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CENTRAL BANK OF NIGERIA UNDERSTANDING MONETARY POLICY SERIES NO 26 CAUSES OF BANKING CRISES POLICY DEPA RY 10 TH T MEN RT MONE TA Igoni Pedro Anniversary Commemorative Edition c 2013 Central Bank of Nigeria Central Bank of Nigeria 33 Tafawa Balewa Way Central Business Districts P.M.B. 0187 Garki, Abuja Phone: +234(0)946236011 Fax: +234(0)946236012 Website: www.cbn.gov.ng [email protected] E-mail: ISBN: 978-978-53862-1-9 © Central Bank of Nigeria Central Bank of Nigeria Understanding Monetary Policy Series 26, February 2013 EDITORIAL TEAM EDITOR-IN-CHIEF Moses K. Tule MANAGING EDITOR Ademola Bamidele EDITOR Charles C. Ezema ASSOCIATE EDITORS Victor U. Oboh David E. Omoregie Umar B. Ndako Agwu S. Okoro Adegoke I. Adeleke Oluwafemi I. Ajayi Sunday Oladunni Aims and Scope Understanding Monetary Policy Series are designed to improve monetary policy communication as well as economic literacy. The series attempt to bring the technical aspects of monetary policy closer to the critical stakeholders who may not have had formal training in Monetary Management. The contents of the publication are therefore, intended for general information only. While necessary care was taken to ensure the inclusion of information in the publication to aid proper understanding of the monetary policy process and concepts, the Bank would not be liable for the interpretation or application of any piece of information contained herein. Subscription and Copyright Subscription to Understanding Monetary Policy Series is available to the general public free of charge. The copyright of this publication is vested in the Central Bank of Nigeria. However, contents may be cited, reproduced, stored or transmitted without permission. Nonetheless, due credit must be given to the Central Bank of Nigeria. Correspondence Enquiries concerning this publication should be forwarded to: Director, Monetary Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria, Email:[email protected] iii Central Bank of Nigeria Mandate §Ensure monetary and price stability §Issue legal tender currency in Nigeria §Maintain external reserves to safeguard the international value of the legal tender currency §Promote a sound financial system in Nigeria §Act as banker and provide economic and financial advice to the Federal Government Vision “By 2015, be the model Central Bank delivering Price and Financial System Stability and promoting Sustainable Economic Development” Mission Statement “To be proactive in providing a stable framework for the economic development of Nigeria through the effective, efficient and transparent implementation of monetary and exchange rate policy and management of the financial sector” Core Values §Meritocracy §Leadership §Learning §Customer-Focus iv MONETARY POLICY DEPARTMENT Mandate To Facilitate the Conceptualization and Design of Monetary Policy of the Central Bank of Nigeria Vision To be Efficient and Effective in Promoting the Attainment and Sustenance of Monetary and Price Stability Objective of the Central Bank of Nigeria Mission To Provide a Dynamic Evidence-based Analytical Framework for the Formulation and Implementation of Monetary Policy for Optimal Economic Growth v FOREWORD The understanding monetary policy series is designed to support the communication of monetary policy by the Central Bank of Nigeria (CBN). The series therefore, provides a platform for explaining the basic concepts/operations, required to effectively understand the monetary policy of the Bank. Monetary policy remains a very vague subject area to the vast majority of people; in spite of the abundance of literature available on the subject matter, most of which tend to adopt a formal and rigorous professional approach, typical of macroeconomic analysis. However, most public analysts tend to pontificate on what direction monetary policy should be, and are quick to identify when in their opinion, the Central Bank has taken a wrong turn in its monetary policy, often however, wrongly because they do not have the data for such back of the envelope analysis. In this series, public policy makers, policy analysts, businessmen, politicians, public sector administrators and other professionals, who are keen to learn the basic concepts of monetary policy and some technical aspects of central banking and their applications, would be treated to a menu of key monetary policy subject areas and may also have an opportunity to enrich their knowledge base of the key issues. In order to achieve the primary objective of the series therefore, our target audience include people with little or no knowledge of macroeconomics and the science of central banking and yet are keen to follow the debate on monetary policy issues, and have a vision to extract beneficial information from the process, and the audience for whom decisions of the central bank makes them crucial stakeholders. The series will therefore, be useful not only to policy makers, businessmen, academicians and investors, but to a wide range of people from all walks of life. As a central bank, we hope that this series will help improve the level of literacy in monetary policy as well as demystify the general idea surrounding monetary policy formulation. We welcome insights from the public as we look forward to delivering content that directly address the requirements of our readers and to ensure that the series are constantly updated as well as being widely and readily available to the stakeholders. Moses K. Tule Director, Monetary Policy Department Central Bank of Nigeria CONTENTS Section One: Introduction .. .. .. Section Two: Basics and Importance of Banking .. .. .. 1 .. .. .. 5 Section Three: History of Banking Crises and Country Experiences .. 3.1 The Great Depression 1929-1939 .. .. .. .. 3.2 Other Regional and Country Experiences .. .. .. 3.3 21st Century Financial System Crises: Adverse Effect on Banks Section Four: Causes of Banking Crises 4.1 Responses to Banking Crises .. 4.2 Global Response to Banking Crises Section Five: Conclusions Bibliography .. .. 7 7 10 13 .. .. .. .. .. .. .. .. .. .. .. .. 15 18 19 .. .. .. .. .. .. 23 .. .. .. .. .. .. 25 vii CAUSES OF BANKING CRISES CAUSES OF BANKING CRISES1 Igoni Pedro2 SECTION ONE Introduction The latest global financial crisis led to the most wide-spread banking crises after the Great Depression. However, unlike preceding crises, the financial crisis principally impacted the industrialised countries, with the adverse consequences still persistent. This has prompted new concern about the causes and effects of banking sector crises, and the possible strategy to address the problem. Banking crises refers to a condition of significant disturbance in a country’s banking industry. Banking crises have occurred many times throughout history, when one or more risks have occurred for a banking sector as a whole. Financial analysts and macroeconomists have posited that banking crises is not new and are inherent in the business cycle and is the outcome of the tendencies of market participants for absurd reaction and narrow-minded anticipation (Allen, Babus, & Carletti, 2009). Banking crisis in its proper perspective, entails either a panic or waves of bank failures. Panic in the banking sector refers to instants of momentary misconception about the unrecognizable cumulative surprises that are worrisome, to give rise to mutual action by banks and regulators (Calomiris & Gorton, 1991); while waves of banking collapse are those arising from aggregate negative net worth of failed banks in excess of one per cent of Gross Domestic Product (GDP). Caprio & Klingebiel, 1996 and Reinhart & Rogoff, 2009 viewed banking crises as noticeable bank runs that lead to the failure of banks, and that starts a string of similar demises. A bank run, which is a feature of banking crisis, ensues when a large number of bank customers voluntarily and hastily withdraw their deposit with the bank, with the conviction that it will fail. A crisis ensues when the capital of a bank is eroded due to poor risk management and nonperforming loans, leading to adverse net worth of the bank. Alashi, 2002 posited that a bank will exhibit the following characteristics to manifest crisis: insufficient capital compared to the sophistication of the firm; increased non-performing 1This publication is not a product of vigorous empirical research. It is designed specifically as an educational material for enlightenment on the monetary policy of the Bank. Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the accuracy of the contents of this publication as it does not represent the official views or position of the Bank on the subject matter. Igoni Pedro is an Assitant Director in the Monetary Policy Department, Central Bank of Nigeria. 2 1 CAUSES OF BANKING CRISES loans to total loans; illiquidity manifested in the bank’s inability to meet depositors’ cash withdrawals needs, and / or an insistent desire to overdraw from the Central Bank window. it also manifested in poor receipts arising from substantial losses from a bank’s operations; and, poor corporate governance, including inadequate corporate control mechanism and insider abuse, fraud, corrupt and unprofessional behaviour, board crises, poor human capacity and low staff morale as well as high staff turnover, among others. Banking crises according to Laeven & Valencia, 2008, entails bank sector runs, affecting particular banks; panics, affecting several institutions; while systemic banking crises involves a country- wide impact on the failure of a large number of banking institutions and corporation with many of them facing serious challenges in meeting their obligations. In an update, Laeven & Valencia, June 2012 defined a systemic banking crises to occur when certain criteria are met: noteworthy indication of collapse in the banking sector (as specified by important runs, losses in the banking system, and /or bank liquidation,; and, important strategy intervention measures in reaction to substantial losses in the banking industry. They posited that the fulfilment of the criteria in the first year occasion the commencement of a systemic crises, while intervention measure is considered significant if three of the following six measures have been used. These measures include: widespread and continous liquidity support (5 percent of liabilities and deposits to non-residents; bank restructing total costs (at least 3 percent of Gross Domestic Product); important banking sector nationalisation; noteworthy pledges in the form of guarantees put in place; substantial assets acquisitions (at least 5 percent of GDP); deposit freezes as well as bank holidays. Table 1 shows a list of current and on-going cases that meet the definition of a systemic banking crises from 2007 -2011. Table1: Systemic Banking Crises, 2007 - 2011 Country Start of Crisis Date when Systemic Extensive Liquidity Support Austria Belgium Denmark Germany Greece Iceland Ireland Kazakhstan Latvia Luxembourg Mongolia Netherlands Nigeria Spain 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2009 2008 2008 2008 2009 2009 2009 2008 2009 2010 2008 2008 2009 2008 2011 2011 ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ Significant Guarantees on Liabilities Systemic cases ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ Significant Restructuring Costs ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 2 Significant Asset Purchases Significant Nationalizations ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ CAUSES OF BANKING CRISES Ukraine United Kingdom United States 2008 2007 2009 2008 ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 2007 2008 ✓ ✓ ✓ ✓ ✓ France Hungary Italy Portugal Russia Slovenia Sweden Switzerland 2008 2008 2008 2008 2008 2008 2008 2008 ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ Borderline cases ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ Source: IMF Working Paper: Systemic Banking Crises Database 2013 Notes: Systemic banking crises are defined as cases where at least three of the listed interventions took place, whereas borderline cases are those that almost met our definition of a systemic crisis. Extensive liquidity support is defined as a situation where the amount of central bank claims on the financial sector and liquidity support from the Treasury exceeds 5 percent of deposits and foreign liabilities and is at least twice as large as pre-crisis levels; direct bank restructuring costs are considered significant when they exceed 3 percent of GDP and exclude liquidity and asset purchase outlays; guarantees on liabilities are considered significant when they include actions that guarantee liabilities of financial institutions other than just increasing deposit insurance coverage limits; nationalizations are significant when they affect systemic financial institutions. In Nigeria, a study jointly conducted by the CBN andNDIC in 2002,expressed a systemic banking crisis as a situation in which the following conditions are prevalent: firstly, banks that are unfavorably distressed holds 20.0 per cent of the total assets in the banking system; and, secondly, 15.0 per cent of total deposits are exposed; and, 35.0 per cent of banks’ total loans are non-performing. Banking crises are not particular to the contemporary times or particular countries, as most country has experienced one, and some have had multiple banking crises. Though, banking crises may emerge in various ways their essential characteristics and socio-economic impact, are similar. Banks are vulnerable to many forms of hazards which can cause crises. The disruption of the smooth functioning of the banking system is not only inimical to the financial system but to the economy as a whole, this explains why banks are among the most heavily regulated institutions in any economy. Banking sector regulation and supervision have however, not averted the concern and deep rooted consequences of banking crisis. This is associated with the issue of moral hazard arising from customer protection with the provision of government safety net and safety of the banks with the lender of last resort window provided by the central banks. 3 CAUSES OF BANKING CRISES Generally, banking system collapse are signaled by sustained of increased growth in credit as well as related huge discrepancies in the private sector’s balance sheets., This would then culminate into disparities in maturity and possible manifestation of exchange rate challenges, that eventually turn into banks’ credit risk. Banking crises is inadvertently used interchangeably with financial crises. However, banking crises is a distinct subset of financial crises. According to Calomiris, 2009, banking crises comprised of panic, moments of momentary misperception about the indiscernible occurrence in “the financial system of observable aggregate shocks, or severe waves of bank failures which result in aggregate negative net worth of failed banks in excess of one per cent of Gross Domestic Product (GDP)”; whereas, financial crises, encompasses the totality of the financial system. Financial crises include exchange rate collapse, asset price bubbles as well as banking crises among others. Calomiris, 2009 further enumerated four distinguishing features of banking crises and financial system failure to include: non-randomness of bank failures that occurs mostly at times of cyclical downturns, which are tightly associated with increase liabilities of failed businesses and fall in asset prices; banking crises were relatively rare, historically, than financial crises; the past investigation of the different bank crises occurrences(banking waves and banking panics of crises) shows they hardly happen together; and “banking crises of both types vary in their frequency across countries and across time.” Following this introduction, section two reviews the basics and importance of banks in any economy, while section three highlights the history of banking crises with country experiences., Section four discusses the causes of banking crises and solutions to mitigate the crises, while section five concludes with the possible way forward. 4 CAUSES OF BANKING CRISES SECTION TWO Basics and Importance of Banking In order to evaluate the causes of banking crises, it is important to understand the rudimentary aspect of banking and its relevance to the economy. Conventionally, a bank is a financial institution that serves as an intermediary that accepts deposits from economic units with surplus, and channels these deposits through lending activities to units with deficits, such as individuals, corporate organization and government. This important function of intermediation makes the bank one of the most crucial institution in the financial system in any economy. In addition to the traditional banking activities, banks in emerging economies performs other functions to enhance economic growth and development. Some important functions of the banks include promoting the growth and development of the industrial sector by providing short-term, medium-term and long-term financial resources in the form of loans. For example, in Bangladesh, India, and Malaysia, banks provide short-term and medium- term financing for hire- purchase and small scale industries; loans in the medium-term ranging between one and three years in the Latin American countries like Guatemala; and long-term loans to industry in Korea. Banks, also aid in deepening the capital market which is emergent in most developing countries; assist and promote most domestic and international economic activities through funding. Banks facilitates trade and services through the provision of different payment arrangements, such as overdraft, discounting, accepting bills of exchange and issuing drafts. The banks also provide funds to support international trade through the provision of foreign exchange; the banks also provide facilities especially in developing and emerging economies to support the growth and development of the real sector of the economy. This include the provision of low interest guaranteed agricultural credit facilities in collaboration with government to farmers, as well as priority loans to small, medium enterprises (SMES) In this way, the banks, meet the credit requirements of various types of customers; and finance employment generating activities. The banks also provides consumer loans for the purchase of certain products such as houses, refrigerators etc. The banks facilitates monetary policy implementation in the economy, serving as a channel for the transmission of monetary policy of the central bank. Thus, the banks contribute immensely to the growth and development of economies by providing finance to foster international trade, support agriculture, trade and industry, as well as assist in physical and human capital formation. 5 CAUSES OF BANKING CRISES It is in the light of the crucial role of the banks in the financial system and the general economy, that the issue of banking crises, and how to mitigate its adverse consequences, becomes germane. The next section will discuss the history of banking crisis and country experiences. 6 CAUSES OF BANKING CRISES SECTION THREE History of Banking Crises and Country Experiences The discussion on the history of banking crises and country experiences requires to first identify and date banking crisis episodes. In doing so, special reference will be made to the Great Depression, for its adverse effect on the international financial systems, especially the massive banking crises and massive bank failure in the period. It is important to note that information relating to banking crises for the pre- World War 11 era was limited. This is because most banking crises then were the concern of the domestic economy, and not as serious and far reaching as foreign debt on the international scene. The order and number of banking crises in developing economies before the period may be lost as a result of poor documentation and information management. However, in the advanced economies, banking crisis occurrences tend to be better documented. This is evident in the later part of the 18th century, starting with the collapse of the Leendert Pieter de Neufville in Amsterdam in 1763. The crises spread to other countries; Germany and the Scandinavian. Other recorded events on banking crises in the century included: the 1772-1773 collapse of Neal, James, Fordyce and Down in London and Amsterdam; the New York panic of 1792; as well as the 1796-1797 banking panic of Britain and the United States. In the 19 th century; the 1819 banking panic in the United States following the recession resulted in bank failures; the 1825 banking panic which resulted in the collapse of many banks in Britain. The 19th century banking crises were mainly banking panics affecting the developed economies of United States and Britain, except the 1890 banking panic of Argentina and the 1893, Australian banking crisis. The banking panic persisted up until the early 20th century, with the 1901 U.S banking panic and the Showa Financial crises of Japan of 1907, which resulted in mass failure of banks. The 20th century witnessed the worst systemic banking crises, which was associated with the Great Depression. 3.1 The Great Depression 1929-1939 The global economic downturn resulting in the Great Depression started in the last quarter of 1929, in the advanced nations. it heralded the most widespread banking crises with far-reaching consequences in impact and duration, which lasted until about 1939. One of the consequences of the Great Depression was the rearrangement in the global financial architecture in terms of thinking, market structure, strategies, and approach to activities relating to banks and banking. The crises originated in the United State of America and spread to virtually all countries, with severe disruptions in political and socio-economic activities. This resulted in fall in output growth, recession and high level loss of jobs. 7 CAUSES OF BANKING CRISES For example, in the United States, the wholesale price index deteriorated 33 percent, industrial production fell 47 percent and GDP decline 30 percent. Similarly, the banking sector, also recorded substantial losses with the collapse of about 44 per cent or 11,000 of the 25,000 banks and depositors losing approximately $140 billion by 1933. The timing and severity of the Great Depression differs significantly across the different nations of the world. The impact of the Great Depression was predominantly extensive and harsh in the United States and most European nations; while the effect was less intense in Japan and Latin America. Table 2 shows the duration of the impact on economic activity in a number of countries affected by the Great Depression. Table 3 shows the peak-to-trough percentage decline in annual industrial production for countries for which such data are available. Britain experienced acute depression in the early 1930, with drop in industrial production about of one-third that of the United States. The duration of depression in France was small, but the rescue period was also limited, with damaging consequences as output and prices decline drastically in the period from1933 to 1936. In Germany, recession started earlier in 1928, but steadied and thereafter relapsed in the third quarter of 1929, with the fall in industrial production equal that experienced in the United States. Some Latin America nations, notably Argentina and Brazil also experienced the Great Depression earlier between the late 1928 and early 1929, before the United State. Japan also experienced a slight recession within the period. The cause of the depression are multiple; from financial panic, fall in consumer demand and poor regulatory policies, which started from the United States with the gold standard, that connected virtually all the countries to a system of fixed currency exchange rates that intensified the spreading of the downward spiral in the United States to other nations. 8 CAUSES OF BANKING CRISES Table 2: Dates of the Great Depression in various countries (in quarters) Country Depression Began Recovery Began United States 1929:3 1933:2 United Kingdom Germany France Italy Japan Canada Belgium The Netherlands Sweden Switzerland Denmark Poland Czechoslovakia Argentina Brazil India South Africa 1930:1 1928:1 1930:2 1929:3 1930:1 1929:2 1929:3 1929:4 1930:2 1929:4 1930:4 1929:1 1929:4 1929:2 1928:3 1929:4 1930:1 1932:4 1932:3 1932:3 1933:1 1932:3 1933:2 1932:4 1933:2 1932:3 1933:1 1933:2 1933:2 1933:2 1932:1 1931:4 1931:4 1933:1 Table 3: Peak-to-trough decline in industrial production in various countries (annual data) Country Decline United States United Kingdom Germany France Italy Japan Canada Belgium The Netherlands Sweden Denmark Poland Czechoslovakia Argentina Brazil 9 46.8% 16.2% 41.8% 31.3% 33.0% 8.5% 42.4% 30.6% 37.4% 10.3% 16.5% 46.6% 40.4% 17.0% 7.0% CAUSES OF BANKING CRISES The recovery from the Great Depression was spurred largely by the abandonment of the gold standard, and the ensuing monetary expansion. The economic impact of the Great Depression was enormous, including both extreme human suffering and profound changes in economic policy. 3.2 Other Regional and Country Experiences There were other banking crises in the 20th century, but they did not create much adverse and far reaching consequence globally, as the Great Depression. A survey by Laeven and Valencia in 2008 as cited in the work by Valdez & Molyneux, 2013 indicates that during the period 1970-2007: there were 124 systemic banking crises in 101 countries; crises often occur regularly in the same countries, with 19 countries experiencing more than one banking crises, for example Argentina four, Mexico two, the US two; with very large fiscal cost. For example in Argentina, the cost was 75% of GDP; Chile,36% of GDP; China, 18% of GDP; South Korea, 31% of GDP; Indonesia, 57% of GDP, and Mexico, 20% of GDP. The crises were often associated with very large output losses. For example, relative to trend output, losses reached 73% in Argentina, 92% in Chile, 37% in China, 59% in Finland, and 31% in Sweden. This section will examine what happened in several other countries, though the causes of banking crises are propelled by similar forces in all countries. Table 4: The Cost of Rescuing Banks in Several Countries Dates Country Cost as a Percentage of GDP 1980-2007 1997-2002 1990s- ongoing 1996-2000 1981-1983 1997-2002 1993-1994 2000-ongoing 1997-1983 1997-2002 1988-1991 1991-ongoing 1994-1995 1998-2001 1994-2000 1997-2001 1992-1994 1998-ongoing Argentina Indonesia China Jamaica Chile Thailand Macedonia Turkey Israel South Korea Cote d’Ivoire Japan Venezuela Ecuador Mexico Malaysia Slovenia Philippine 10 75 57 18 44 36 35 32 31 30 31 25 24 22 20 20 16 15 13 CAUSES OF BANKING CRISES 1994-1999 1995-2000 1989-1991 1997-1998 1991-1994 1989-1990 1991-1995 1990-1993 1991-1994 1988-1991 Brazil Paraguay Czech Republic Taiwan Finland Jordan Hungary Norway Sweden United States 13 13 12 12 11 10 10 8 4 3 Source: 1. Extracted from the Economics of Money, Banking and Financial Markets by Frederic S. Mishkin, 8th Edition 2. IMF Working Paper: Systemic Banking Crises Database 2013. Scandinavia In the Scandinavian countries of Norway, Sweden and Finland, a significant cause of banking crises in the 1980s was financial deregulation. Banks in these countries before this period were under the control of the government, noncompetitive and restricted on the use of banks instruments in the conduct of banking business. Banking sector deregulation led to boom in lending, especially in the real estate sector, but lacked expertise in risk management. The resultant risky lending activities led to huge loan losses in the 1980s as a result of the collapse of the real estate prices. The government intervened in the banking sector and the cost of the bailout to Norway, Sweden and Finland were 8%, 4% and 11% of GDP, respectively. Latin America The Latin America banking crises exhibited similar trend with that of the Scandinavian countries, as banks were controlled and regulated by the government in the 1980s. The banking sector was regulated with restrictions in interest rate. With the wave of deregulation globally, many of the credit markets were liberalized and the banks privatized, leading to increased banking activities. The increased activities in the banking sector were not matched by improved human capacity, as the operators and the regulators were not able to manage the banks, thereby, resulting in huge loan losses and government intervention. The Argentina case was quite peculiar compared to other countries in the region. Between October and November 2001, a bank panic ensued, resulting in the loss of US$8 billion and by December 1, 2001, government imposed restriction of US$1,000 monthly limit on deposit withdrawals. The cost of the banking crises as a percentage to GDP amounted to 55% from 1980-1982. Other Latin American 11 CAUSES OF BANKING CRISES countries such as Venezuela, Ecuador, Brazil and Paraguay incurred lower cost than Argentina of 22%, 20%, 13% and 13% of GDP, in that order, respectively. Japan The Japanese banking sector before the 1980s was among the most highly controlled banks. Restrictions were imposed on interest rate and the use of security instruments. The trend was similar with other countries that experienced banking crises; financial liberalization and advance in technology not matched by the required expertise by regulators and bankers led to lending boom in especially in the real estate sector, resulting in excessive risk that created huge bad loans when the real estate market collapsed in the 1990s. In 1995, Hyogo Bank was the first bank to fail followed by the Hanwa Bank, a large regional bank and Nippon Credit Bank in 1996 and 1997, respectively. Also, in 1997, Hokkaido Takushoku Bank went out of business. In order to arrest the complete collapse of the banking system, the government reassigned supervisory authority by the Ministry of Finance to the Financial Supervisory Agency (FSA). Between 1991 and 2003, the government burdened with massive bad bank loans (non-performing loans exceeding US$1 trillion) and meager profitability incurred a cost amounting to 24 percent of GDP. Russia and Eastern Europe Banks in Russia and the Eastern European countries were owned and controlled by the government, until the end of the cold war and the death of communism. Both the bank regulators and the operators in these countries lacked the capacity to monitor and supervise the risk of the banks at the end of communism and onset of financial liberalization, thereby ensuing huge loan losses, leading to government intervention and bank failure. In Russia, for example, a bank panic in 1995 following the closure of the interbank market and insolvency of many banks led to government intervention. This was further reinforced in 1998, with the imposition of suspension on the settlement of external liability arising from the collapse of the banks; following the threat of nearly 50% of the banks in Russia collapsing resulting in a bail out cost of US$15 billion. In Hungary, eight banks that accounted for 25% of the financial system’s asset went bankrupt, with cost as percentage to GDP, amounting to 10% between 1991 and 1995, while, in 1995, about 75% of all loans in Bulgaria were subnormal. China The prominent banks in China are the State- owned banks which have lent hugely to poorly managed and highly inefficient state- owned enterprises. Between 1991 and 2003, non-performing loans amounted to about US$500 billion; with government bailout of US$30 billion on four largest banks; Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and China 12 CAUSES OF BANKING CRISES Reconstruction Bank in 1998. Also, between 2001 and 2004, injections worth US$170 billion and US$100 billion, respectively were released to salvage the banks. The government is planned to partly privatize the banks, as the cost of bailout as a percentage of GDP stood at 47 between 1991 and 2003. East Asia In the aftermath of the financial liberalization leading to lending boom, huge loan losses emerged due to the poor supervision of the banking system and the currency crises in 1997. In 1997, between 15% and 35% of total loans became subnormal in Indonesia, Malaysia, Thailand and South Korea and the bailout stood at 15% of GDP. It was 55% of GDP in Indonesia; 35% of GDP in Thailand; 28% in South Korea and 13% of GDP in Philippine. In recent times, the causes of banking crises in the various countries of the world has been financial liberalization, poor adaption to innovation in technology, government policy of regulation and poor management of risk by regulators and operators in the banking sector. Though, financial system liberalization is good as it promotes competition and market efficiency, it can result in moral hazard with increased risk appetite on the part of banks in a regime of weak regulation. However, common in all cases of banking crises is the existence of government safety net, which increases moral hazard through motivation for unguided risk- taking by banks. 3.3 21st Century Financial System Crises: Adverse Effect on Banks Another far reaching event leading to massive banking crises and eventual collapse in recent times was Global Financial Crises of 2007-2008. This resulted into the collapse of several banks, especially in the advanced economies where the crises originated. Though, it was not a banking crises, its adverse effect on the global banking sector was enormous and worth mentioning. Several banks faced tough times, as some collapsed, while others were nationalized. Others still, were acquired by larger and stronger competitors, as well as merger, and in other cases the government intervened through bailouts. By the end of September 2008, over 284 banks and lenders had collapsed globally. Most prominent among them included: Northern Rock, nationalized in February 2008, after failing to be resuscitated with the £25 billion it borrowed from the Bank of England and loss of jobs; Bear Stearns, intervened by the US government for assistance in the face of the crisis and later sold to JP Morgan on March 17; Dresdner Kleinwort, a German investment bank acquired by Commerzbank AG on 31 August following its failure; the two largest US mortgage lenders, Fannie Mae and Freddie Mac, two government-sponsored enterprises, which guaranteed about half of the US mortgage market of about $12 trillion were nationalized by the US government; the fourth largest investment bank in the US, Lehman Brothers collapsed and filed for Chapter 11 bankruptcy protection on September 15;to prevent the collapse 13 CAUSES OF BANKING CRISES of another major investment bank, Merrill Lynch was taken over by Bank of America, in an arrangement involving about $50 billion on 15 September, after having written -off an equivalent amount as a result of sub-prime and unable to secure foreign investment; Washington Mutual – taken over by JP Morgan on September 25, WaMu (the self-professed "Wal-Mart of Banking") the largest bank to fail was taken over for a pittance of $1.9 billion, with assets of $307 billion; and Fortis, a prominent bank in low countries in which the government intervened on 29 September, 2008. Others included: Wachovia – sold out by Citigroup on 29 September, 2008, but later acquired by Wells Fargo on December 31, 2008 ; Glitnir, the Icelandic bank taken over by the government and nationalized on 29 September, 2008; the German bank, Hypo Real Estate bailed out by the government on 29 September, as well as Dexia, the Belgian bank saved by the intervention of the governments of Belgium, France and Luxembourg, respectively on 30 September, 2008; Landsbanki, the Icelandic bank was also bailed out by Russian funds on 8 October,2008. 14 CAUSES OF BANKING CRISES SECTION FOUR Causes of Banking Crises Conventionally, central banks globally are responsible for the maintenance of the stability of the banking sector. In spite of this, economies seem to be continually plagued by banking crises, arising in some cases, from regulatory failures. According to Allen, Babus, & Carletti, 2009 two distinct theories seek to explain the origin of banking panics: firstly, that banking crises are “caused by random deposit withdrawals” not related to the vagaries in the fundamentals of the economy, and that economic actors have an indeterminate consumption need under a circumstance in which it is difficult to settle transactions . In the event that customers are certain that there will be withdrawals in the system, all other customers and economic players will follow suit to withdraw their deposit with the banks, thereby, creating a bank panic in a self-fulfilling manner, while the other stance is where everybody believes there will be no panic and economic participants withdraw their funds following their consumption demand, that is no panic occurs. However, none of the two positions in the first theory states how a crisis is started. The second theory, according to them dwell on the fact the crises “are a natural outgrowth of the business cycle”; and that a recession will lower the worth of banks’ assets with the chances that the banking institutions will not be able to meet their obligations. In this case, they stated that a crisis is not a random event, but rather depositors’ view of a bad news with respect to an economic downturn. The main issue in the two theories according to them, is the nature of the deposit contract, which provides an incentive for bank runs because of the first come, first served basis on which the demand for depositors’ liquidity is met. While Allen, Babus, & Carletti, 2009 evolved the theories behind banking crises, Latter, 1997 enumerated the causes of banking crises as follows: poor regulation and supervision; macroeconomic instability; deficient policies; poor corporate governance; weak internal control measures; corruption and fraud and failure in operational techniques. Macroeconomic factors according to Latter is a major source of banking sector instability and crises, arising from a sharp increase in interest rates or decline in exchange rate; a sudden slowdown in general inflation or onset of recession and the deterioration of asset prices, particularly in real estate after an earlier unsustainable increase arising from an inappropriate policy or banking decision. Another source of challenge, especially in developing and transition economies, is the dramatic change in relative prices or the removal of subsidies that affect adversely, particular sectors of the economy to which the banks are exposed. Microeconomic policy reasons entail all structural and supervisory factors, which fall under the control of the monetary authority of a country. Some of these factors include: financial sector liberalization; moral hazard; government interference; lack of transparency; poor 15 CAUSES OF BANKING CRISES supervision and regulatory failure and inadequate infrastructure in terms of accounting principles, legal framework; and, appropriate institutions. Financial sector liberalization has resulted in dramatic change in the nature and behavior of economic agents. The sudden shift from regulation to market driven policies in the financial system implies that the practice, operations and attitude of stakeholders contribute to the causes of banking Crises. The confidence that no bank will fail or will be supported financially in periods of crises lead to moral hazard. This result in banks behaving in manners that could impair rather than improve their position; and depositors may not bother to distinguish between healthy and unsound banks, thereby delaying survival but amplifying a crisis. Poor and inadequate institutional arrangements such as legal frameworks; poor regulatory capacity; cultural and technological deficiencies could hamper banks transparency to depositors and other stakeholders. This would encumber the functioning of free market principles, especially in a deregulated financial system, thereby, culminating to undesirable consequences in the banking sector. Closely related to the issue of transparency is the lack of appropriate infrastructure relating to poor accounting and legal principles. Poor accounting and auditing may delay the recognition of illiquidity or insolvency, while inadequate legal framework may frustrate the exercise of certain activities such as the pledge and collateral support for loan and property rights. Government interferences in the forms of financial and economic policy on banks activities could also lead to banking crises. Such directives as to lending to preferred sector of the economy at preferential interest rates, or to extend and maintain bank branch network that are uneconomical, has triggered a liquidity or solvency crises. Also, the imposition of certain adverse directives such as funding government deficit on non-market basis, and malign reserve requirement either unremunerated or bearing a sub- market rate of interest, could result in a banking crises. Supervision is a key factor in banking crisis. There is a common view that banking crises is a result of supervisory failure, this however, may not be completely correct, as there must be first some short coming in the bank, which escaped the attention of supervision. However, if supervision is tight to eradicate the chances of bank failure, banking business would in all sense be repressed and uncompetitive, and fail to function efficiently in financial intermediation to the economy. The cause of banking crises in some cases pertain to the banks’ operation modalities or strategy. Banking crises may arise due to the desire of banks to 16 CAUSES OF BANKING CRISES delve into certain activities without adequate information, and sometimes wrong timing. For example, banks sometimes introduce new products or expand their branch network to new geographical areas that are not profitable. The haste to expand has been one of the most common causes of bank failure. Also, banking crises could be as a result the challenges with the changing information technology; failure to rationalize staff; and adopt new management technique or to organize and operate effectively. Some common operational challenges that result in banking failures are: failure to make accurate assessment of credit risk and to price appropriately. There is also the problem of adverse credit selection in which case, the bank does not take adequate care in pricing the risk associated its customers. Banks sometimes deny credit to more cautious and prudent customers, while granting credit to more speculative ventures ready to meet higher interest charges but with greater the risk of default is ; exposure to the vagaries of interest rate or exchange rate, which may result in losses and subsequently banking crises. These exposures are expected to be put in check internally or by the regulatory body, though major changes in macroeconomic policies may cause losses beyond the limits set by the regulatory authority or the internal control mechanism; also concentration of lending on particular sector, which can become vulnerable as a result of the uncertainties in the global economy can be a source of banking problems. The Nigerian banking crises of 2009, was an example of loan concentration to a particular sector in the economy (oil and gas sector). In some countries, especially the advanced countries, ceilings on loan concentration are specified and strictly adhered to; trading in new products for which expertise is low or nonexistent can also be a source of banking crisis. Other operational pitfalls include: unauthorized trading associated with failure in internal controls; poor quality of staff as a result of rapid business expansion or high staff turnover; poor management structure without clear functions of oversight and responsibility; poor cost control mechanism; lack of contingency arrangement to address external and internal challenges; poor documentation process, and audit trails; and, excessive reliance on information technology without sufficient understanding and enough back-up. Weak corporate governance coupled with fraud and corruption. Employees, management and outsiders may all be susceptible to corruption or fraud on a bank. In a nutshell, the causes of banking sector crises vary and several factors are always at play in event of a crisis. While, macroeconomic factors are frequently adduced, the actual problem rest with the banks strategy and operation modalities. There are supervisory and regulatory lapses but also certain government policy on the banking sector creates banking failure, more 17 CAUSES OF BANKING CRISES importantly is the issue of poor risk assessment and the rising rate of fraudulent practice, coupled with lack of effective internal controls measures have resulted in banking sector crises. 4.1 Responses to Banking Crises Preventing banking crises and eventual collapse of the banking system is a major challenge not only to countries, but also an issue of global concern. Governments and their respective regulators, mostly central banks have adopted measures to arrest banking crises in view of the important role of banks in the economy, and the interconnectivity of the global banking system. Though, not all policy initiatives employed to address the issues of banking crises have been successful, substantial gains have been made to engender the confidence and trust in the banking sector. However, most of the policies to mitigate the crises are put in place when the crises has already crystalized. This may be because every banking crisis has its own peculiarity. For example, one of the policy responses to the banking crises in 1929 was the discontinuation of the fixed exchange rate regime and the gold standard. The banking crises in the 1980s and 1990s were principally the result of financial liberalization, innovation in information technology and the global interconnectivity through trade and capital mobility, and poor credit risk management by regulators and bankers. The collapse of banks following the recent Global Financial Crises is the result of poor regulations, policy of universal banking and the lack of transparency in product innovation. Policy strategy and preventive measures requires identifying the nature of the crises, whether it is a systemic or non-systemic banking crisis. When a nonsystemic crisis is identified the bank concerned is liquidated in the extreme case or acquired and or merged with a healthy financial institution. If however, it is a systemic crisis, which involves several banks within the economy, the immediate concern is to engender financial stability. This requires the intervention by the monetary authority and the government to boost confidence and avoid bank runs. Generally, the responses to addressing banking crises could be achieved either with the bank resolving its challenges without intervention or by intervention. When the crisis does not require government intervention, the bank can adopt the following rescue options: undertake changes in the management team and staffing structure as well as adopt a new and effective operational strategy. This could also imply rationalisation of staff with emphasis on retention and or engagement of qualified and competent manpower, adoption of new and innovative technology and replacement of management where weak corporate governance is identified. The bank could also review its lending strategy with a 18 CAUSES OF BANKING CRISES view to adopting appropriate credit risk management technique. This is done to mitigate the banks’ heavy exposure to either a particular sector of the economy or reducing the level of non-performing loans to total loans. The bank could also request for additional funding from its shareholders to boost its capital base. If these measures do not mitigate the crisis, the bank would be open to a possible merger with a stronger and healthier bank; otherwise in an extreme case the affected bank could declare bankruptcy and go out of business. Where banking crises requires the assistance of the government, different strategies could be adopted. These include; the intervention by central banks as lender of last resort to provide liquidity, in which case, the cause is a bank run arising from liquidity crises. This is done with a view to rescuing the financial system from a systemic crises and boost confidence. The government could also provide financial support in the form of capital without changes in the structure and ownership of the concerned banks. The danger with this option is the problem of reinforced moral hazard i.e lack of incentive to guard against risk in which one is protected from its consequences, as well as enormous fiscal cost. The intervention could also be in the form of bridge banking – temporary government ownership of failed bank to allow for restructuring and sale to the market in future. It is usually held for a specific time period to improve its balance sheet for resale to the market. In this case, the banks’ status would change and the shareholders would lose their ownership interest in the bank. Another response strategy to banking crises could be by assisted merger and or acquisition, resulting in the change in the banks status. These are business combination strategy- a merger occurs when two companies combine to form a new one, while acquisition is the outright purchase of one company in which no new company is formed. Finally, there could also be outright ownership by government through nationalisation. This is done to protect depositors and creditors in an event of the collapse of a large bank. 4.2 Global Response to Banking Crises Following the advent of financial system deregulation and the internationalization of the banking business, there have been efforts at the global level to evolve solution to banking crises. The Basel Committee on Banking Supervision which comprised, Group of Central Bank Governors and Heads of Supervision, has the objective to appraise an all-inclusive set of strategies to reinforce the supervision, regulation and risk management of the banks globally. It also aims to promote the supervisory ability of the committee as well as the worth of banking supervision globally. To achieve the committee’s objectives, members meet regularly to: promote the effectiveness of techniques for banking supervision globally; encourage exchange of information on national supervisory measures; and, set minimum supervisory standards in areas considered desirable. 19 CAUSES OF BANKING CRISES The Committee was conceived to evolve banking regulation and supervision for the central banks of the group of ten nations, in the aftermath of the 1974 drastic banking and foreign exchange collapse (especially following the collapse of the German Bankhaus Herstatt). Basel Committee members are drawn from central banks as well as the representatives of the prudential supervision of banking business from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. Though, the Committee does not have any official global supervisory authority as its decisions do not have legitimate force, but it articulates guidelines and strategies and makes recommendations on perceived suitable practice. Concerned about the deteriorating capital ratios of the main international banks coupled with the growing heavily indebtedness of countries in the early 1980s, it agreed to work on a comprehensive weighted approach to the measurement of risk of banks’ balance sheet. The result of this led to the establishment of capital measurement classification, commonly referred to as the Basel Capital Accord of 1988. Although, the aim was to protect the banking industry of the advanced economies, the convention is being adopted increasingly by banks in emerging and developing economies. The elements or characteristics of the Basel Accord are as follows: Basel Accord The 1988, Basel Accord, popularly called Basel 1, basically address the issue of credit risk and the classification of risk weighting of asset. It allocates zero per cent to cash being very liquid and 100 per cent to residential mortgage. Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA). One major defect of the Basel 1 Accord was the consideration of only credit risk, which could not address the challenges of banking crises in the advanced economies due to other risks such as market risk, operation risk and others. It was, however, a major breakthrough in setting the pace for international supervisory measures toward addressing banking crises. The short coming of the 1988 Basel Accord gave rise to a revision, resulting in the Basel 11 Accord 1999 based on three pillars. The three pillars are: pillar1-minimum capital requirements with some modification; Pillar I1- the supervisory review process; and, Pillar 111- on market discipline. The first pillar, minimum capital requirements, expands on the rules from the 1988 Capital Accord (Basel I). Some of the inputs in the earlier accord, such as the capital requirement was also adopted, and improved upon in the new 20 CAUSES OF BANKING CRISES convention. The modification in Pillar I included: the inclusion of operational riskdue to poor internal control measures. With the acceptance of international best practice by emerging market economies, the Basel 11 Accord met with challenges. Under Pillar 1, data limitations became a major limiting factor, especially for emerging economies, as design and implementation could not be done. There were issues of poor human and technical resources in the areas of supervision; also the framework for accounting was a challenge. The unfolding challenges coupled with the global financial crises led to the review of the Accord, which resulted in the Basel 111Accord. Some elements of the Basel111 Accord included: the elimination of tier 3 capital; increased common equity from 2 per cent in Basel11 to 4.5 per cent, also raised tier 1 capital to 6 per cent including common equity. The efforts of the Committee reveals the concern of the global community to financial system stability, in view of the rising interconnectivity of the global financial architecture. The response in recent times has also extended beyond the advanced countries, as emerging market economies are keying into the rules and regulation for the safety of their banks and financial systems. 21 CAUSES OF BANKING CRISES 22 CAUSES OF BANKING CRISES SECTION FIVE Conclusion Preventing the failure of banks and evolving appropriate response measures to mitigate crisis is a daunting task, even in the short term. Considering the pivotal role of the banking system in the economy, the issue of bank collapse and failure has been of grave concern to authorities and governments in both advanced and emerging economies. With the rapid growth of global interrelationship of the financial system, financial sector deregulation, international trade and capital flow and advancement in technology, the concern has moved beyond individual nation to the global level with the involvement of international organisations responsible for making rules on supervision and regulation of international banks. Banking crises, especially systemic failure has also resulted in enormous fiscal cost to governments, loss of confidence in the economy and instability of the financial system. Measures to mitigate banking crisis has been very costly in terms of its impact on the social, political and economic spheres. While governments have made concerted efforts to arrest the collapse of the banking system, other factors beyond their scope had resulted in the failures of banks. Within the banks also are operational deficiencies such as poor corporate governance, fraud and corruption and poor credit risk management. The effort to resolve banking crises is a dynamic one as the financial system keeps evolving with advancement in technology, product innovation and competition in the worldwide market space. 23 CAUSES OF BANKING CRISES 24 CAUSES OF BANKING CRISES Bibliography Alashi S. O. (2002). "Banking Crisis: Its Causes, Early Warning Signals and Resolution". Central Bank of Nigeria Conference Proceedings on Enhancing Financial Sector Soundness in Nigeria (pp. 126-153). Abuja: CBN. Allen F., Babus A., & Carletti E. (2009). Financial Crises: theory and evidence. Annual Review of Financial Economics 1, 97-116. Calomiris C. W. (2009). Banking Crises and the Rules of the Game. 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