Financial crises

By fmiren | Is recession coming | 17 Oct 2023

In light of the recent fears of recession and several bank failures I think it's time to talk about patterns of banking crises. How and why do they occur? Can we predict and avoid them?

One of the best books on the history of financial crises is “This time is different” by C. Reinhart & K. Rogoff. In the book the authors dedicate many pages to banking crises which seem unavoidable evein developed economies.

Below is my attempt to summarize their findings.

An interesting feature of banking crises is that even developed economies failed to avoid them even though these countries were able to handle sovereign debt crises many years ago. Authors call this “graduation”. In the case of sovereign debt defaults, we can say that advanced economies seem to achieve graduation. However, graduation from banking crises remains elusive even for the most advanced economies as the 2007–2008 crisis demonstrated so spectacularly. That banking systems are vulnerable to bank runs exacerbates the situation with banking crises.

Many banking crises were related to real estate prices. These price cycles don’t differ significantly between advanced and emerging markets. However, most macroeconomic variables, such as government spending, interest rates and time series on income and consumption etc, show higher volatility in emerging markets. So the finding that real estate prices cycles around financial crises exhibit the similar pattern in two categories of countries (advanced and emerging) is surprising.

Another not so conspicuous feature of banking crises is their relationship with financial liberalization. Kaminsky and Reinhart have demonstrated that in most banking crises cases (eighteen out of twenty-six) after 1970, the financial sector had been liberalized in the five-year run-up to the crisis. In the 1980s and 1990, many liberalization cases resulted in financial crises. This doesn’t mean that no country managed to arrange the financial liberalization to proceed easily. Very few countries (e.g, Canada) could escape the crisis.

There’s a mathematical evidence to this claim too. The same authors, Kaminsky and Reinhart, provide evidence that the probability of a financial crisis conditional on liberalization is higher than the unconditional probability of a banking crisis. In another research, Demirguc-Kunt and Detragiache confirm this by using a fifty-three country sample and presenting evidence that the effect of financial liberalization on the banking sector is negative. In other words, financial liberalization is a destabilizing factor for the financial sector.

Another feature of the banking crises is related “capital flow bonanzas” mentioned in the paragraph on debt crises. It turns out that in the run-up to a crisis capital inflow to the country persistently increases. One research also provided evidence that a high capital inflow (equaling several percent of GDP) makes the economy more crisis prone.

Capital flow bonanzas are related not only to banking crises but also to credit cycles. Two researchers, Mendoza and Terrones, looked at credit cycles in developed and emerging markets. They found that increase in capital inflows tend to be followed by credit booms in emerging markets. Though credit booms are not a necessary condition for a banking crisis, there were credit booms in the run-up to most financial crises in emerging market economies.

Another regularity of the banking crises is their link to housing prices as previously mentioned. Two economists (Bordo and Jeanne) looking at advanced economies during the 1970–2001 period found that banking crises usually occur when real housing prices reach the peak or immediately after the bust.

Are there any markers that may predict a banking crisis? The research on financial crises answers yes to this question. Some forerunners of these crises include significantly increasing asset prices and big current account deficits. Ramping up of public or private debt can also predict a financial crisis. The other two precursor factors to banking crises have already been mentioned. Capital inflow bonanzas and financial liberalization more often resulted in financial crises than not.

Other than precursors, most severe banking crises also are followed by some common results which the authors categorize into three groups.

The first aftermath of the financial crises is that asset prices markedly fall which may last more than several years. Average decrease in real housing prices is 35 percent, while stock market crashes average more than 55 percent. The average duration for real estate and equity markets collapses is 6 and 3.5 years respectively. One episode is especially remarkable in the case of housing prices declines. In Japan real housing prices collapsed during seventeen consecutive years. But even if we exclude Japan’s experience, the average duration of housing markets falls remains more than five years.

Second, unsurprisingly banking crises negatively affect the output and employment. During the decline phase of the crises, which can last more than more than four years, the average unemployment rate jumps to 7 percent. The magnitude of the output decrease is more than that of the unemployment rate — output falls on average 9.3 percent. However, the duration is less prolonged averaging two years.

Though the decline in real per capita GDP has averaged more than 9 percent as noted, there is a considerable difference between the experiences of advanced and emerging market economies. During the post-World War II period, the former group of economies experienced less decline in real per capita GDP than the latter group. The authors suggest an explanation for more severe contractions of emerging market economies related to credit availability. When foreign credit decreases, the economy recedes which is translated to the decline in real GDP.

Third, as a result of a banking crisis the government debt drastically increases in value. In the post-World War II cases the real value of the sovereign debt almost doubled in comparison to precrisis levels (actually it jumped to an average of 86 percent but this doesn’t change the fact banking crises are followed by the explosion in government debt). The literature on financial crises usually points to bailout costs as the main driver of debt increase. However, the authors note that there is another factor which dwarfs the effect of bailout costs. They mention that since output reduces there’s a marked reduction in tax revenues. And this “inevitable collapse in tax revenues” is the most significant driver of debt explosion. Another factor contributing to the debt buildup is the increase in interest expenses since interest rates increase during the crises.

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