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Banking Crises
Regulation & Performance
Economics 102
Winter 2002
Early Regulation
• Scams, Bank failures ==> bank licensing from early 1800s
• Minimum capital requirements
• Attempt to exclude criminals
• But US had 20,000+ banks
– In much of midwest, branch banking prohibited
– Interstate banking prohibited
• Federal Reserve System from 1913
• Smooth interest rate swings
• Support faith in money, quell banking panics
• Foster national market
Great Depression
• Big swings in prices: deflation
– Debtors hurt, many default
– Real GDP fall likewise leads to defaults
• Banking “panic”
– Fears lead to bank runs
• 9755 banks failed in 1929-33
• FDR declared bank holiday in March 1933 to stop panic
• Sum
– Illiquidity issues
– Insolvency issues
• Promote “sound” banking practice
• More below...
• Depositor insurance (FDIC, 1933)
• Restores confidence
• But insurance has side effects
– Moral hazard
• Encourages risk taking
• Heads I win … tails you lose
Safe Banking
• Sound practice
– Glass-Steagall (1933): segment services
• Insurance - banking - securities - underwriting
• NOW DEFUNCT cf. Enron issues
– Bank supervision (gradual from 1800s, state & federal)
• Inspection
• Case study: Bank of Tokyo NY, 1979
– Regulation Q (1933)
• Prevent competition for deposits
• Help guarantee margins
Banking Crises
• Structural change is the enemy of sound banking
– Managing risk is undermined
– Mix of products / operations undermined
1970s shifts
• 1970s
– Inflation rose ==> disintermediation
– MMMFs developed
• Donahue and money market [mutual] funds
• Incentive to pull money from term savings accounts
• Also could buy bonds directly …. such as I did.
– Regulation Q broke down [for S&Ls from 1982]
• Banks were freed to pay market interest rates
• Savings & Loan Institutions
– State-chartered banks (initially)
– Restricted to local residential real estate ca. 1936
• No geographic or industry diversification
– Typical product fixed-rate 30 year mortgage
• Core of business
– Borrow short
– Lend long
– “Maturity transformation”
Demise of S&Ls
• 30 year mortgages
– Collecting 4%
• Short-term deposits
– Paying 10%
• Entire sector rendered insolvent
Further deregulation
• So rechartered as federal institutions
• Freed S&Ls to lend to new business
• Allowed to enter new, more profitable types of
lending, such as commercial real estate
development in other states
S&Ls in the New Age
But the same old regulators - and understaffed
And the same old bankers
In a brave new world
California S&Ls in Texas …
….. Dentists as Bankers?!
• No ability to practice or assess sound banking
• Outright fraud
– Ex: Over $1 billion in fraud at one S&L in Colorado
– Chs Keating bought 5 US Senators to protect himself, with $2
billion in losses and (for him) a brief stint in jail
Bottom Line
• Initial $250 billion cost to taxpayers
– Liquidation of real estate recouped $90 bil thereof
• Lots of bad assets
– Lots of unmitigated waste
– Local business cycle accentuated (Tx, Fl, La)
• Ultimate total elimination of S&L segment
• Commercial banks alternatives
• floating rate mortgages [undermined S&Ls in their latter days]
• so it’s still possible to finance a home purchase
More recent crises
• Japan
– Traditional business disappeared
• Growth slowed from 10% pa to 5% pa
• Less Investment
– business borrowing fell by 10% of GDP
– savings (deposits) continued to rise
– So need new business
• Small firms (60% of economy)
• Real estate (good collateral, prices always rise)
Japan’s Crisis
• New business plan a failure
• Good small businesses already had bankers
• Real estate prices could fall, too
• Began shift in a boom, hiding bad practices
• Banking crisis from 1992
• Real estate prices fell
• Stock-market based financing backfired
• Japan in 2001 is back in recession, with only one year of good
growth since 1990.
Thailand, Argentina
• A supposedly fixed foreign exchange rate
– But domestic interest rates high!
– Answer?
• Borrow in US $ from foreign / offshore banks
• But the exchange rate depreciated
– Suddenly instead of owing B20,000 you owe B40,000
– And interest payable doubles too
• Widespread defaults / bankruptcies
Tomorrow’s crisis?
• Citigroup gone awry?
• Home mortgage loans in a falling real estate
• Etc .. ?
• Why worry?
Structural change
but management change?
Expansion in up cycle when hard to lose money
Mistakes now coming home to roost
• Leverage:
– a little is very powerful
– Try to move too much and something will snap - or spring back
and slap you
– Institutional change: both regulators & lenders find hard to handle
• Regulation
– Regulations generate side effects
• Moral hazard
– Heads I win, Tails you lose
– Adverse selection: if you try to expand quickly, you have to lower
standards, and (like grade inflation) those rejected by conservative
banks will seek you out! Losses always prove worse than average!