Inflation seemed to be driven by an unusual mix of supply shocks associated with the pandemic and later Russia’s invasion of Ukraine, and it was expected to decline rapidly once these pressures eased. Central banks in major economies are susceptible to bank crises if the situation is not normalized. The Federal Reserve, Bank of Canada, and Bank of England have raised interest rates in order to manage the heat of the bank crisis.
What is the bank crisis?
Banks are susceptible to a range of risks. These include credit risk (loans and other assets turn bad and cease to perform), liquidity risk (withdrawals exceed the available funds), and interest rate risk (rising interest rates reduce the value of bonds held by the bank, and force the bank to pay relatively more on its deposits than it receives on its loans).
A decline in the value of banks’ assets is frequently the cause of financial issues. For instance, a decline in real estate values or a rise in non-financial sector bankruptcies might both result in a decline in asset values. Or, if a government ceases meeting its obligations, this may cause the value of the bonds that banks hold in their portfolios to drop significantly. A bank may have obligations that are greater than its assets as a result of a significant decline in asset values, which would indicate that the bank has negative capital or is “insolvent.” Or, the bank may still have capital, just not to the minimal level required by law (this is also referred to as “technical insolvency”).
If a bank has too many liabilities that are due and is short on cash (or other assets that can be quickly converted to cash), this can also cause or exacerbate financial troubles. This may occur, for instance, if numerous depositors request withdrawals of deposits at the same time (depositors run on the bank). It might also occur if the bank’s borrowers need their money but there isn’t enough cash on hand. The bank can lose liquidity. Liquidity and insolvency are two different concepts that must be understood. A bank might be solvent but liquid, for instance (that is, it can have enough capital but not enough liquidity on its hands). However, insolvency and liquidity frequently go hand in hand. Depositors and other bank borrowers frequently start to feel nervous and demand their money when there is a significant decrease in asset values, which exacerbates the bank’s problems.
Systemic banking crisis
A (systemic) banking crisis happens when numerous banks in a nation experience severe solvency or liquidity issues all at once, either as a result of being hit by the same external shock or as a result of one bank or a group of banks’ failure spreading to other banks in the system. A systemic banking crisis, in more precise terms, occurs when there are several defaults in a nation’s corporate and financial sectors and when financial institutions and corporations have significant trouble meeting their contractual obligations on time. The net capital of the entire banking sector is depleted as a result of the high increase in non-performing loans. Depressed asset prices (including equity and real estate prices) following run-ups prior to the crisis, substantial increases in real interest rates, and a slowdown or reversal in capital flows may all be present in this scenario. The crisis is occasionally brought on by bank depositor runs, but more often than not, it is recognized that systemically important financial institutions are in trouble.
Bank systemic crises can have serious consequences. They frequently cause severe current account reversals and deep recessions in the impacted economies. Some crises proved to be contagious, quickly spreading to other nations with no obvious weak points. Unsustainable macroeconomic policies, including large current account deficits and unsustainable public debt, excessive credit booms, significant capital inflows, and balance sheet fragility, along with policy paralysis brought on by a number of political and economic constraints, have been among the many causes of banking crises. Currency and maturity mismatches were a key aspect of many financial crises, while off-balance sheet activities of the banking industry predominated in others.
Caprio and Klingebiel created the first global database on banking crises (1996). The most recent database version is accessible as Laeven and Valencia, which has been updated to reflect the most recent global financial crisis (2012). It lists 147 systemic banking crises between 1970 and 2011 (of which 13 are borderline occurrences). Additionally, it provides information on 66 sovereign debt crises (defined as a government defaulting on its debt to private creditors) and 218 currency crises (defined as a nominal depreciation of the currency relative to the US dollar of at least 30% and at least 10% higher than the rate of depreciation in the year prior). The database contains thorough details regarding the various governments’ crisis management strategies. According to analyses based on the dataset, there are several characteristics (such as those reflecting high leverage and rapid credit expansion) that imply a greater chance of a crisis. However, consistently predicting banking crises is very difficult.
The database of banking crises created by Laeven and Valencia (2012) is in the Global Financial Development Report to examine what works (and what doesn’t) in banking supervision and regulation. The report and supporting papers compare nations that experienced banking crises with those that were able to avoid them using data from the Banking Regulation and Supervision Survey conducted by the World Bank to accompany the Global Financial Development Report.
According to the report and paper, countries affected by the crisis had less strict and more complicated definitions of the minimum capital requirements, lower actual capitalization rates, less stringent regulatory policies regarding bad loans and loan losses, and fewer restrictions on non-bank activities. Although there were lower incentives for the private sector to monitor bank risks, they had stricter disclosure obligations. Overall, the global financial crisis has only, at most, caused incremental reforms in regulation and oversight. Some adjustments, like raising capital requirements and tightening resolution procedures, have moved regulation in crisis countries closer to regulation in non-crisis countries in the right direction, but some of the crisis’s policy interventions have also reduced the incentives for the private sector to keep an eye on banks’ risks. The analysis reveals room for improving legislation, oversight, and the incentives for the private sector to keep an eye on risk-taking.
Effects of banking crisis
Banking crises are typically followed by slow credit expansion and GDP increases. But the question remains is this due to the fact that crises frequently occur during economic downturns, or do issues with the banking sector have separate detrimental real effects? According to Jerome H. Powell, Governors of the Federal Reserve System says, “sectors that are more dependent on outside financing should perform comparatively worse during banking crises if banking crises exogenous impair real activity”. In developing nations, in nations with less access to international finance, and in nations where banking crises were more severe, the differential effects across sectors are larger. Controlling for recessions, currency crises, and alternative proxies for bank dependency are some robustness assessments.”
Long-term solutions
In the short term, it will be a difficult effort to stop the banking system from collapsing and restore its functionality. Starting to develop the regulations for a new banking system is equally crucial. There are two directions one can take. The Basel approach is one, while the Glass-Steagall method is the other. The Basel approach states that banks will continue to function as universal banks, carrying out both conventional and investment bank activities. The next step in this strategy is to establish and put into place regulations that set limits on the risks that these universal banks can accept. Its guiding principle is that determining the necessary capital to be utilized as a buffer against future shocks in credit risk may be done through an appropriate study of the risk profile of the banks’ asset portfolios.
Once these minimum capital ratios are in place, credit risk accidents can be absorbed by the existing equity, preventing banks from going broke and thereby avoiding the devilish spillovers from solvency problems into liquidity problems. This approach has completely failed. As was argued earlier, it was first implemented in the Basel first approach, but was massively circumvented by banks that profited from the loopholes in the system. Basel’s second approach attempted to remedy this by allowing banks to use internal risk models to compute their minimum capital ratios. The underlying assumption was that scientific advances in risk analysis would make it possible to develop a reliable method of determining minimum capital ratios.