The banking system is the heart of a country’s economy. It pumps the money that is required for the economy to grow and for businesses to develop. This is especially true for developing countries as they typically do not have developed capital markets and so bank credit makes up most of the funds that small businesses need to expand. Without such funds, companies cannot develop and jobs cannot be created. And yet banking crises are endemic, for it is much easier to lend money than to get it back. And when banks run out of money, they cannot lend, and the broader economy may come to a standstill. This is why the repercussions of banking crises are so severe. The Mexican banking crisis in 1995 (see Case Study: Mexican Banking Crisis) and the one suffered by several East Asian nations in 1997 and 1998 tipped those countries into serious recessions that affected the broader community. In 2001 Argentina suffered its worst ever financial crisis, which had deep and lasting economic and political repercussions, while around the same time Bolivia and Turkey narrowly avoided the same fate. Though all these countries’ financial systems have substantially recovered, banking crises are by no means a thing of the past (according to a World Bank research paper there were more than a 100 systemic crises in the last two decades of the 20th century). Nor are they a concern only for developing countries. In 2007 serious trouble in America’s housing market had a knock-on effect in Europe, with Britain suffering a “run” on a bank (when panicking depositors form lines at the banks’ doors in an effort to withdraw their money as quickly as possible)—the first in that country in 150 years.
Once a banking crisis starts, it spreads. If problems in one bank are made public, small depositors get scared and that’s when a “run” begins. This causes the bank to fail, which generates bigger headlines, and scares even more people, who then withdraw their funds and cause even more banks to fail. As a result, government and bankers fear panics and do their best to keep information secret. This can make it very hard for reporters to cover banking. In 1997 the Politburo in Vietnam issued a law making it illegal to write about banking. Non-performing loans and other information were considered state secrets. The Communist Party felt this was essential to safeguard the stability of the banking system.
Banking crises essentially stem from the same problem—large amounts of non-performing loans. In a healthy banking system “problem loans”—loans that are non-performing or close to non-performing—account for a fraction of outstanding loans. Even as US banks were counting the costs of the housing market-related “credit crunch” in 2007, loan “delinquency” across the whole banking system was still below 3%. During the Asian banking crisis, the numbers were as high as 47% in Thailand and 75% in Indonesia. (With the recovery of these and other developing countries’ economies over the past decade, non-performing loan numbers are right down, as low as 5.8 per cent in 2006, according to a Goldman Sachs study of banks in a sample of emerging economies.)
There are several reasons why banks can end up with bad debt:
- State-directed lending to unprofitable government-run businesses, also known as "policy lending." During the era of state socialism, many countries did not have a private banking sector. In countries such as Russia, China and Vietnam, banks existed only to finance government activities and state-owned enterprises and their lending was rarely based on sound financial criteria. Many of these state companies were overstaffed and inefficient, and were not required to make a profit. Governments did not subsidize these businesses directly. Instead they used the banking system to channel funds to them. A direct subsidy would have been a clearer way of supporting the businesses and the jobs they created. But funding companies through the banking system meant that the banks were also put into danger. In many of these countries there were designated banks that funded different types of industry, farmers and foreign trade. Most countries are retreating from such lending practices, some more readily than others. In Brazil, for instance, the government has compelled banks to stop this sectoral lending and has phased out regional, specialized development banks altogether, but in India there is much greater resistance to this kind of change.
- Non-financially based lending is but one step away from a second problem: corrupt lending. In Vietnam, for instance, the small, semi-private banks lent money to their friends. There was no control over such lending, the friends' companies did not post collateral, and there were no strict requirements guaranteeing that the money would be paid back. But these problems can also exist in developed capitalist countries. In the Texas Savings & Loan scandal of the 1980s, for instance, bank directors were found guilty of making loans to "insiders" in excess of the regulatory limits.
- Excessive exposure to sectors experiencing "bubbles". Some banks have gotten into trouble by excessively lending to particular sectors. The demand that the lending finances causes an excessive rise in the value of the assets to a degree that often outstrips the asset's "reasonable" value. As asset prices "come down to earth", banks end up having, on their books, overvalued collateral. Real estate is the most common example of a bubble with internet companies a more recent case and tulips a classic one from a more distant time. In Thailand and Vietnam banks lent money to companies that built or bought office buildings. Soon there was too much office space and when the price of the buildings fell the companies were no longer able to repay their loans. A number of Thai banks were hurt by loan defaults, and Bangkok wound up with hundreds of empty office buildings, some of which still stand today as half-finished, high-rise concrete reminders of the excesses of the 1990s. The latest example of a real estate bubble is the so-called “sub-prime” lending crisis which began in the US in mid-2007, when excessive lending to home-buyers with poor credit histories had a knock-on effect through the financial markets and across the globe.
- Banks have a close relationship to fluctuations in currency. Currency crises can lead to banking crises, and vice versa. Sometimes the two emerge simultaneously, an event referred to as the "twin crisis phenomenon." If banks in developing countries have loans taken out in foreign currencies, such as dollars, euro or yen, and the local currency is devalued, then it becomes more expensive to repay those loans and banks' balance sheets deteriorate. This was a major problem in Korea and Indonesia during the Asian crisis, and also one of the reasons that Argentina postponed devaluing the peso during the crisis in 2001.
A rise in interest rates also affects banks, for the simple reason that high interest rates make loans more expensive to repay. During the Asian crisis, the IMF encouraged countries to hike up interest rates to support their currencies, which were in freefall. As soon as interest rates went up (reaching above 30% in Indonesia) the banks started to fail.
Also, look out for portfolio mismatches of long-term and short-term debt. If interest rates go up, the bank must begin paying a higher interest rate to its depositors. But its long-term loans cannot be rolled over to a new interest rate. Thus the value of its assets (loans) goes down while the value of its liabilities (deposits) goes up -- a recipe for insolvency. This was a major cause of the Texas Savings & Loan crisis mentioned above, when the Federal Reserve (the US central bank) raised interest rates dramatically to stave off inflation. Savings & Loan banks were faced with rapidly rising cost of deposits, while heavily invested in home mortgages, which were fixed at a lower interest rate. The high interest rates also caused a recession and loan defaults, eventually amounting to billions in losses for the S&Ls.
- Adverse selection. According to economic theory, high interest rates encourage bad borrowing. This sounds strange but it works like this: when interest rates are 5% it is not expensive to borrow money. When rates rise to 15% only the companies that are the most desperate will borrow at such a high rate. The strong companies will get money somewhere else. So the companies that borrow at 15% are, by definition, the least credit-worthy and the most likely to default on loans. The process becomes a vicious cycle. Banks worry that they won't get paid back so they raise rates to 20%. The only companies that borrow at 20% are even more desperate and the process continues.
- "Macroeconomic imbalances" are typically associated with loose monetary and fiscal policy. When governments/central banks decide to loosen the supply of money, for example by lowering interest rates or increasing government spending, it often means that banks wind up lending a lot of money as well, without taking sufficient precautions as to the credit-worthiness of their clients. In good times, this is not a problem but when the economy slows, the number of non-performing loans typically rises. Many economists believe that the “sub-prime” crisis in America was the eventual outcome of a policy under which the Fed lowered interest rates to counter the threat of a recession after the bursting of the dotcom bubble in the 2000-2001 and kept them low for too long.
- Weak banking supervision and regulations by central banks. Typically developing countries lack adequate regulations and those they have are not consistently enforced. There may be poor credit controls in place, lack of deposit insurance and few capital adequacy requirements. It may be hard for banks to collect collateral and courts may not support the banks when they try to collect on debts. The role of regulation can be debated but there is no question that banking crises can be exacerbated by lack of good regulation.
The last century has been marked by frequent banking crises. The Great Depression was in part a result of bank failures in the U.S. and elsewhere. The 80s and 90s saw banks fail in Latin America (see Case Studies) and trouble in post-communist transition economies, as well as the East Asian financial crisis, have brought financial stability to the forefront of global concern. As a result of these events, policy-makers have developed many safeguards to stop crises from occurring.
- Capital adequacy requirements. The Basel Committee and the Bank for International Settlements (BIS), which creates financial regulation accords among advanced industrialized nations, has established standards for capital adequacy requirements. Currently, for every nation that follows the Committee’s guidelines, 8% of (risk-weighted) assets must be kept aside to cover the loans that are not repaid. (The Basel rules have been under review for the past several years, and new ones were due to come into effect at the beginning of 2008. These provide for capital adequacy requirements that are targeted according to specific lending risks.)
Deposit Insurance. In the wake of bank failures during the Great Depression of the 1930s, the U.S. government created the Federal Deposit Insurance Corporation (FDIC), an independent federal agency which serves to protect depositors in the event of a crisis, as well as monitor the banks. The FDIC backs deposits as large as $100,000, and derives income from payments by insured banks and interest on government securities.
Many nations around the world have developed deposit insurance schemes, hoping to protect against bank runs and strengthen the overall financial systems. Some, as in Germany and Switzerland, function privately and with a minimum of government involvement. Schemes range from partial cover to full cover — in Korea, Thailand and Malaysia, for instance, insurance was extended to blanket coverage after the crises of the late 1990s (Japan already had 100 protection). There is energetic debate surrounding the most appropriate approach to deposit insurance, especially in nations with weak financial infrastructures. Critics claim that deposit insurance pushes down interest rates and thus reduces market discipline. New research from the World Bank suggests that deposit insurance actually raises the risk of bank crises because it contributes to what is known as moral hazard—knowing that the deposits are covered, banks make riskier loans and depositors are less careful about which banks they put their money into. Others say that deposit insurance is inherently vulnerable to asymmetric information problems. Such controversy has generated new approaches to deposit insurance design, which focus on appropriate insurance pricing, risk-weighting and other ways to compensate for incentive problems under a deposit insurance program.
- Subordinated debt. Some argue that banks should be required to sell subordinated debt, a market-based approach that can help keep banks in line. Subordinated debt is high-interest debt that by law cannot be paid back until all other liabilities are satisfied. Investors holding the debt have the most to lose from a default, and will thus monitor the banks closely.
- Categorizing loans. Many banks keep strict categories of overdue loans, indicating how long loan payments have been delinquent (i.e. 30 days overdue, 60 days, 120 days, etc.). When interest payments are overdue for a significant period of time (it varies country to country) the loan is classified as non-performing. Banks also are often required to classify even performing loans as "doubtful". Regulators can use these classifications to identify the stability of individual banks and the banking system as a whole. Regulators are supposed to keep a close eye on the process of classification: many banks try to hide problem loans by "ever greening" -- a process of recapitalizing interest due while showing the loans as continuously performing.
- Arms-length lending laws. To avoid conflict-of-interest problems, U.S. federal law prohibits banks from lending excessively large amounts of money to officers, directors, principal shareholders and their related interests. Banks are also subject to limits on how much to lend to particular entities and sectors ("exposure limits").
- Bank-firm relationships. Countries have very different traditions regarding how their financial system operates. Under a market-based system like that in the U.S. and the UK, big businesses access finance capital largely through the markets for stocks and bonds. In Germany and Japan, on the other hand, companies tend to rely on a single large, "main-or universal-bank," which lends it money and may even become a large equity shareholder. In this system the bank plays an active monitoring role and can minimize moral hazard problems, which is why some argue that the main-bank system is more stable. But others contend t that the Anglo-Saxon system, with its reliance on the capital markets, leads to a more efficient allocation of capital and can detect approaching crises with "price signaling."
Tips for Writing About Shaky Banks
- What level of NPLs are in the banking system and in the banks you cover? What is considered a healthy level? If you are in a country where this information is kept secret, try to figure out how NPLs are defined and how lax or tight the credit controls are. Find out whether they have any overdue loans, and how generous the definition of overdue is. In the Vietnam crisis, for instance, interest on a loan had to be a year overdue before the principle was considered to be at risk. Thus, official pronouncements about their being few "bad loans" in the Vietnamese banking sector were hardly credible. Though by the government's definition everything was okay, their loan classification did not meet international norms. By international standards it was clear there was a high level of NPLs in the system.
- The executives at the top of the banks aren't likely to speak frankly about their banks, so go way down the chain of command. Talk to managers and credit officers at the local branches. Ask them how they feel about their loan portfolio, whether it looks solid, whether the government-run companies are good at paying back their loans.
- Report from the other side of the problem. If the banks won’t talk, go see the companies that borrow from the banks to get a sense of how strong they are and whether they are in a position to repay their bank loans. If your country has a bank that specializes in lending to agricultural businesses, go visit them and find out how profitable they are.
- Find out what sort of collateral has been pledged and look at how easy it is to collect. If the collateral is real estate and you are in a country with a real estate bubble, then chances are the banks will have a problem. If you work in a country where the court systems are slow and inefficient (or corrupt), it may be unlikely that a bank will be able to collect and resell the collateral.
- Get a local accountant or banker to go over the profit and loss statements of some banks and explain how things work. Make sure you look for major write-downs and try to get a sense of off-balance sheet exposures as well.
- In the event of a devaluation, pay attention to what percentage of loans and deposits are held in foreign currency. Also, keep an eye on the currency mismatch from the borrower's perspective: e.g., if a large share of loans is in foreign currency but borrower's revenues tend to be in local currency then a devaluation could well cause corporate failures and, in turn, banking problems.
- Keep an eye on interest rates. If interest rates go up, loans are more difficult to repay and there may be defaults. Also, look at which banks have long-term loans with fixed rates, like mortgages. Because bank deposits are short term, this may lead to serious balance sheet problems.
- Recapitalizing banks. There are many ways to go about patching up the damage of a banking crisis and replenishing dried-up banks with fresh capital. Sometimes, after taking control of failed banks, governments opt for straight capital injections. Or they will issue government bonds to finance the recapitalization. These can be very costly endeavors, and if a government prints money in order to pay for the recapitalization, inflation may follow.
- Stripping off bad loans. In a number of Asian countries after the 1997 crisis, NPLs were first transferred to an asset management company and then sold off, leaving the banks healthier. (This is nearly always done in conjunction with recapitalizing the banks. Otherwise, you are stripping the bank of its assets and leaving it only with liabilities).
- Sale to foreign banks. Countries that have sold off their ailing banks to foreign competitors usually end up with stronger banking systems. But there can be downsides, too. For instance, foreign banks don’t tend to do much local lending. Citibank in Ecuador, for instance, is more likely to lend to the local branch of IBM then to a small local company. Also, if the local bank gets into trouble later there is no guarantee it will be bailed out by its big foreign parent. ABN Amro could just decide to pull out and take a write-off on their accounts.
- Shutting banks down. In countries where there is a lot of corruption this can seem like the best solution. Shutting down a few seriously troubled banks sends a signal that the government is serious about reform and lets depositors know they have nothing to be afraid of. If the worst banks aren’t closed, it is likely they will go back to their old habits and get into trouble again. However, shutting down banks can cause panic and thus send the opposite signal. Depositors start to look around and worry that other banks are in trouble and rush to pull out their money before they get shut down as well. In Indonesia, the IMF pressured the government to shut down 14 banks in November, 1998, and by the end of the month nearly two-thirds of all Indonesian banks suffered a run on deposits.
When evaluating the different options take a look at the situation in your country.
- Are local businesses highly dependent on bank finance? Would a credit crunch be a disaster for them? Are there alternate forms of finance for local firms?
- What is the public mood like? Would bank closures create a panic?
- Does the government have persuasive advisors? Do the economists from the IMF and World Bank who are dealing with your country really seem familiar with the banking sector? Are they making a big effort to familiarize themselves with the domestic situation, or are they holed up in the central bank crunching numbers? Are they being lied to by local officials?
- Are steps really being taken so the crisis doesn't happen again, or is it likely the scenario will be repeated in a few years?