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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
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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
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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.
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Email:[email protected]
iii
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effective, efficient and transparent implementation
of monetary and exchange rate policy and
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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
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Section Two: Basics and Importance of Banking
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Section Three: History of Banking Crises and Country Experiences ..
3.1
The Great Depression 1929-1939
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3.2
Other Regional and Country Experiences
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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
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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
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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
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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.
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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
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