Study of Banking Crises and Failures - Dissertation Example

April 2006 Study of Banking Crises and Failures Introduction Banks are s dealing in money. They borrow and lend money in trust. Depositors place with banks their moneys with an inherent trust that these moneys will be returned to them when demanded. Banks lend moneys obtained from depositors to worthy borrowers at an interest premium so that they can earn a spread which soon enough translates into profits. There can be multiple varieties of lending depending on say, the purpose, security, borrower etc. Any money that is not lent is deployed in various categories of investment and chases profits for the bank. There can again be multiple varieties of investments ranging all the way from money market instruments to capital market instruments. Banks also invest in real estate, commodities etc.By doing the above banks here do a vital task for the economy. They collect moneys from people who have no use for it and lent it to people who need it. Thus banks have a key role in playing an intermediary role in collecting savings and deploying them in the economy or overseas. Large and growing sizes of banking institutions which have assumed international proportions have ensured that their intermediation role has become critical, cross border and intertwined with operations of similar and other generic players in financial markets. A collapse of an international bank can have telling implications globally. Domestically supervisory jurisdictions have expressed long coded concerns about bank failures in the form of "protection of depositors interests" and internationally there has been a global consensus on capital adequacy of banks.Superviosrs ensure protections of depositors interests by constantly evaluating the capacity of a bank to repay its deposits which again is derived from a dispassionate assessment of the asset quality. If realizable value of bank assets exceeds, after providing for all categories of erosions, its known outside liabilities (deposits of all kinds) then the bank is considered to have a positive net worth and no deposits are considered eroded. On the contrary if assets have eroded more than outside liabilities then it is the shortfall that represents eroded deposits and the bank is considered to be unable to repay deposits to that extent. Asset erosion normally arises from non performance of large borrowal accounts/facilities and/or investments. This is called financial erosion. Any banking institution which is unable to repay its depositors having eroded a majority of its assets is placed as a failed bank. It can be merged/amalgamated with another healthy institution, declared bankrupt/insolvent and taken into liquidation or be supported in capital by state or other agencies. However a failed bank spells misery for multitudes of stakeholders-in fact all of its vertical and horizontal functional linkages can be shaken and can cause systemic shocks through contagion effect causing other similarly placed banking institutions to either perform worse or even collapse. Since globalization and liberalization of cross border capital flows has taken place these shocks can reverberate wherever the failed bank has transactional links. Domestic supervisors have in general two more policy responses to ensure that banks depositors are protected. One is an ongoing operational prescription of reserve requirements and the other is some kind of deposits insurance. International concern for capital adequacy as reflected in Basle I (1988) and Basle II (2004) addresses these very concerns. Convergence has been arrived that internationally active banks and significant banks will keep capital as a fixed percentage of their risk weighted assets. Basle I prescribed this capital as a ratio of risk weighted assets on a static accounting date with risk weights being standard and predefined. Basle II makes it an ongoing process involving a comprehensive risk analysis with risk weights being functions of risk profiles of counterparties. However given the rapid globalization, advances in communications, dynamic product innovations the financial markets as used by todays banks have turned high risk assumption markets. The bank failures have a greater probability to occur in such a scenario. Despite Basle I prescription the Asian crisis precipitated causing economy wide concerns in affected South East Asian economies. A study of bank failures, causes of failures, early warning signals that were not recognized in time and preventive measures that could have been taken or were taken becomes important; hence the present research proposal. Present research would study cases of bank failures across continents from available information and arrive at macro-micro empirical exploration of these episodes. Literature Review The number of studies and research papers probing causes and types of bank failures is substantial. These research efforts have presented wide ranging evidence of bank failures from across various continents and cover the period as early as the Great Depression period of 1930s to as recent as couple of years back just prior to release of final Basle II framework in June 2004.Great Depression was a period of a downside economic shock and affected the larger economies in a major manner. While general economic outlook was highly pessimistic in these years it often precipitated in economy wide panics running through money and capital markets. Several research papers have studied the effect of the panics on the banking system and focused on enumerating the timing and geography of bank failures during panics (Wicker,1996).While some other research efforts have attempted to explain if panics were one time abnormal periods that resulted in the failure of even solvent banks by comparing banks that failed in panic periods to banks that failed outside such periods and finally tracing the survival of some such banks (White,1984) and (Calomiris and Mason,1997).The former paper arrives at the conclusion that banks failing during panic periods were weaker than banks that survived and not quite similar in financial characteristics to banks that failed during non-panic periods. Literature has identified four major panics were identified in the Great Depression period (1930-1933). Friedman and Schwartz attribute the 1930 panic to a contagion of fear" caused by the failure of a major US bank (Friedman and Schwartz, 1963). This was followed by two other panics in 1931. One, which Wicker attributes to the collapse of a real estate bubble in the Midwest in early1931. The second panic in late 1931 was caused, according to Friedman and Schwartz, primarily due to a perceived attack on the currency which fuelled on speculations that U.S. would quit gold standard following the example of the Great Britain. The last panic ran through US in early 1933 and culminated in the declaration of the National Bank Holiday. Friedman and Schwartz trace the reason for 1933 panic to the fact of people increasingly hoarding gold for fear of devaluation of the dollar. Financial panics are extreme general sentiments which makes market participants act unidirectionally in herd mentality aggravating either supply or demand for short or long term money and/or financial instruments/products. Their initiation is caused by an event of impact and spread is directed by dispersal of information or misinformation about such events among market participants. Great Depression imbalances and panics were caused in gold standard era which was marked by encapsulated economies running on trade and attempting to adjust imbalances. Such panics could be caused and have been caused in current financial scenarios of globalization though economic and banking contexts have drastically got altered and turned far more dynamic in an era of floating exchange rates and almost free movement of cross border capital. New technological developments, improvements in communication, growth in transnational infrastructure and liberalizing of trade and capital flows have enabled entrepreneurs the globe over to deploy and run their capitals chasing markets the globe over. The globalization aligned attitudes of IMF and World Bank are exemplified with clarity by Jean-Claude Trichet, President of the European Central Bank, when he says that," The key aim of today’s policy makers has not changed compared to those at the Bretton Woods times - it has been, and still is, global prosperity and stability - but the environment in which we are acting has changed profoundly. The founders of the IMF and the World Bank wanted to create institutions that prevent countries from falling back into autarky and protectionism and that help them to raise growth and increase stability in a world of fixed exchange rates with still a large degree of capital controls. Today we are striving for stability of the international financial system in a world of free capital flows with a growing importance of private flows and increasing trade and financial integration"(Trichet, 2004).The phrase " prevent countries from falling back into autarky and protectionism " clearly implies that IMF and World Bank intend on hastening globalization albeit with stability-which essentially means without panics with or without contagion effects. In order to gauge a brief view of globalization of banking activity we quote McGuire as follows," Cross-border activity surged in the first quarter of 2004. US dollar-denominated interbank claims, much of them involving repo transactions, drove the increase. Euro-denominated claims were up too. Although overshadowed by interbank activity, new credit to non-bank borrowers was also robust. Notably, this credit seemed to reflect a pickup in lending to offshore and other major financial centers, as well as purchases of government and other international debt securities, rather than renewed corporate loan demand"(McGuire,2004). "Under Basel I, deterioration in the credit quality of a bank’s portfolio during a cyclical downturn is reflected in its capital adequacy ratio only at the last moment, i.e. at the time of the accounting recognition of the impairment. At that stage, banks often have no effective measures available to improve their capital ratios other than to stop extending new credit, which can in turn aggravate the downturn. In contrast, under Basel II, the deterioration of a portfolio should begin to be reflected in the bank’s capital adequacy ratio at a much earlier stage, and no further deterioration should occur in the capital adequacy ratio at the moment it is recognized as an accounting loss. In addition, even when minimum capital requirements become binding constraints, the incentives to reduce exposures to good borrowers are much smaller than under Basel I, as this would not improve the capital ratio by much. The most effective way to reduce the total capital requirements under Basel II is timely restructuring, selling or foreclosing of exposures to borrowers already in trouble, behavior which can pave the way for the recovery of the economy"(Himino, 2004).Basle I & II are calling for capital and banking behavior vis a vis troubled borrowers so that cyclical downturns are negotiated smoothly and recovery of economy is ensured. In other words no event of impact happens in respect of banking assets for which bank is not capital prepared which may aggravate a cyclical downturn and have economy wide repercussions viz.panics.In summary terms Basel II ," embraces a comprehensive approach to risk management and bank supervision. It should enhance banks’ safety and soundness, strengthen the stability of the financial system as a whole, and improve the financial sector’s ability to serve as a source of sustainable growth for the broader economy"(Jeanneau, 2004). Basle II can be considered an evolutionary piece of prescription over Basle I however it has been partly propelled by the banking crisis in Asian economies and elsewhere in the decades of 1990s and 2000s.Literature is rife with several papers covering the genesis and macro micro economic analysis of these banking crises documenting the specific bank failures. The Groupe de Contact studied in 1999 the causes of banking stress in the European banks in the period of late-80s. The study was based on117 individual banks critical events in 17 countries and country reports from France, the UK and some of the Scandinavian countries. The major banking stresses were sourced in credit risk assuming unmanageable proportions whereas operational risk also caused a few of the stresses. Though market risk, on stand alone basis, was rarely a critical factor in causing crisis. problem. Banks internal management and control problems contributed substantially to these stresses. However, 90% of the banks had capital ratios nearing the regulatory requirement when problems had precipitated. The Groupe de Contact report ended with the conclusion that booked loss provisioning fell short of the real assets impairment and reported regulatory capital ratios were inflated. Generally, these quantitative measures did not reflect critical and internal problems such as poor management irrespective of the fact that the booked provisioning was accurate or otherwise (WP13, 2004). Literature on banking crises and failures essentially adopt two approaches -a micro approach and a macro approach. Micro approaches deploy individual banks balance sheet data and supplant it with equity quote data to predict or post mortem a bank failure. These studies essentially use some sort of bank rating conclusion akin to CAMEL rating used by the supervisory authorities. Some of these studies have also built in macro economic variables without any formal linkage to the main construct. Rojas-Suarez (1998) adopted this approach to examine banking crises in Mexico, Venezuela and Colombia using bank specific factors. Their main conclusion was that in developing countries basic factors like deposits and lending rates of interest and growth in interbank deposits and loans can better predict growing crisis than traditional CAMEL pattern factors/ratios. Macro approaches, essentially expost studies, take up examples from a few countries who suffered a banking crisis in a given period and examine them using macro variables such as cyclical downturns, decline in asset prices, adverse terms of trade, rising real interest rates,inflation,dynamic credit expansion, reduction in foreign exchange reserves and role of volatile capital inflows. Research papers by Kaminsky and Reinhart(1996),Demirguc-Kunt and Detragiache(1998) and Hardy and Pazarbasioglu (1998) fall in the category of macro approaches. "The key role played by poor management in crises has also been highlighted by various academic studies. In a sample of 24 systemic banking crises in emerging-market and developed countries, Dziobek and Pazarbasioglu (1997) found that deficient bank management and controls (in conjunction with other factors) were responsible in all cases. In a study of 29 bank insolvencies, Caprio and Klingebiel (1996) found that a combination of macroeconomic and microeconomic factors was usually responsible. In particular, on the macroeconomic side, recession and terms of trade were found important. Also, on the microeconomic side, poor supervision and regulation and deficient bank management were often significant" (WP13, 2004). The BCBS working paper can be quoted yet again to cite some other important research efforts in studying banking crises as follows," In a major study of the U.S. banking crisis in the 1980’s and early 1990’s, the FDIC (1997) analyzed the causes of the crisis, the regulatory responses to the crisis and the lessons that could be learned. Five of the lessons identified in that study which may be relevant are: First, bank regulation can limit the scope and cost of bank failures but is unlikely to prevent failures that have systemic causes. Second, for most of the period studied, there were no risk-based capital requirements and therefore there was little ability to curb excessive risk taking in well capitalized, healthy banks. Third, problem banks must be identified at an early stage if deterioration in the bank’s condition is to be prevented. In the U.S. system, this required frequent, periodic bank examinations. Fourth, the presence of deposit insurance helped maintain a high degree of financial stability throughout the crisis, but not without costs. The direct costs of the banking crisis were born by the industry"(WP13, 2004). .Research Methodology and data Present research would study cases of bank failures across continents from available information and data and arrive at macro-micro empirical exploration of these episodes. The major macro-micro implication concerns the role of credit in bank failures/crises. The tested hypothesis is that credit impairment contributes to bank failures more than any other identified single cause. The entire work would be an expost study and consider case studies from (i)UK, (ii)USA, (iii)Germany, (iv) Japan and (v)Norway. In case of each bank/crisis event selected from above countries two categories of scenarios would be drawn: (a) Macro Economic Background, and (b) Micro level Bank analysis. The former would be essentially a statement of major macro policy prescriptions governing the working of the bank which suffered the crisis event. It would also highlight distinguishing features of the economy that could work as ideal background for precipitating a crisis event. This would have an ideal temporal context of about three years- a year prior to the crisis event (sometimes more as may be required), the year of crisis and the year subsequent to the crisis. Information on economic conditions and regulator policies would be obtained from government, regulator, institutional and rating agencies publications. Books, journals, periodicals available online or otherwise would also be used to collect data and information. In short macro analysis will be used to draw up the enabling environment in which the crisis was building up. Macro analysis would rarely interact directly with micro analysis though several macro causality implications might be drawn about the crises/failure. Micro level analysis would also generally have a temporal context of three years- a year prior to the crisis event (sometimes more as may be required), the year of crisis and the year subsequent to the crisis. The latter would enable view on the final fate of the crisis ridden institution and state/regulator response to the crisis situation. Micro level analysis would be carried out through balance sheet and annual reports data for the three years. The analysis would calculate some important ratios: Credit-Deposit Ratio Investment to Deposits Ratio Various loan types to Total Loans Ratios Various maturity Deposits to Total Deposits Ratio Loans with outstanding fixed maturity to Deposits with same outstanding maturity Ratio Short term loans to Short term Deposits Liquid Assets to Short term Deposits Ratio Overseas Lending to Domestic Lending Ratio Currency wise loans/investments to total loans/investments Ratios Overseas Investments to Domestic investments Ratio Overseas lending/Investments to total lending/investments Ratio and same for domestic lending/investments Impaired assets to total assets Ratio Impaired loans to total Loans Ratio Rated Loans and unrated loans to Total loans Ratios Categories of impaired loans to total impaired loans Ratios Accounting provisions to total provisions Ratio Loan specific provisions to total provisions Ratio Overseas impaired loans to total loans Ratio Provisions for overseas impaired loans to total loan provisions Ratio Provisions as ratio of tier I capital funds Ratio Real sector Loans to total loans Ratio Impaired Real sector loans to total impaired loans In addition to above stated asset-liability mismatch ratios some focused ratios on short end liquidity would be calculated to arrive at conclusions pertaining to state of liquidity of the bank prior to crisis, in crisis and after crisis. There are some very standard mathematical and statistical methodologies making the use of ratio analysis more relevant. The two such methodologies are ratio disaggregation and multi-discriminant analysis which are useful in identifying operating and financial difficulties in basic ratio analysis. The multi-discriminant analysis and methodologies involving ratio disaggregation or decomposition such as DuPont analysis have proven very useful tools for financial statement analysis and projections. Ratio disaggregation decomposes a ratio into various component ratios facilitating analysis of the factors affecting the original ratio in question. Statistical techniques based on combinations of ratios have proven very useful in predicting and identifying specific problems. For example, combinations of leverage, liquidity and profitability ratios have proven to be very reliable in forecasting corporate default or bankruptcy. Ratios taken from these categories can be organized and combined based on statistical analysis in a manner that can reveal the firm’s current risk situation. Variations of this type of ratio-based model are used for almost every type of corporate lending and debt analysis. These models have even been adapted to consumer lending including mortgage evaluations, credit card debt and automobile financing. Ratio analysis often involves the comparison of financial ratios one at a time, then a rather subjective evaluation of these comparisons in order to make a judgment about a firms characteristics or problems. Statistical frameworks such as the multi-discriminate analysis model enable the analyst to aggregate various ratios in a more objective manner for analysis. One of the earliest of these models was Edward Altmans model, which was developed to forecast corporate default or bankruptcy. Altmans model is based on a series of five ratios which, when combined, seemed to distinguish in advance those firms which defaulted in the following year(s) from those firms that did not. Utilizing one such model we would test if failure of the organization could have been predicted by the adopted model. We would use ratio disaggregation techniques on above calculated ratios to further focus on credit factors as contributing to crisis/failure and test the hypothesis if it is a major contributory factor. Some of the illustrative data sources can be: Source: Above snap shots of data sources obtained from IMF working Paper WP/01/63 titled: Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence from East Asia by Robert Dekle and Kenneth Kletzer,May 2001. Essentially IMF and World Bank publications alongside rating agencies publications would provide critical data for macro analysis. Micro analysis would depend on balance sheet/annual reports of chosen banks and articles and journal covering such banks events. Working plan would commence from laying core theoretical foundation of the micro analysis in terms of deciding on a firm bankruptcy model to use. Adjusting it for ratios to be finally used. Collection of relevant data both for micro and macro analysis. Compiling macro analysis portions of the paper for each country case. Writing up of micro cases for each country. Doing ratio analysis followed by disaggregation of ratios to focus on credit. Linking micro findings with macro background and drawing conclusions. Announcing the results of hypothesis testing. Additional References The present research would extensively use journal articles from literature in order to investigate and develop the research topic. An illustrative list of such literature is appended below: Anari, A., J. Kolari, and J. Mason (2000)."The Speed of Bank Liquidation and the Propagation of the US Great Depression," unpublished manuscript, Texas A&M University. Bernanke, B. (1983)."Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review. Board of Governors, Federal Reserve System (1938).Sample Study of the Records of Suspended Banks. Federal Reserve Board of Governors. Board of Governors, Federal Reserve System (1943): Banking and Monetary Statitics.Federal Reserve System, Washington DC. Menzie D. Chinn & Kenneth M. Kletzer, 2000. "International Capital Inflows, Domestic Financial Intermediation and Financial Crises under Imperfect Information," NBER Working Papers 7902, National Bureau of Economic Research, Inc. Laeven, Luc, 1999. "Risk and efficiency in East Asian banks," Policy Research Working Paper Series 2255, The World Bank. Roberto Chang & Andres Velasco, 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," NBER Working Papers 7272, National Bureau of Economic Research, Inc. BIS (2002) ‘Supervisory Guidance on Dealing with Weak Banks’, Basel Committee paper no 88, March. Caprio G and D Klingebiel (1996), ‘Bank Insolvencies: Cross Country Experience’, World Bank Policy and Research WP 1574. Curry, T and Shibut L (2000), ‘Cost of the S&L Crisis’, FDIC Banking Review, V.2 No.2. Dziobek C and C Pazarbasioglu (1997), ‘Lessons from Systemic Bank Restructuring: a Survey of 24 Countries’, IMF Working Paper 97/161. FDIC (1997), ‘History of the Eighties - Lessons for the Future’. Hoggarth G, Reidhill J and P Sinclair (2003), Resolution of Banking Crises: A Review, Financial Stability Review, Bank of England, December. OECD (2002) ‘Experience with the resolution of weak financial institutions in the OECD area’, Chapter IV, of Financial Market Trends, No 82, June. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110. Rafael La Porta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, 1998. "Law and Finance," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1113-1155. James R. Barth & R. Dan Brumbaugh & Daniel Sauerhaft & George H.K. Wang, 1985. "Thrift institution failures: causes and policy issues," Proceedings, Federal Reserve Bank of Chicago, pages 184-216. Kiefer, Nicholas M, 1988. "Economic Duration Data and Hazard Functions," Journal of Economic Literature, American Economic Association, vol. 26(2), pages 646-79. Kaminsky, Graciela L & Reinhart, Carmen M, 1998. "Financial Crises in Asia and Latin America: Then and Now," American Economic Review, American Economic Association, vol. 88(2), pages 444-48. Gavin, M. & Hausmann, R., 1996. "The Roots of Banking Crises: The Macroeconomic Context," Working Papers 318, Inter-American Development Bank, Research Department. Breuer, Peter, 2000. "Measuring Off-Balance Sheet Leverage," IMF Working Papers 00/202, International Monetary Fund. Levine, Ross & Caprio Jr., Gerard & Barth, James R., 2001. "Bank regulation and supervision : what works best?," Policy Research Working Paper Series 2725, The World Bank. Johnston, R. Barry & Chai, Jingqing & Schumacher, Liliana & Monetary and Exchange Affairs Dep, 2000. "Assessing Financial System Vulnerabilities," IMF Working Papers 00/76, International Monetary Fund. Charles Enoch & Paul Louis Ceriel Hilbers & Russell C. Krueger & Marina Moretti & Armida S. San Jose, 2002. "Financial Soundness Indicators: Analytical Aspects and Country Practices," IMF Occasional Papers 212, International Monetary Fund. ROCHET, Jean-Charles, 2004. "Macroeconomic Shocks and Banking Supervision," IDEI Working Papers 276, Institut dÉconomie Industrielle (IDEI), Toulouse. Dekle, Robert & Kletzer, Kenneth M., 2001. "Domestic Bank Regulation and Financial Crises - Theory and Empirical Evidence from East Asia," IMF Working Papers 01/63, International Monetary Fund. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc. Cole, Rebel A. & Gunther, Jeffery W., 1995. "Separating the likelihood and timing of bank failure," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 1073-1089. Gonzalez-Hermosillo, Brenda & Western Hemisphere Department, 1999. "Determinants of Ex-Ante Banking System Distress: A Macro-Micro Empirical Exploration of Some Recent Episodes," IMF Working Papers 99/33, International Monetary Fund. References White, E. (1984)."A Reinterpretation of the Banking Crisis of 1930," Journal of Economic History. Wicker, E. (1996)."The Banking Panics of the Great Depression". Cambridge University Press, New York, New York. Calomiris, C., and J. Mason (1997)."Contagion and Bank Failures During the Great Depression: The June 1932 Chicago Banking Panic," American Economic Review. Friedman, M., and A. Schwartz (1963)."A Monetary History of the United States, 1867-1960". Princeton University Press, Princeton. Trichet, Jean-Claude" The international financial architecture - where do we stand?" Speech by Mr. Jean-Claude Trichet, President of the European Central Bank, at the Conference “Dollars, Debt and Deficits - 60 Years after Bretton Woods”, Madrid, 14 June 2004. McGuire, Patrick (2004)." The international banking market". BIS Quarterly Review, September 2004. Ryozo,Himino (2004)." Basel II – towards a new common language". BIS Quarterly Review, September 2004. Jeanneau, Serge (2004)." Recent initiatives by Basel-based committees and the Financial Stability Forum". BIS Quarterly Review, September 2004. Working Paper No.13. (2004)."Bank Failures in Mature Economies" Basel Committee on Banking Supervision. Rojas-Suarez,Liliana.(1998)."Early Warning Indicators of Banking Crises:What Works for Developing Countries?" Unpublished manuscript. Kamisky,Graciela and Carmen Reinhart.(1996)."The Twin Crises: The causes of banking and Balance of Payment Problems". International Financial Discussion paper No.544(Washington: Board of Governors of the Federal Reserve System, March). Demirguc-Kunt,A and Enrica Detragiache.(1998)."Determinants of Banking Crises in Developing and Developed Countries". Staff Papers. International Monetary Fund,Vol 45(March).pp-81-109. Demirguc-Kunt,A and Enrica Detragiache.(1998)."Monitoring Banking Sector Fragility: A Multivariate Logit Approach with an Application to the 1996-97 banking Crises".IMF Working Paper. (Washington: International Monetary Fund). Hardy,C.Daniel and Ceyla Pazarbasioglu.(1998)."Leading Indicators of Banking Crises: Was Asia Different?" IMF Working Paper. (Washington: International Monetary Fund). Dziobek C and C Pazarbasioglu. (1997). "Lessons from Systemic Bank Restructuring: a Survey of 24 Countries". IMF Working Paper 97/161. Caprio G and D Klingebiel, (1996). "Bank Insolvencies: Cross Country Experience". World Bank Policy and Research WP 1574. Read More