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Financial Fragility: Causes and
Policies
Thorsten Beck
Too much financial intermediation…
Arcand, Berkes and Panizza, 2012
… can end badly…
25
Great
Recession
20
Tequila
crisis
15
Transition
Economies
10
Asian
Crisis
Latin American
debt crisis
5
Source: Laeven and Valencia (2012)
2010
2005
2000
1995
1990
1985
1980
1975
1970
0
…and costly!
Output losses relative to potential output;
Source: Laeven and Valencia (2010)
Who cares?
 Disruption of credit flow and payment services can bring
economies to a halt
 Loss of access to savings can put depositors in precarious
situation
 Very high fiscal and output costs (up to 55%)
Defining Stability
 Individual bank fragility – distance from insolvency or actual failure
 How to measure bank fragility?
 Systemic bank distress:
• The ratio of non-performing assets to total assets in the banking system
exceeded 10 percent;
• The cost of the rescue operation was at least 2 percent of GDP;
• The episode involved a large scale nationalization of banks
• Extensive bank runs took place or emergency measures such as deposit
freezes, prolonged bank holidays, or generalized deposit guarantees were
enacted by the government.
 Between 1973 and 2002: 116 systemic crises in 113 countries, with fiscal
costs of up to 55% of GDP.
Banking Crises around the world
Number of countries in crisis
70
60
50
40
Non-systemic
30
Systemic
20
10
0
1980
1982
1984
1986
1988
1990
1992
Year
1994
1996
1998
2000
2002
Bank Fragility: Liability side (1)
 Large number of agents; three time periods (0, 1 and 2); one good
 Agents born with endowment e and enjoy access to long-term production process,
with yield of
 r < 1 in period 1
 R > 1 in period 2
illiquidity assumption
 2 types of agents
 λ impatient agents who only derive utility from period 1 consumption
 (1- λ) patient agents who only derive utility from period 2 consumption
 Type discovered in period 1
 Financial intermediaries can help overcome liquidity problem and thus increase
investment in economy and thus growth
 Fragile equilibrium, possibility of bank run
Bank Fragility: Liability side (2)
 Irrational run: coordination failure among depositors
 Information-based runs:
 If R is stochastic, with a bad outcome, patient consumers realize that
they will not earn promised interest and run in period 1.
 Inability of uninformed patient depositors to distinguish between high
liquidity needs of impatient depositors and insolvency due to shock.
Bank runs in practice – example from India
 Iyer and Puri (2012)
 Minute-by minute withdrawal data from a bank that faced a





non-fundamental run
Social networks and neighborhood effects important in
determining run probability
Longer-term relationship (deposit or loan) reduce run
probability
Geographic distance does not seem to matter!
Uninsured depositors more likely to run
“Runners” do not return!
Exogenous shock caused panic
Asset bubbles
 Assume existence of land, with exogenously fixed supply and
exogenously fixed yield for rentiers.
 Usage of land increases return on long-term investment;
price being bid up, i.e. socially optimal price boom
 In case of bank run – bank liquidates long-term assets and
land
 Land price crashes back to fundamental value
Bank Fragility: Asset side (1)
 Principal-agent problem
 Depositors bear down-side risk, while shareholders (and
management) only participate in upside risk due to limited liability
 Bank shareholders have incentive to take more aggressive risk and
reduce monitoring effort vis-à-vis borrowers
 Worse in banking than in other industries
 Opacity and long-term maturity of banking assets
 Disperse depositor population prevents discipline, invites free-riding
Bank Fragility: Asset side (2)
 2 period economy
 Investment project with return R or zero
 Success probability depends on costly monitoring effort by
bank
 Self-financed project:
 Profit:
 Monitoring effort:
 Financed with deposits:
 Profit:
 Monitoring effort:
Fragility in reality – how to measure?
 Individual bank fragility
 Distance from insolvency or actual failure
 CDS spread – market-based
 Systemic bank distress:
• The ratio of non-performing assets to total assets in the banking system exceeded 10
percent;
• The cost of the rescue operation was at least 2 percent of GDP;
• The episode involved a large scale nationalization of banks
• Extensive bank runs took place or emergency measures such as deposit freezes, prolonged
bank holidays, or generalized deposit guarantees were enacted by the government.
 Between 1973 and 2002: 116 systemic crises in 113 countries, with fiscal
costs of up to 55% of GDP.
Determinants of bank-level fragility
 Size
 Ownership
 Liquidity
 Asset growth
 Herding
 Idiosyncratic vs. systemic fragility
Determinants of country-level fragility
 GDP Growth
 Real exchange rate changes
 Real interest rate
 Inflation
 Fiscal position
 Financial depth
 Credit growth
Signaling method vs. prediction models (problem: out-ofsample power)
Financial liberalization and fragility
 Compare monopolistic to competitive banking system: fewer
obligations to depositors, lower risk of bank run
 Financial liberalization, resulting in more competition can
lead to financial crisis
 But competition might also lead to growth-enhancing
financial deepening
 Cost-benefit analysis on trade-off
Competition and Stability: What does
Theory Tell us?
 Ambiguous predictions, depending on modeling of
competition on asset or liability side
 Competition-stability hypothesis
 Competition-fragility hypothesis
Competition-fragility hypothesis
 Charter value hypothesis – monopoly rents prevents banks
from taking too excessive risk
 Liability risk – concentration can lead to more stability, but
not necessarily; deposit insurance and deposit interest rate
ceilings might be needed
 Larger banks that can better diversify
 Fewer banks that facilitate supervision
Competition-stability hypothesis
 Banks with greater market power charge higher interest
rates, inducing moral hazard behavior by borrowers, with
negative repercussions on stability
 Larger banks and conglomerates are more opaque and
therefore are harder to supervise
 Fewer banks means larger banks that are subsidized through
“too big to fail” policies thus higher risk and more fragility
Defining Competition
 Market structure measures
 Concentration ratios, number of banks, Herfindahl indices
 Do not gauge banks’ behavior
 Structure-conduct-performance hypothesis vs. efficient structure hypothesis
 Competition measures – H-Statistic
 Measures reaction of output to input prices
 Imposes assumptions on banks’ cost function
 Regulatory indicators to gauge contestability
 Entry requirements, formal and informal barriers to entry for domestic and
foreign banks, activity restrictions etc.
 Challenges for market structure and competition measures:
 Relevant market (national, sub-national etc.), institutional rather than product
approach
What do the Data Tell us?
Summary of empirical results
 Bank-level studies do not give clear evidence either way, but
might be biased by changes in regulatory framework in
countries under study
 Cross-country comparison show that concentration is not a
good measure of competition and that competition does not
hurt stability (Beck, Demirguc-Kunt and Levine, 2006)
 Important interaction between regulatory framework and
competition in their effect on stability (Beck, De Jonghe and
Schepens, 2013)
Source: Ranciere, Tornell, Westermann, 2006
Bank regulation and supervision and
the role of government
Thorsten Beck
What is special about banking
 Banks
 Provide payment services (network character)
 Transform short-term liquidity into long-term investment (maturity
mismatch)
 Screen and monitors borrowers (private information creation)
 Interlinkages between banks
 Claims between banks
 Contagion
 Network effects
 Failure of one bank does NOT necessarily benefit competitors
Market discipline vs. regulation
 Market discipline might not work as well in financial
sector as in others
 Opacity
 Dispersed creditors, free-riding
 Disruption of credit flow and payment services can bring
economies to a halt
 Loss of access to savings can put depositors in precarious
situation
 Failure of one institution does not help others –
contagion risk
Tools of bank regulation
 Capital requirements
 Risk-based, but how?
 Liquidity requirements
 Activity restrictions
 Bad for diversification
 Bad for competition
 Entry restrictions
 Increases franchise value
 Reduces competition
 Diversification guidelines
Capital requirements and governance
 Management with bank-specific human capital might be less
risk-inclined
 Diversified owners have strong incentive to take risks
 Strong owners can increase risk-holding (power vis-a-vis
management)
 What about debtholders?
Capital requirements in a downturn?
Basel I vs. Basel II
 Capital decreases due to losses
 Might result in higher capital requirements (under Basel II)
 Lower credit worthiness of borrowers
 Lower asset prices
 Mark-to-market pricing
How important are capital
requirements?
Tools of bank supervision
 Off-site supervision
 On-site supervision
 Restrictions, prohibitions, MOUs
 Intervention
 Forced merger, liquidation
Financial safety net – the components
 Deposit insurance (DI), bank failure resolution (BFR) and lender
of last resort (LLR) are part of the overall financial safety net
 Opposing objectives
 Minimize risk of contagion and protect small depositors
 Reduce moral hazard risk
 All countries have financial safety net and its component, even if
not explicit
 Implicit DIS for gov’t owned banks and Too-Big-To-Close banks
 Even the failure to resolve banks constitutes a form of bank failure
resolution
 LLR as part of monetary policy
Financial safety net – the components
 Deposit insurance (DI), bank failure resolution (BFR) and lender
of last resort (LLR) are part of the overall financial safety net
 Opposing objectives
 Minimize risk of contagion and protect small depositors
 Reduce moral hazard risk
 All countries have financial safety net and its component, even if
not explicit
 Implicit DIS for gov’t owned banks and Too-Big-To-Close banks
 Even the failure to resolve banks constitutes a form of bank failure
resolution
 LLR as part of monetary policy
Financial safety net – the trade-off
 Lender of last resort
 Help overcome temporary liquidity problems to avoid bank runs
 Avoid risky lending sprees with lender of last resort resources
 Don’t delay day of reckoning
 Deposit insurance
 Protect small depositors and prevent bank runs
 Avoid reducing market discipline exercised by depositors and putting a
greater burden on supervision
 Bank failure resolution
 Minimize disruption and cost of bank failure
 Minimize aggressive risk-taking by banks
Bank resolution
The basic trade-off
 Minimizing external costs vs. enforcing market discipline
 Dynamic feature: today’s behavior by authorities will
influence tomorrow’s behavior by banks
 Expectations are important
The basic trade-off
Minimizing external costs
Ideal
Forbearance
Open bank assistance
Liquidation
Enforcing discipline
The basic trade-off
Minimizing external costs
Bail-out
Open bank assistance
BFR possibilities frontier
Liquidation
Enforcing discipline
Expanding the failure possibilities frontier
Minimizing external costs
Forbearance
Open bank assistance
Bridge bank
Ideal
Purchase and assumption
Merger and acquisition
Partial pay-out
Liquidation
Enforcing discipline
How to change possibilities frontier
 Better – less disruptive – resolution mechanisms
 Deposit insurance ??
 Early intervention
 Resolution tools
 Private market solution (merger and acquisition)
 Supported market solution (purchase and assumption)
 Transitional solutions (bridge bank)
But who decides on structure of
financial safety net?
 … the politics of finance
 …more on this tomorrow…