Backgrounder: Banking
by Anya Schiffrin Initiative for Policy Dialogue http://www2.gsb.columbia.edu/ipd/j_banking_bk.html The banking system is the heart of a countrys 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 can not develop and jobs can not 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 Asian banking crises of 1997 and 1998 tipped those countries into serious recessions that affected the broader community. Today there are many countries that fear banking crises. Argentina and Bolivia are just two countries where the banks have large amounts of bad debt. Once a banking crisis starts, it spreads. If problems in one bank are made public, small depositors get scared and they take their money out of that bank. 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. Suddenly, you have a massive run on the banks. 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 problemlarge amounts of non-performing loans. In a healthy banking system such as that presently found in the US, problem loansloans that are non-performing or close to non-performingaccount for about 9% of outstanding loans. During the Asian banking crises, the numbers were as high as 47% in Thailand and 75% in Indonesia. There are several reasons why banks can end up with bad debt: 1) 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 these companies. A direct subsidy would have been a more clear 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. In Brazil, the government has compelled banks to stop this sectoral lending and has phased out regional, specialized development banks altogether. 2) Non-financially based lending is but one step away from a second problem: corrupt lending. In Vietnam 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 capitalist countries. In the Texas Savings & Loan scandal, for instance, federal regulators accused bank directors of making loans to "insiders" in excess of the regulatory limits. 3) 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 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. 4) 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 dollar-denominated loans and the local currency is devalued, then it becomes more expensive to repay loans that are dollar-denominated, 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. 5) 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 in the early 1980s, when the Federal Reserve 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 t he S&Ls. 6) 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, who can not differentiate very well between the weak and the strong banks (asymmetric information), 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. 7) "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 amount of non performing loans typically rises. 8) 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 de debated but there is no question that banking crises can be exacerbated by lack of good regulation. Crisis Prevention 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 Committees guidelines, 8% of (risk-weighted) assets must be kept aside to cover the loans that are not repaid. (The Basel rules are currently being revised.) 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 protect against bank runs and strengthen the overall financial systems. Some, as in Germany, function privately and with a minimum of government involvement. But there is energetic debate surrounding a one size fits all 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 moral hazardknowing 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 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." --------------------------------- How much free photo storage do you get? 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