3.3.1 Financial crises, explanations, types and implications
The GFC of 2007–2009 has been disastrous for the world’s economy, causing a negative economic growth into the world’s economy for the first time in more than 10 years (Saayman, 2010: 1). The crisis has also shed more light on the drastic effects of financial integration, innovation and shallow pricing.
In the past decade, most banks believe that preventing crises and systemic risk can be forestalled by having narrow banks which are focused on investing in more equity rather than demand deposits, making the reserve bank the central bank and lender of last resort (Diamond and Dybvig, 1983). Banks are also required to increase their capital asset ratio as a regulatory precaution to prevent crises. Bank capital regulation is predicated on two main assumptions: firstly, more capital means more financial buffer during crises. Secondly, equity capital encourages risk-taking and enhances moral hazard, and thus restricts bank lending.
There two ways of increasing the capital asset ratio (CaR): reducing assets or issuing new equity. Most banks focus on loan reduction, which ends up enhancing the credit crunch which occurs when loans are difficult to get from banks, especially when borrowers are willing to pay a higher interest rate. It has been established in the literature that raising interest rates and rationing credit to avoid adverse selection can cause further credit crunch and end up causing more crises (Stiglitz and Weiss, 1981; Berger and Udell, 1994; Peek and Rosengren, 1995).
Figure 3.3: The relationship between business cycle and credit crunch especially during recession
Source:Author’s computation
Policy makers face a huge problem of preventing bank crises during recession and at the same time prudently responding to the regulatory requirement to prevent credit crunch given the cyclical nature of the banks’ behaviour during recession periods. The GFC of 2007 to 2009 exposed the weakness of prudential regulation and the global financial system in preventing crises given the complexity and openness of financial systems around the world.
3.3.2 Summary of Claessens et al. (2014) on financial crises
Figure 3.4: Types of financial crisis
Source:
Claessens et al. (2014)Business
Cycle
Credit
Crunch
Currency Crises Debt Crises Banking Crises Sudden Stop (BOP and CALiterature such as Mitchell (1913); Fisher (1933), Minsky (1977), Kindeberger (1978), Friedman and Schwartz (1963), Bordo (1985), and Gordon (1988) predicted that changes in interest rates, stock returns, deposit to currency ratios and asset prices are indicators of financial crises.
Figure 3.5: Main causes of financial crises Source: Author’s computation
There are still gaps in the literature, for instance:
Most literature are yet to establish how asset prices and credit booms become unsustainable, uncontrollable or unmanageable in the financial market.
Policy makers are yet unable to ascertain and envisage the risk in credit boom and bust so as to prevent the menace of financial crises.
Combination of different events
Changes in asset prices and credit volumes
Disruption of banking and financial intermediaries
Sharp movemnet in asset and credit boom and bust
Macroeconomic imbalance of internal and external shocks
Figure 3.6: Asset price and credit boom and bust Source: Author’s computation
3.3.3 Two theories on bank panic
There are two theories on bank panic. The first theory asserts that bank panic is just a random event, uncorrelated with belief systems or the reality of the economy. The second theory postulates that bank panic is triggered by investors’ or depositors’ behaviour which can be a result of bad news or bad government forecast, and can be caused by asymmetric information between banks, risk perceptions, systemic risk, bank crises, and recession (Gordon, 1988: 755: Dwyer and Hafer, 2001).
A financial crisis is usually defined as a situation in which a significant group of financial institutions have liabilities exceeding the market value of their assets, leading to runs on banks, portfolio shifts in banks’ balance sheets, collapse of some financial firms, government intervention, a sharp reduction in credit and trade, and breakdown in exchange rates (Brunnermeier, 2009; Gorton, 2010; Goldstein and Razin, 2013). A financial crisis can also be defined as a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. Typically, a banking crisis starts when the share of nonperforming loans to total outstanding loans in banks’ balance sheets grows, and/or the value of investment in banks’ balances drops dramatically, both resulting in solvency and liquidity problems.
Asset Price
Boom and
Bust
Credit
Boom and
Bust
• flight to quality
• irrationality if
investors
• information
asymmetry
• changes in
fundamentals
• leverage build-up
• economic policy
changes
• structural changes
• increase in economic
growth
• international financial
flows
Many theories have been developed over the years to explain financial crises. The literature established three main types of crises: banking crises, currency crises and credit and market freezes. These types of crises will be briefly reviewed in the next sections (Dekle and Kletzer, 2001; Klomp, 2010; Gavin and Hausman, 1998; Goldstein and Razin, 2013).
3.3.4 Banking crises
Diamond and Dybvig (1983) provided a scenario where a customer panics as a result of asymmetric information and causes a bank run in the financial system. The idiosyncratic behaviour of the banking system is that they receive demand deposits with a short maturity and invest in long maturities instruments. This makes them very vulnerable to liquidity constraints, especially in a situation where most depositors want their funds. This often leads to a bank run and bank crises (Goldstein and Pauzner, 2004; Santos, 2001). Prior to Diamond and Dybvig’s analysis, Kahane (1977) and Sharpe (1978) had already established the need for deposit insurance to secure bank deposits against insolvency.
The main problem with banking crises is that they spread to other banks, especially due to financial innovation and integration. When bank runs cause other banks to fail it is called systemic risk. Studies on the contagion effect of banking crises are divided into three main groups. The first school of thought believes contagion is caused by a pool of investors who decide not to keep all their eggs in one basket but invest in different banks, and when one bank fails it can lead them to pull their funds out of the banks which can eventually lead to bank crises (Goldstein and Pauzner, 2004; Kyle and Xiong, 2001). The second school of thought connects contagion to the high cost of information gathering in the banks. When a bank gets bad signals about the fundamentals of the other banks, it can lead to crises because at this point interbank lending will be suspended and this can have a ripple effect in the long run (Calvo and Mendoza (2000) cited in Goldstein and Razin, 2013). The last school of thought believes that systemic risk can also be caused by the “too big to fail problem”, where the big banks believe that because of their big size and concentration, they are too important to fail hence they venture into risky businesses causing moral hazard knowing that the government will always restructure and rescue them if they fail (Farhi and Tirole, 2012; Mishkin, 2009).
3.3.5 Credit crunch and market freeze
“Credit crunch” is generally refers to as the reduction in credit supply available to borrowers, particularly bank lending supply, for some lender specific reasons. (Watanabe, 2005; Seo, 2013; Walsh, 2003; Stiglitz and Weiss, 1981 and Jaffee and Russell, 1976).The major explanation for the credit crunch phenomenon as investigated in this study is the “regulatory driven capital crunch hypothesis”.
Minsky (1977:23) stated that “banking crisis is credit boom gone wrong”. In this school of thought assets and loans are assumed to be exogenous. The main players here are the depositors and creditors. He also assumed there is a credit market where the supply shock increases the productivity of capital and investment, causing an expansion of credit in the economy. The bank’s lending and loan increases at this stage and the economy is at its peak, which provides an incentive for bankers to invest in risky assets (moral hazard problem). Consequently, the banks make losses from the risky assets and try to cut back lending by rationing credit from bad decisions. This outcome brings fear and uncertainty to the market, which further precipitates the market freeze. Stiglitz and Weiss (1981) provide a framework that establishes a certain behaviour of banks by rationing credit and increasing interest rates to be able to sieve out the good borrowers in the market from the bad on the assumption that bad borrowers are likely to borrow at a higher interest rate than good borrowers (Holmstrom and Tirole, 1997; Kiyotaki and Moore, 1997; Gertler and Karadi, 2011; Shin, 2008; Claessens et al. 2008 Boissay et al., 2013).
3.3.6 Currency crises
Theory states that an increase in international capital flows in terms of current account deficit and exchange rate mismanagement can result in big crises. The “first generation crisis model” states that a government with imprudent budget deficit mismanagement and limited reserves tries to peg its currency but ends up with a currency mismatch which attracts speculative attacks on its domestic currency, leading to banking crises (Krugman, 1979; Flood and Garber, 1984). Obstfeld (1994, 1995) took the debate further to a “second generation crisis model” where the government tries to make an imperative decision either to defend its pegged exchange rate or to be flexible and allow macroeconomic fundamentals to determine the currency value which might attract a bigger cost. It becomes obvious that the government will not be able to defend its currency, hence a speculative attack can arise to cause more crises. The “third generation crisis model” evaluated the importance of bank lending and asset market in terms of causing “boom and bust cycles” in the asset market (Reinhart and Rogoff, 2009a; McKinnon and Pill, 1996). Most economists viewed the Argentinian (1994), Turkish (2000) and Asian crises (1998-1999) through the lens of currency crises theory.