Banking Crises, Liquidity, and Credit Lines

A Macroeconomic Perspective

Gurbachan Singh

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781136342493
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The banking crises in 2007-10 are not exceptional. There have been many such crises in the past in both developed countries and emerging economies. A banking crisis can be related to solvency or liquidity (or both). This book focuses on banking crisis and liquidity. This book starts from basics and gradually builds up with very few technicalities. Though the analysis is primarily theoretical, we provide a historical background, a macroeconomic perspective, and policy implications for both closed and open economies.

1 Introduction

Banking crises are very costly.¹ There is something intriguing about them. Why must banking crises occur? Why must they occur again and again – in one form or another, in one part of the world or another?² Why can’t the policy-makers do something about them?³

An important aspect of banking crises is the sudden desired outflow from deposits in banks. This, as we will see, is similar to the problem in international economics of sudden and large outflow of funds from emerging economies.⁴ This too is very costly. Here again the question arises – can’t the policy-makers do something about this?

The literature on banking crises and liquidity includes some remarkable writings – Thornton (1802), Bagehot (1873), Friedman and Schwartz (1963), Diamond and Dybvig (1983), and others. However, much of this literature does not incorporate a line of credit (LOC). This will occupy centre-stage in the analysis in this book. We build on the work on lines of credit (LOCs) for banks in Goodfriend and King (1988), Goodfriend and Lacker (1999) and elsewhere. This book supplements the material in Allen and Gale (2008), Berger et al. (2010), Rochet (2008), Tirole (2002), and many other wonderful books.

The next section will provide a perspective on banking crises, liquidity, and LOCs. It will also outline the scope of this book. Thereafter, we will provide a glimpse of the main contents in this book (Section 1.2). Finally, we will outline the plan of the book (Section 1.3).

1.1 A perspective on banking crises, liquidity, and credit lines

We will quickly explain what we mean by financial crises, and then move to the focus of the book – banking crises, liquidity, and LOCs. Thereafter, we will introduce the problem of sudden outflows of funds from emerging economies.

‘Financial crisis’ is a generic term, and it can mean different things to different people. One textbook defines ‘financial crisis’ as follows: ‘A major disruption in financial markets, characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms’ (Mishkin and Eakins 2006, p. G-6). Some authors, such as Reinhart and Rogoff (2009), use the term ‘financial crisis’ more generally to include also inflation crises, currency crashes, currency debasement, external debt crises, and domestic debt crises.

We may add that asset prices can include prices of real assets such as real estate, gold and silver, and prices of derivatives. Though it is common to consider only a sharp fall in asset prices, we may consider both a sharp rise and a sharp fall in asset prices (a sharp and excessive rise in prices is often not recognized as a part of the problem; if it were recognized and some attempt made to address it, then the difficulties might be less severe).

Financial crises are old phenomena. There is also a long history of economic thought on the subject, which includes writings as diverse as Marx (1905–10), Simons (1936), Minsky (1982), Diamond and Dybvig (1983) and, of course, many others.

We have witnessed a major financial crisis in and around the year 2008 (for details, see Acharya and Richardson 2009). This is not an isolated set of events. There have been many such crises in the past – in one form or another, in one country or another (Reinhart and Rogoff 2009). There were frequent financial crises in the nineteenth century (e.g. in 1837, 1857, 1873 and 1893). Then in the first half of the twentieth century, some prominent examples include the crises in 1907, 1914, and the Great Depression in the 1930s. In relatively more recent times, we have had the European exchange rate crisis of 1992–93, the Tequila crisis of 1994–95, the East Asian financial crisis in 1997–98, the Brazilian crisis of 1998–99, and the Long-Term Capital Management hedge fund crisis in the US in the late 1990s.

In an important study of financial crises from a historical perspective, Bordo et al. (2001, p. 72) concluded:

Since 1973 crisis frequency has been double that of the Bretton Woods and classical gold standard periods and matched only by the crisis-ridden 1920s and 1930s.…Crisis length has remained constant. Output losses have changed little. Crises may have grown more frequent but they have not also grown more severe.

The rise in frequency of financial crises is often attributed to the liberalization in the financial sector, and to a more open economy. An early work in this context is Diaz-Alejandro (1985). There has been a long debate on the merits and demerits of liberalization and globalization. There are the benefits of financial and economic development, and there are the costs of possible financial crises due to liberalization. A related issue is whether the possible failures are due to liberalization per se, or due to liberalization that is unaccompanied by an adequate and meaningful policy framework within which markets function.

This book will, it is hoped, contribute to a better understanding of some of the issues involved in a financial crisis. We will deal with a subset of financial crises. This subset consists of banking crises. There have been eight major banking crises in the period from 1873 to 2009 in the US (Tallman and Wicker 2010, p. 36). What are banking crises?

When defining banking crises it is important to distinguish between two different aspects of banking crises – waves of bank insolvency (episodes in which bank losses result in many failed banks), and banking panics (moments in which the banking system as a whole suffers from sudden, large withdrawals of deposits).

(Calomiris 2009, pp. 5–6)

In this book, our main focus will be on ‘banking panics’, though we will briefly deal with ‘waves of bank insolvency’ as well. There are considerable differences in the terminology used in the literature. We will throughout use the term ‘banking crises related to liquidity’ for what Calomiris (2009) refers to as ‘banking panics’.

There is a build-up of evidence that supports the view that banking crises are more often than not observed to be cases of waves of bank insolvency rather than banking panics (Gorton and Winton 2003; Calomiris 2009; Caprio and Honohan 2010). In 2010–11, the difficulties being faced by European banks that held considerable amounts of debt issued by countries such as Greece would also fall into the category of (potential) ‘waves of bank insolvency’. We have, nevertheless, chosen to focus on banking panics. The motivation is as follows.

First, it is not clear if the banking crisis in 2008–09 is unambiguously a case of waves of bank insolvency. Gorton (2010, p. 15) ‘makes the case that the ongoing “credit crisis” is actually a banking panic’. Even in the case of the East Asian Crisis in 1997–98, a strong view was that it was a case of panic (Radelet and Sachs 1998). Though deposit insurance has considerably reduced the problem of banking panics, it cannot rule out bank runs, given that a sizeable proportion of deposits is uninsured. According to Maechler and McDill (2006), ‘small banks (with total assets up to $100 million) fund on average 13 percent of assets with uninsured deposits; banks with assets between $5 billion and $50 billion fund 16 percent of assets with uninsured deposits’. So banking panics are still important and there is a need to study them.

Second, it is interesting that Calomiris (2009) finds that the cause of waves of bank insolvency lies in risk-inviting rules framed and enforced by the public authorities (the central bank or the government).⁵ Calomiris (2009) suggests that there is a government failure involved in ‘waves of bank insolvency’. Similarly, Caprio and Honohan (2010) find that banking crises are primarily due to bad banking or bad policies (and not due to panics). Bad policies are very similar to risk-inviting rules⁶ in Calomoris (2009). So Caprio and Honohan (2010) too suggest that there is a government failure involved. Though bad banking is not always related to bad policies, it does ‘help’ to have a permissive and faulty regulatory regime that facilitates bad banking. We may say then that, broadly speaking, waves of bank insolvency are to some extent related to government failure. This raises another question.

Why do we have (extra) government involvement in banking in the first place? It is this question that motivates us to some extent to go back to studying banking panics. One important reason why we have government involvement in the first place is that there is a mismatch on the balance sheet of a bank.⁷ The assets of a bank are typically illiquid, whereas its liabilities are liquid. This makes it vulnerable to a socially costly bank run. This can have systemic implications which can be avoided if the central bank acts as the lender of last resort, as Francis Baring first conceived it in 1797. This safeguard or facility may be misused, so the government needs to supervise and regulate banking. Here, then, we have a rationale for government involvement in banking. Note that the rationale is to take care of banking panics.

To prevent banking panics, government has also used the policy of deposit insurance. This policy has, by and large, succeeded in preventing (traditional) bank runs.⁸ However, deposit insurance led to moral hazard (Demirgüç-Kunt and Kane 2002). The stakeholders in banks in the private sector became complacent, and even started taking more risks. The result was that banks incurred losses, their capital was considerably reduced and even wiped out in many cases, and they had to be recapitalized by the government in many cases. In these cases, it is true that we observed waves of bank insolvency. However, these occurred as a result of the remedies provided by the government to take care of banking panics. The original sin is, in a sense, banking panics. So even if we accept the observation that there are more waves of bank insolvency than cases of banking panics, we need to understand banking panics. An important part of the root problem lies there.

Third, in practice, for policy-makers the distinction between banking panics and waves of bank insolvency can be quite blurred at the time that there are difficulties in the banking sector (even if ex-post analysis shows that there are more cases of insolvency than of illiquidity). Argentina went through a bank run in November 2001. The total bank deposits in the banking system fell by more than US$2 billion, or nearly 3 per cent, on the second day of the run alone. The demandable deposits fell by more than 6 per cent (Ennis and Keister 2009, p. 1588). It was not obvious immediately whether this was a case of banking panic or a wave of bank insolvency, so we need to understand both. Here we focus on banking panics.

Fourth, though there is groundbreaking work in writings such as Thornton (1802) and Diamond and Dybvig (1983), these writings do not incorporate an ex-ante LOC for banks. Discussion of an LOC for banks came later in Goodfriend and King (1988) and Goodfriend and Lacker (1999). We will attempt to carry this analysis further. We will see that an LOC by banks (which is very familiar) can be quite different from an LOC for banks (which is less familiar).

Fifth, banking panics have been prevented by deposit insurance. However, it may be possible to take care of bank runs in other ways. We will see that if banks operate under an appropriate legal and regulatory framework, are well capitalized, and have credible LOCs for liquidity, then we can have systemic stability in the banking sector. So there is, as we will see, hardly any need for deposit insurance for ensuring systemic stability. However, we will argue that there is a rationale for private deposit insurance for safety of individual bank deposits, given that there is systemic stability. Finally, in a second-best world, there is a rationale for government deposit insurance, though it is hard to see why it should continue to be difficult to meet the conditions required for systemic stability (which will obviate the need for government deposit insurance for systemic stability).⁹

Sixth, we will draw a parallel between the problem of bank runs and the problem of sudden outflow of capital from emerging economies, and show how an international LOC can be useful in the latter case. Though a parallel has often been drawn between the two cases, the idea of the use of an LOC in this context is not widespread. This is despite the fact that the International Monetary Fund (IMF) now offers LOCs to central banks in emerging economies, and despite the fact that four countries (Poland, Columbia, Mexico and Romania) actually bought LOCs from the IMF around 2010.

This completes our discussion of the motivation for studying banking panics rather than waves of bank insolvency.¹⁰ There is one other aspect in the context of banking crises that is particularly relevant in the context of emerging and developing economies.

After about the middle of the twentieth century, many developing countries gained independence from the former colonial powers, and in many cases considerably changed their economic policies. They started relying more on government planning and less on market forces. Consistent with this was an interventionist policy in banking, which has two versions. One is the strong version under which we had the policy of government ownership of banks. Another is the weak version under which we had the policy of social control of banks.¹¹ In the case of government ownership of banks, the government nationalizes banks and exercises direct control as their owner. The government attempts to conduct banking operations such that allocation of credit is consistent with government priorities and planning strategy (in lieu of, or in addition to, market forces). In the case of social control of banks, the government does not nationalize banks to control them. Instead, the government frames rules and regulations for private banks in such a manner that the latter need to make decisions which are consistent with government’s planning strategy.

Another reason for government intervention in banking in developing and emerging economies that was not usually stated explicitly was to get banks to finance government deficits. There were two aspects here. One was the assured access to bank funds, and the other was the possibility of borrowing at interest rates that were lower than those prevailing in the market.

While the typical government in a developing economy viewed and presented its banking policy as one of ‘progressive intervention’, many outsiders viewed it as ‘financial repression’. This is a case of excessive or inappropriate regulation in the financial sector.

The interventionist policy of the government was a successful one in some places. But in many places it led to losses for banks (in some places with social benefits and in others without much of such benefits). Non-performing assets of banks increased and banks’ capital was wiped out in several cases.¹² There were banking crises in such emerging and developing economies. Observe that these banking crises were not related to liquidity. Such crises occurred in Zimbabwe in 1995, in Zambia in 1995, in Yemen in 1996, in Vietnam in 1997, in Uganda in 1994–2002, in Sri Lanka in 1989–93, in Peru in 1983–90, in India in 1993–96 and in other countries (Reinhart and Rogoff 2009). It is not clear if these are crises of banking, or crises of planning strategy, as the two more or less went together. Our focus here is on crises which are clearly cases of banking crises only. We will not deal with what we may call ‘mixed’ cases that involve crises of banking and crises of planning. This is beyond the scope of this book. Henceforth, we will deal with banking crises that are related to liquidity.

In this book we will deal primarily with commercial banks and not with investment banks. The reason is as follows. There is a long history of banking crises. Though the recent crisis related primarily to investment banks, most of the history of banking...