Modern Banking

[ 409 ]

F I N A N C I A L C R I S E S

Minsky (1977, 1982, 1986) wrote about a unit’s financing shifting from hedge finance (cash flows are sufficient to meet the commitments on outstanding liabilities) to speculative finance (receipts are less than payments, making it necessary to roll over the debt) to ponzi1 finance (an unsustainable sequence of ever-increasing borrowing – interest on debt repayments exceeds net income, and agents have to increase the debt to keep up their debt servicing), which heightens financial fragility: the probability of firms and households defaulting on their loans.

The speculative boom continues until it snaps. Some event or signal (e.g. the failure of a key firm in one of the boom areas, a bank collapse or an unexpected shift in government policy) which damages the sector(s) at the centre of speculative activity or the economy as a whole. ‘‘Distress selling’’ (Fisher, 1932) begins when firms or households, unable to repay their debt, are forced to liquidate their assets. More and more people see that at some point, sellers may outnumber buyers, causing prices to fall. Those who borrowed to finance their speculation will find it increasingly difficult to service/repay their debt. The longer the financial distress continues, the greater the realisation that markets are likely to collapse. This new, negative view of the markets might form gradually or very quickly but either way, at some point, there is a rush to liquidate. The bubble implodes, panic erupts, and prices collapse: Kindleberger defines a crash as an extended negative bubble (1978, p. 16). The above account provides the three words in Kindleberger’s (19782) title: Manias, Panics, and Crashes.

The panic continues until:

žAgents realise asset prices are so low they are undervalued; OR

žTrading is halted (e.g. closure of a stock exchange, declaration of bank ‘‘holidays’’); OR

žA lender of last resort restores confidence to the market by making it clear that sufficient liquidity will be supplied to meet demand. Though Kindleberger recognised the need for a lender of last resort, he acknowledged the negative effects of moral hazard arising from rescues – other banks could expect an equivalent response in future crises. Kindleberger emphasised that the authorities must create ambiguity as to when and if they would intervene – easier said than done.

žKindleberger reports 373 (international) financial crises between 1618 (set off by the debasement of coins in several European states) and the East Asian, Russian and Brazilian crises of 1997 – 98, caused by volatile international capital flows, deregulation and borrowing from overseas lenders. Caprio and Klingebiel (2003) report 116 systemic bank crises4 since the 1970s. Beim and Calomiras (1999) identify 126 banking crises in developing/emerging market countries during the 1980s and 1990s.

1 The term is named after Charles Ponzi, a Boston swindler who ran a pyramid scheme in 1920. Investors were promised 50% profit 45 days after they purchased his notes. The early buyers were paid off by later investors, but as they began to realise the scheme was unsustainable, it collapsed.

2 Four editions were published. Here, reference is to the 4th edition (2000). 3 See Appendix B of Kindleberger, 4th edition (2000).

4 Caprio and Klingebiel (2003) define a systemic banking crisis as one where most, if not all, of the capital in the banking system is exhausted.

[ 410 ]

M O D E R N B A N K I N G

Other definitions and/or explanations of financial crises have appeared in the literature. For example, the banking sector is often identified as the source of the problem. Banks take on increasing amounts of risk by lending to firms and households, which use the loans to finance purchases in assets such as property, equities, etc. Increasingly the purchases are made for speculative purposes. As the proportion of short-term debt finance rises, the risk increases. An event triggers a fall in the value of these assets and increasingly, borrowers find they are unable to repay the banks. Banks have typically accepted the assets as collateral, so they, too, encounter problems, as their ratios of non-performing loans to total loans begin to rise. With lower profit prospects, share prices fall, depleting bank capital. Depositors become concerned and, in the absence of adequate deposit insurance, move their funds to safety. If this transfer is sufficiently widespread, banks could collapse.

Along a similar vein, many authors argue that in developing countries or emerging markets, high net inflows of foreign capital can trigger a crisis, which is even more severe if the foreign capital is largely in the form of short-term debt denominated in dollars. Foreign lenders become excessively optimistic, the capital market overshoots, but some event causes concern among lenders, who start cutting back on loans to the country that triggers the crisis.

Others point to the danger of a pegged exchange rate. A peg means the currency is fixed against some other currency, usually the dollar. There are fixed but adjustable peg regimes, which have a band width, such as Europe’s exchange rate mechanism which preceded the adoption of the euro. For example, when the UK was part of the ERM, its band width was (+) or (−) 2.25%, a parity condition of £1 = 2.95 Deutsche marks.5 A currency board is the most rigid form of fixed exchange rate. Hong Kong has a currency board, as did Argentina until the end of 2001. A crawling peg means the par rate is subject to revisions, usually pre-announced, of, for example, 1% per month. The adjustment is normally downward if the inflation rate in the home country is higher than that of the country it is pegged against. Less developed countries (LDCs) often opt for some type of peg, hoping to stabilise their currencies. Rising inflation rates (well in excess of US inflation) put pressure on the peg, because the LDC currency should be falling against the dollar. This scenario heightens expectations that the currency will be devalued, causing it to be offloaded. World-wide,

5 The European case illustrates that currency crises are not confined to developing nations. Britain joined the EU’s exchange rate mechanism in 1990, and experienced a currency crisis in September 1992. For two years, the UK had languished in steep recession. By 1991, the inflation rate had been sharply reduced, and the priority for monetary policy was to reduce interest rates. The ERM required member countries to impose German rates (with a small differential) to maintain parity conditions (£1 = 2.95 DM, + or −2.25%). Germany, having just reunified, was facing a construction boom and rising inflation rate. The Bundesbank’s priority was to keep interest rates high to maintain monetary stability. The UK authorities pleaded for an interest rate cut. The Bundesbank reacted with understandable irritation, emphasising it did not take instructions from the German government, let alone foreign ones – e.g. Britain, Spain and Italy. These events convinced the Bundesbank that the sterling parity would have to change, and it was unwise for the Bundesbank to intervene on the foreign exchange markets to defend it. The Governor of the Bundesbank went further – he revealed his thinking to a financial news journalist and when asked to retract his words, refused to do so. This provoked gigantic capital outflows from the UK on one day, the 16th September, despite two large interest rate hikes (peaking at 15%). When the interest rate increases failed to stop the fall in sterling, the British government suspended ERM membership the same evening. The cost of defending sterling was £14 billion. The Italian and Spanish parities broke on the same day.

[ 411 ]

F I N A N C I A L C R I S E S

currency traders, out to make a profit, will go short on the currency, undermining its value still further. At some point the pressure is too great, the peg breaks and the currency plummets. Whether or not the currency crisis leads to a banking/financial crisis depends on the state of the economy.

Lamfalussy (2000), referring to developing economies or emerging markets, defined a crisis as the situation where a nation’s central bank has (or is about to) run out of reserves, or cannot service foreign debt obligations, denominated in another currency. Once this unexpected news is made public, there is a rapid outflow of foreign capital,6 a collapse of domestic equity bond markets, and a sharp decline in the value of the home currency.

Haldane et al. (2004) claim a third generation of models of financial crises has emerged, which identify the capital account as the source of the problem.7 Mexico, South East Asia, Russia, Brazil and Argentina have all recently experienced a financial crisis, where the capital account was a major factor. In the review of the crises earlier in this chapter, short-term net capital inflows were a major contributory factor to the South East Asian crises, though this is not true for Japan. Nonetheless, if the capital account has become so important, then it has policy implications for resolving the crises. The issue of the capital account is revisited in section 8.7.

All of the above scenarios, including the third generation models, are variations of the Kindleberger theme. The key to his argument is that agents may start by being excessively optimistic about the future price of certain assets, but at some point grow excessively pessimistic. In both cases, the price(s) of the asset(s) (e.g. stocks, property or currencies) will overshoot their equilibrium price. However, the Kindleberger approach suggests agents are irrational, an inconsistency with the efficient markets hypothesis.8 The EMH states that, in the absence of full information, speculators can make mistakes, but not systematically so, if expectations are rational. Still others, such as Flood and Garber (1994), argue that the efficient markets model is misspecified, and call for further research to identify the variables at work not accounted for in the theory.

In some multiple equilibrium models, expectations are treated as exogenous to the model, so a collapse or overshoot in prices can be consistent with rational behaviour. See, for example, Obstfeld (1986, 1996), Chang and Velasco (1998a,b), among others. Other authors use the presence of incomplete markets to explain bubbles. For example, Schleifer and Vishny (1997) argue that the more prices rise above their true value, the greater the cost of going short (selling borrowed securities), making it difficult to arbitrage away excessively high prices. This would explain why rational informed investors did not, for example, arbitrage away the excessively high dot com prices during the dot com bubble, which finally burst in mid-2000. Ofek and Richardson (2003) argue that the IT firms limited the issue of dot com shares, so there were no new shares to short sell. As a result, as the price of these share rose, the dot com bubble burst.

6 Lamfalussy (2000) acknowledges that domestic residents can initiate capital outflows well before there is news of problems in the central bank. Such behaviour can speed the development of a crisis.

7 See, for example, Chang and Velasco (1998a,b), IMF (2002) and Krugman (1999). The first generation models argue fundamentals cause crises; while fragility expectations are central to the second generation models.

8 The seminal papers on the efficient markets hypothesis include Fama (1970, 1991).

[ 413 ]

F I N A N C I A L C R I S E S

Table 8.1 The Cost of Financial Crises

Sources: Evans (2000); Japan’s estimate – Heffernan (2002).

BIS (2004) estimates the total cost of dealing with Japan’s non-performing loans between April 1992 and September 2001 was 20% of GDP or ¥102 trillion.

Beim and Calomiris (2001).

+BIS (2001).

žEstimates are not normally done on a present value basis, but if they are computed in this way, what discount factor is used?

žWhich measure of GDP is used in the denominator, and from what date are the costs calculated?

žPosing and answering the counterfactual: how differently would GDP have evolved had the crisis been prevented?

The estimates of the costs for Sweden and Finland in Table 8.1 are very close to Sandal’s estimate using gross costs, without using present value. Based on net costs, the figures fall to just over 5% for Finland, and 1.9% for Sweden. He does supply a ‘‘simple’’ estimate for Norway. His present value estimates range between 2.6% and 3.4% using gross costs, and 0.4 to 0.9% using net costs. Not surprisingly, the estimates fall once net costs are used.

Below, some actual crises are explored in more detail, to enhance readers’ understanding of how they arise, and what might be done to minimise their potentially considerable costs

[ 414 ]

M O D E R N B A N K I N G

in terms of a country’s GDP. The Overend Gurney and US banking crises have already been discussed. Below, the South Sea bubble provides another historical example, followed by analyses of more recent financial crises.

8.2.1. South Sea Company10

The South Sea bubble is considered by many to be the first major international financial crisis,11 because it involved investors in England, France, the Netherlands and other parts of Europe. In 1711, the Sword Blade Company (later a bank) assumed some of the government debt issued in the War of the Spanish Succession. In exchange the group, led by Robert Harley,12 was given a monopoly in South (Atlantic) trade and formed the South Sea Company. Holders of the government debt were to exchange it for South Sea stock, though they would be paid interest by the Treasury. South Sea also sold shares to raise capital to finance what was expected to be lucrative trade with the South American Spanish colonies, after the cessation of hostilities in 1713. In fact there were a few unprofitable slave trades, before the British and Spanish went to war again in 1718. Despite this poor record, investors in South Sea looked to the future and seemingly attractive trade prospects that would be realised once the war was over.

South Sea wanted to emulate the success of the Paris based Mississippi Compagnie des Indes, which had been granted the monopoly of French trade with North America. Mississippi was owned by a Scot, John Law, who used his bank to issue stock and raise capital. By May 1719, the firm was overwhelmed by subscribers: in addition to the French, foreign subscribers, including some from Britain, were trying to buy stock. Investors from all the major Continental cities (e.g. Paris, Amsterdam, Geneva) now clamoured to buy shares in South Sea. The share price rose from £175 in February 1720, and peaked at over £1000 by the end of June.13 On the Continent, speculation in a number of stocks also took place.

However, there was some unease at the sheer scale of speculation, and a few investors, including some of the South Sea directors, sold their stock. There was no sudden burst in the bubble – but a slow, steady fall in price through the summer months. It finally collapsed at the end of September 1720, when the price dropped to £135. Fortunes had been lost, Parliament was recalled, and a Committee formed to investigate. Many of the key players escaped to other countries with the books, making it difficult to prosecute, though some

10For a more detailed account see Balen (2002).

11Kindleberger, in his 4th edition (2000), discusses an earlier crisis, known as the ‘‘Kipper-und Wipperzit’’. It began with debasement of coinage around 1600, which involved putting baser in low value gold or silver coins used in daily transactions. It grew very quickly after 1618 (to finance the Thirty Years’ War, which began in 1618) with a speculative peak and crash in February 1622. It began with the debasement of a nation’s own coinage, but spread to other countries after nobles came up with an even better system: taking the bad coins across the border, bringing back good ones, and debasing them. It came to an end when all the coins of low value were treated as virtually worthless.

12Harley’s group, by assuming some national debt, also hoped to challenge the Bank of England (created in 1694) which was beginning to emerge as the state’s banker.

13The sale of South Sea shares would also help to stop the drain of capital from London to Paris.

[ 415 ]

F I N A N C I A L C R I S E S

properties were seized. The Bank of England rescued South Sea but refused to assist Sword Blade, which failed, thus ensuring the dominance of the Bank of England.14

The next two sections look at financial crises in developed and emerging market economies, the Asian crisis in the late 1990s and the prolonged crisis in Japan, largely confined to its banking sector. The reviews illustrate how economies that appear to be reasonably stable can suddenly shift into crisis mode and, depending on conditions, the frightening speed with which contagion can spread a crisis from one country to another. While they share a few common features, there are many differences, especially the policy responses where, ironically, Japan could have learned a great deal from the Korean experience.

8.3. The South East Asian Financial Crisis, 1997–99

8.3.1. An Overview of General Contributing Factors

What became known as the Asian financial crisis originated in Thailand, then spread quickly to South Korea, Indonesia, Malaysia, Thailand, other Asian economies and beyond.15 The onset, speed and seriousness of the crises took experts by surprise – there were no official forecasts of a sudden downturn, let alone crisis. Spreads on Asian bonds had substantially narrowed during 1996 and for most of 1997; likewise, credit ratings remained largely unchanged. Until the onset of problems, fiscal and monetary indicators were relatively stable. While it was acknowledged in some quarters that the growth of the ‘‘tiger’’ economies could not be sustained,16 there was little reason to think a slowdown would turn into a meltdown.

The first sign of trouble was when prices on the Thai stock market began to fall in February 1997, and by year-end had declined by more than 30%. Pressure on the Thai baht quickly turned into a currency crisis, which spread to the financial sector. Thailand had experienced a massive net capital inflow during the previous three years, especially 1995 – 96, amounting to 13% of Thai GDP compared to 0.6% for the G-7 economies. The year 1997 saw this inflow at first stop, and by the second and third quarters, sharply reverse. Exports had grown by 25% in 1995, but fell (−1.3%) in 1996. The growth of imports also slowed but not by enough, resulting in a large current account deficit (8% of GDP by 1996). An unexpected fall in exports in early 1997 heightened concerns about the sustainability of the baht.

The Thai baht was pegged to the US dollar. It depreciated through 1996 and 1997, but within the intervention band.17 From early 1997, despite rising interest rates, the Thai

14When its charter was renewed in 1792, the Bank of England (known as the Bank of London until the early 1800s) was given a near monopoly over note issue in England – private banks (partnerships of up to six people) could still issue notes.

15Taiwan, the Philippines and Hong Kong were also affected, but the discussion here will focus on Thailand, Indonesia and Korea, with some references to Malaysia and the Philippines. It aggravated problems in Russia, which had its own crisis in 1998. By September 1998, Mexico, Brazil, Chile, Colombia and other countries were fighting hard to defend their currency pegs – some were forced to abandon them.

16See Krugman (1994), Young (1995) and McKinnon and Pill (1996), among others.

17From late 1996 until the onset of the currency crisis in 1997, the baht fluctuated (+) or (−) 3% around a mean of 24.5 baht = $1

[ 417 ]

F I N A N C I A L C R I S E S

žIn this region, exports (increasingly manufactured goods) trebled between 1986 and 1996 and, on average, made up about 40% of each country’s GDP by 1996. These countries, competing with each other in global markets, faced growing pressure from Chinese products and, frequently (except in Korea), the firms were foreign owned.

žRestrictions on capital movements had been liberalised, and by 1996 were completely free. These economies experienced a huge inflow of foreign credit but (see below) inward foreign direct investment had started to decline. Increasingly, foreign firms were looking to China as the Asian base for their manufacturing plants. For the five Asian countries,18 $75 billion of net international credit was granted in 1995 – 96, consisting of bank loans (20%), net bond finance (22%) and net interbank (58%), compared to just $17 billion (or 18% of total net capital inflows) for net equity and portfolio investment. In 1997 it fell to $2 billion (just under 4% of net capital inflows), compared to $54 billion in foreign credit.19

žLarge, indebted corporations exerted strong political influence. Nowhere was this more evident than in Korea. In the 1960s, the Korean government adopted an industrial policy that was to transform it from a largely agricultural economy to one based on manufacturing, which, by 1996, absorbed 90% of capital and accounted for 61% of GDP. The ‘‘economic miracle’’ was achieved through complex, interactive relationships between the government which directed state investment in around 30 chaebol: family owned industrial groups, each associated with a financial institution responsible for meeting the chaebol’s funding needs. Long-standing relationship banking consolidated the link between chaebol and bank.20

Using funds generated from household savings, the government also supported about 30 state owned firms which were largely monopolies. The government promoted key sectors such as steel, vehicles, chemicals, consumer electronic goods and semiconductors. Provided an industry met the goals set by the state, it could expect protection from imports and foreign investors, preferential rates from state controlled interest rates, and cheap financing from the banks. There was significant competition among the four car manufacturers, the five chemical firms and four semiconductor companies. However, the emphasis was on revenue growth and capturing market share, rather than adding value. In the 1990s, return on capital was less than the cost of the debt.

At the onset of the crisis in 1997, most of the chaebol had debt to equity ratios in excess of 500%. Any equity was held by the family, which meant there was little in the way of corporate accountability. In July 1997, the eighth largest conglomerate, the Kia group, collapsed, defaulting on loans of just under $7 billion. Two more chaebol had failed by December, which, together with other factors, undermined foreign and domestic confidence in the economy and contributed to the onset of crisis.

18Korea, Indonesia, Malaysia, Philippines, Thailand.

19Source: BIS (1998, table VII.2).

20Bae et al. (2002) show that relationship banking can be costly to the firm in periods of bank distress. Looking at the bank crisis period, they show that firms which are highly levered experience a larger drop in the value of their equity. By contrast, the drop in share value is less pronounced for firms that rely on several means of external financing, and with more liquid assets.