Are
financial crises rare events in emerging economies? Banking crises have become
increasingly common especially in the developing world. In this paper, a brief
look at the banking problems in emerging economies is observed. Most of the examples that have been
presented are drawn from are the experience of the emerging economies rather
than from either the transition economies or the low-income developing
countries. The factors responsible for
banking problems in developing countries and the policy options that are
available for reducing the frequency and severity of these crises are not addressed. The question is how fragile is the financial
structure and the risk associated with the problem of banking in emerging
economies and how can this be prevented is addressed
“Over
the 1980–2001 period at least two-thirds of International Monetary Fund (IMF)
member countries experienced significant banking sector problems.”[1]
In many regions, almost every country has experienced at least one serious
problems of banking trouble; however, “the incidence of banking crises in the
1980s and 1990s has been significantly higher than in the 1970s, and much
higher than in the period of the 1950s and 1960s.”[2] Numerous economists have observed, “The
frequency and size of financial crashes during the last quarter-century is
“unprecedented” – much worse than was experienced prior to 1950.”[3]
The
risk of banking in emerging economies can cause serious problems to the
emerging country. They are:
Banking
crises in developing countries have been far more severe during the past 25
years than those in industrial countries and developing countries for this
period. The estimates of losses for the most “severe industrial country-banking
crisis was that of:
The
US saving and loan crisis (1984–91) cost about 3% of GDP.”[5] In the developing world, by contrast, “more
than a dozen episodes in which losses or resolution costs exceeded 10% of GDP,
they are:
In
several cases (Argentina, Chile and Côte d’Ivoire), losses were greater
than or equal to 25% of GDP. While such estimates are inevitably imprecise, the
greater severity of banking crises in developing countries is a common finding
of several different studies”[6]
The
risk of banking crises is hardly surprising. Bank difficulties or failures are
presumed to generate more serious negative problems for the rest of the economy
than those at either other kinds of financial firms or non-financial firms.
These problems take a variety of forms.
“The use of public money to recapitalize insolvent banks can seriously
handicap efforts to control budget deficits. Even if public expenditure
on rescuing banks is viewed as a (domestic) transfer rather than as a real
economic cost, it can push the authorities toward less benign ways of financing
the deficit (e.g. the inflation tax); moreover, the rescue itself can sap the
incentives for private creditors to monitor the behaviour of banks in the
future. ”[7]
If
recapitalization takes the form of weak banks cutting back lending and widening
spreads, “the lower availability and higher cost of bank credit can undermine
the real economy, particularly for small and medium-sized firms which have
fewer alternative sources of financing. In general, a decline in economic
activity precedes the outbreak of a banking crisis so that it becomes difficult
to isolate the independent effect of the crisis on output during and after the
event.”[8]
“Nevertheless, there is widespread agreement that a
banking crisis is likely to amplify a downturn;”[9] in addition, “the worsening
of information and adverse selection problems that typically occurs during a
financial crisis (as it is the least creditworthy borrowers who will be
prepared to pay high interest rates) means that the quality of investment is
likely to suffer; that is, saving will not flow to its most productive uses.”[10]
Serious
banking problems also create difficulties for monetary policy. “They may not
only distort the normal relationships between monetary instruments and the
intermediate and final targets of monetary policy,”[11]
but they may also compromise the
overall stance of monetary policy. Fears of pushing an already strained banking
sector over the edge may constrain the monetary authorities from tightening
monetary policy to deal with, for instance, “a loss of confidence by foreign
investors or a rise in incipient inflationary pressures. Banking sector
weaknesses explain, as much as anything else, why the Mexican authorities (in
April–December 1994) both sterilized so heavily after private capital flows
tailed off and engaged in large-scale substitution of lower-yielding,
dollar-indexed tesobonos for higher-yielding peso-denominated cetes.”[12]
Both actions were aimed at limiting the rise in
interest rates and buying time for the banks to recover – “but, in the end,
magnified the decline in international reserves and allowed a currency crisis
to widen into a debt crisis.”[13] More
generally, recent empirical research reveals “banking crises have often been a
leading indicator of balance-of-payments crises in emerging markets during the
last 15 years.”[14] Finally,
“banks in developing countries typically operate the payments system, hold the
bulk of financial assets, are major purchasers of government bonds, and provide
the liquid credit needed by fledgling securities markets.”[15]
Banking
crises in emerging economies can also be costly for industrial countries,
particularly as the importance of emerging countries in the world economy and
in international financial markets has grown. Developing countries nowadays
purchase about one-quarter of industrial country exports. “In 1992–94, they
received about 40% of global inflows of foreign direct investment.”[16]
At end-1995, “banks in the IMF reporting area had
outstanding claims against developing countries of over $717 billion (about $46
billion more than their liabilities to these countries).”[17]
Over the period 1990–95, “developing countries
issued over $133 billion of bonds in international financial markets; at the
time of the Mexican crisis, non-residents held about 80% of the tesobonos held
outside the banking system.”[18] “Portfolio equity flows into
developing countries in the 1990s approached $128 billion. While still very low
(about 2%), the share of emerging markets in the portfolios of industrial
country institutional 7 investors
has increased sharply over the past five years, and optimal portfolio
calculations suggest that this share should continue to rise towards the
emerging market share (13%) of global stock market capitalization.”[19] Honohan (1996) estimates
that “since 1980 the resolution costs of banking crises in all developing and
transition economies have approached a quarter of a trillion dollars.”[20] Since the late 1970s, all
IMF drawings have been made by developing countries. In short, to the extent that
banking crises depress developing countries’ growth and foreign trade, strain
their ability to service and to repay private capital inflows, and eventually
add to the liabilities of developing country governments, industrial countries
are very likely to feel the repercussions.
Banking
crises in emerging economies have multiple risk factors. There is no single
solution. The problem is the more volatile environment (external and internal)
in which banks in these countries operate, such as “along with a reluctance in
many countries, at least so far, to address, or to compensate for, that
volatility with diversification, insurance and higher bank capital. Part of it
reflects a tendency for banks (much like those elsewhere) to lend too
recklessly during the upswing of the business cycle – a tendency that has been
exacerbated by large-scale capital inflows that are ultimately intermediated by
the banking system. Part of it is a rapid expansion in bank liabilities in a
context in which the normal liquidity/maturity mismatches of banks are
magnified by an excessively short-term orientation of the financial system,
relatively little support from securities markets, a sometimes heavy reliance
on foreign currency- denominated debt and the relatively high variability of
international reserves, interest rates and the exchange rate. Part of it
results from implementing financial liberalization before the supervisory and
regulatory system has been strengthened sufficiently to manage prudently the
new risks involved. Part of it is an accounting, disclosure and legal framework
that impede the potential contribution of market discipline to monitoring and
penalizing excessive risk-taking. Part of it is neither an incentive framework
that neither gives bank owners, managers and depositors enough to lose if
excessive risks are taken nor supervisors enough institutional protection
against pressures for delay in implementing corrective action. And part of it
is exchange rate arrangements that, whatever other merits they may have, have
not been conducive to effective crisis prevention and management in the
financial sector.”[21]
There are several possible
policy measures that can significantly reduce the incidence of each of these
factors underlying banking crises. “Greater macroeconomic stability, a larger
role for foreign owned banks, the wider use of market-based hedging instruments
and higher levels of bank capital would all help either to reduce volatility or
to make the consequences for the domestic banking system less damaging.”
Limiting the allocation of bank credit to
particularly interest-rate-sensitive sectors, close monitoring of lending by
weakly capitalized banks and employing the right mix of macroeconomic and
exchange rate policies would similarly limit vulnerability to lending booms,
asset price collapses and surges of capital inflows. Maintaining an ample
cushion of both liquid assets and international reserves, and adopting a
cautious attitude towards short-term, foreign-currency-denominated borrowing
can limit banks’ liquidity or currency mismatches and discourage runs on both
bank and government liabilities.
Careful
screening of applicants for banking licenses along with a prior strengthening
of training in, and resources for, banking supervision can reduce the risks
that often go hand-in-hand with financial liberalization. The privatization of
state-owned banks and enhanced efforts to increase the transparency of implicit
and explicit government taxation of the banking system should help to put more
of the banking system on a commercial footing, with sizable dividends in terms
of efficiency and lower loan losses.
The
more effective implementation of existing restrictions on connected lending
would reduce undue concentration of credit risk and discourage favoritism (and
fraud) in credit allocation. “Stricter asset classification and provisioning
practices could reduce the all-too-frequent growth of bad loans and provide
satisfactory protection against loan losses. Fuller and more internationally
harmonized public disclosure of bank soundness and performance – with a greater
role for private rating agencies – can help to strengthen market discipline.
Considerable scope exists too for tilting the incentives for bank owners,
managers and creditors in the direction of political factors (government interference and
connected lending) were important in at least one-third of the crises,
volatility factors (primarily, terms-of-trade deterioration and recession) in
one-half to two-thirds of them, and deficient bank management and poor
supervision and regulation – broadly defined – in two-thirds to four-fifths of
all cases.”[22]
The
implementation of the practice of “bank soundness”[23]
is quintessential for any bank in a development economy. In this relationship,
higher bank capital, higher personal liability for poor management or oversight
and increased recourse to coinsurance for depositor losses (with uninsured bank
creditors bearing a higher proportion of the losses) would each improve the
structure of incentives. The introductions of some rule-based, prompt
corrective action elements into the bank supervisory process may, in
circumstances where supervisors face strong political pressures for
self-control, enhance supervisory effectiveness.
Several
countries are going through a difficult period of banking sector restructuring,
and are attempting to address the consequences of earlier failures of
oversight. These failures, and the lessons learnt from banking difficulties
worldwide, have naturally prompted international authorities almost everywhere
to take a good look at their safeguards against banking crises and other
systemic financial problems. In some emerging economies, policy measures have
been taken to make the domestic banking system more robust and to improve the
quality of banking supervision. In many others, these questions are under
active consideration. The frequency and severity of banking crises in
developing countries over the past decade and a half argue against complacency.
Reforms need to be more widely shared and deeply rooted than was the case in
the past. Fixing the problems of the banking sector will require a sustained
commitment. The ways that international co-operation can sustain this
commitment is clearly an issue that requires urgent consideration.
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[1] Lindgren et al. (1996)
[2] Honohan (1996)
[3] Honohan (1996)
[4] Morris Goldstein and Philip Turner (1996)
[5] Caprio and Klingebiel (1996)
[6] (see, for example, BIS (2001), Lindgren et al. (2000) and Sheng (1999)).
[7] Edwards (1995) shows how large-scale public bailouts of banks have complicated efforts at fiscal consolidation in Latin America over the past two decades.
[8] Kaminsky and Reinhart (1995), Mishkin (1994) and Sheng (1996).
[9] Lindgren et al. (1996), Johnston and Pazarbasioglu (1995) and Bernanke (1983).
[10] De Gregorio and Guidotti (2002) and Mishkin (1994).
[11] Calvo and Goldstein (1996) and Leiderman and Thorne (1996).
[12] Between 1991 and mid-1994, the share of non-performing loans in the Mexican banking system doubled – from about 4% to 8%.
[13] Calvo and Goldstein (1996) and Leiderman and Thorne (1996).
[14] Kaminsky and Reinhart (1995)
[15] BANKING CRISES:ORIGINS AND POLICY OPTIONS Morris Goldstein and Philip Turner (1996)
[16] Qureshi (1996).
[17] BIS (1996).
[18] BIS (1996).
[19] Levine (1996). 12 Honohan (1996).
[20] BIS (1996), Caprio and Klingebiel (1996b), Folkerts-Landau et al. (1995), Gavin and Hausmann (1996), Honohan (1996), Kaminsky and Reinhart (1995), Lindgren et al. (1996), Meltzer (1996), Rojas-Suárez and Weisbrod (1995a, 1996b), Sheng (1996) and Sundararajan and Baliño (1991).
[21] Morris Goldstein and Philip Turner (1996)
[22] Morris Goldstein and Philip Turner (1996)
[23] Bank Soundness is a term used by a banks board of directors to ensure that all aspect of the its policy, procedures and profitable are being sustained.