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Banking Crises
Regulation & Performance
Economics 102
Early Regulation
• Scams ==> bank licensing by late 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
• 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
• Sum
– Illiquidity issues
– Insolvency issues
Regulation
• 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, state & federal)
• Inspection
• Case study: Bank of Tokyo NY, 1979
– Regulation Q (1933)
• Prevent competition for deposits
• Help guarantee margins
– Federal Home Loan Bank Act (1932)
• Set up S&L framework: some perks, but only mortgages
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 funds
• Incentive to pull money from term savings accounts
• Also could buy bonds directly ….
– Regulation Q broke down
• Banks were freed to pay market interest rates in 1980 for S&Ls
S&Ls
• Savings & Loan Institutions
– State-chartered banks
• Most deposits guaranteed by FSLIC
– Restricted in general to nearby housing
– 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%
• Paul Volcker Fed Chairman 1979 ==> raised “i” sharply
• Entire sector rendered insolvent
– In 1981 3,300 out of 3,600 S&Ls were losing money
– By mid-1982 S&Ls in the aggregate were insolvent
Further deregulation
• So rechartered as federal institutions
• Freed S&Ls to lend to new business
– 1980, esp 1982
• Allowed to do new, “ profitable” types of loans
– Commercial real estate 40%, including outside state
– Consumer loans 20%, also credit cards
– Could accept brokered deposits: phone banks calling people across
the country, and insured up to $100,000
S&Ls in the New Age
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But the same old regulators
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
– Over $1 billion in fraud at one S&L in Colorado with Neil Bush as
director
– More at Keating’s Irvine CA Lincoln S&L, bought 5 US Senators to
protect themselves, but $3.4 bil in losses to taxpayers
– Included Sen. McCain, Glenn and 3 who didn’t run for re-election (1
censured) Riegle DeConcini Cranston (censured!)
Bottom Line
• $250 billion cost to taxpayers
• 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
• so it’s still possible to finance a home purchase
More recent crises
• 1980s Latin America Debt Crisis
• Japan
• Thailand
• Argentina
Latin American Debt
• Big “petrodollar” recycling
– Banks - where to lend?
– Latin America is growing strong
• Esp Brazil
• Commodity prices rising faster than interest rates
– 10% i - 20% π = -10% real i so stupid not to borrow!
– Citibank along lent $1 billion
• But then commodity prices fell, interest rates rose
– 20% i - (-)20% π [deflation] = +40% real I
– Bankrupt!
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?
• Citicorp etc
– Can megabanks handle the menu of new products that
they’re trying to peddle, on a global basis? I wonder…
• Why worry?
– Structural change, but management change?
– Expansion in up cycle when hard to lose money
• Housing bubble
• Hedge funds with new and thus unknown risks.
• Note: most of the above was written in March 2002
Summary
• Leverage:
– a little is very powerful
– Try to move too much and something will snap
– Institutional change: both regulators & lenders find hard to handle
• Regulation
– Regulations generate side effects
• Moral hazard
– Heads I win, Tails you lose