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

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Presentation on theme: "Banking Crises With enough leverage, a small shock can move the whole world ---- with apologies to Aristotle Michael Smitka Economics 102 Winter 2003."— Presentation transcript:

1 Banking Crises With 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 Crisis Latin 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 –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

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