similar to mid-term and practice exams.• Bring writing instruments and a calculator.• Semi-open book – Bring 1 A4 size paper with handwritten

notes on both sides. • Office Hours: Standard.