Banks can play other important roles, such as lengthening the maturity structure of loans by borrowing short-term and lending long-term. Banks do this by taking short-term deposits of say, 1 month, andmaking loans of say 3 years.Moreover, financial markets such as stock and equitymarkets are volatile and expose households that invest their savings in themtomarket risk.Byaccumulating reserves,which are not typically linked to the stockmarket, banks can lessen the market risk for households that instead deposit their savings in banks.
There are times, however, when the banks’ ability to serve this intermediary role is curtailed and banks actually raise the risk level in the financial system. Because banks have a mismatch between short-term liabilities (e.g., demand deposits) and long-term assets (e.g., loans), they are vulnerable to liquidity crises. Such vulnerabilities can lead to bank runs, as a critical mass of depositors suddenly withdraws funds, leaving the bank without liquid assets to carry on their normal business, which in turn may cause more depositors to panic and withdraw their funds.
In addition, when banks are improperly regulated, they are prone to excessive lending and loan creation, leading to a ‘‘bubble’’ in asset prices. The collapse of the bubble can result in defaults, which can lead to serious dislocation of the economy, as happened to Japan in the 1990s. Excessive loan creation abetted by improper regulation is also the root cause of the emergingmarket crisis of the late 1990s.
Causes of Banking Crises
A banking crisis occurs when many depositors attempt to withdraw their funds all at once. In the past, banking crises happened with some frequency in Europe and the United States, particularly during the Depression in the 1930s. Banking crises occur with some frequency in emerging markets. For example, during the turbulent decade of the 1990s, many emerging markets including Mexico, Thailand, Indonesia, Korea, Argentina, Russia, and Turkey faced simultaneous banking and currency crises.
There are two traditional views of banking crises: the ‘‘fundamentals’’ view and the ‘‘random shocks’’ view (Allen and Gale 2000). The fundamentals view is that banking crises are a natural phenomenon of the business cycle. A recession will typically increase loan delinquencies and reduce bank equity, sharply lowering the value of bank assets. As depositors receive information about banking-sector weaknesses, they will withdraw their funds, leading to bankingsector insolvencies. According to this view, bank runs are not random events, but a result of the ups and downs of the business cycle.
The random shocks view is that banking crises are a result of herding ormob psychology. According to this view, bank runs are largely self-fulfilling prophecies (Diamond and Dybvig 1983). If depositors believe that a bank run is about to happen, they will withdraw their funds all at once and a bank run will occur. If depositors believe that bank runs will not happen, then they will stay put and a bank run will not occur. A good rendition of the random shocks view is a scene in the movie It’s a Wonderful Life, in which depositors hear rumors about a failing savings and loan and mob its window. The depositors calm down and stay put when the character played by Jimmy Stewart confidently stresses that the savings and loan is actually doing fine.
In well-supervised jurisdictions, banking regulators promulgate rules and conduct inspections of banks to ensure that they are prudent intheir lending, so that when a downturn inevitably comes, banks’ balance sheets are not unduly impaired. A bank with an impaired balance sheet has many loans for which the collection of principal and interest is difficult. Thus, the loanswill probably have to bewritten off as a loss. Should bank balance sheets become impaired, the country’s central bank usually serves as the lender of last resort to banks, so that bank runs will not occur. Deposit insurance can serve the same role as ‘‘blanket insurance’’ by the central bank, since the government will ‘‘bail out’’ depositors at a failing bank.
The Late 1990s Banking Crisis in Japan
Japan in the late 1990s had a fundamentals-driven banking crisis inwhich a crash in Japan’s equity and real estate markets led to deterioration in bank balance sheets. Dekle and Kletzer (2006) explore the late-1990s crisis in the Japanese banking system and emphasize three key facts about the Japanese financial system at the time: (1) domestic investment was financed primarily by bank loans; (2) the government provided deposit insurance guarantees to the holders of domestic bank deposits; and (3) prudential regulation and enforcement were weak.
Weak prudential regulation in Dekle and Kletzer’s model is interpreted as a failure of the government to enforce loan-loss reserve accumulations by banks against nonperforming corporate loans. Banks thus still make dividend payments to their shareholders against the interest collected on their performing and nonperforming loans, when banks should be foreclosing on firms that are in default on their loans.That is, the banks are paying dividends on even the loan repayments they have not yet received. Nonperforming borrowers are kept afloat by further borrowing frombanks. Although the public is aware of the mounting nonperforming assets of the banks, they do not withdraw their deposits because of deposit insurance. In effect, deposit insurance allows the banks to transfer resources from the government to their shareholders. Deposit insurance makes the depositors feel safe, so they will keep their deposits even in a failing bank. In the eventuality that a bank fails, the depositors will be bailed out by the government.
If the government fails to intervene by closing banks before a critical date, then the banks’ nonperforming loans will exceed the government’s ability to borrow. At that point, there is a bank run by depositors, leading to a banking crisis. This appears to be the story of the Japanese banking crisis, from which Japan began to emerge only in 2006.
Twin Crisis in Emerging Markets
Another example of a fundamentals-driven banking crisis is the emergingmarket crisis of the late 1990s. At that time, many emerging market countries were hit not only with a banking crisis but also with a currency crisis, which is characterized by a rapidly depreciating currency, a sharp outflow of foreign exchange, and a slowdown in fact, almost a depression in the domestic economy. The phenomenon of a banking crisis occurring simultaneously with a currency crisis is called a ‘‘twin’’ crisis.
Perhaps the best description of a twin crisis is by Diaz-Alejandro (1985), who discussed the Chilean crisis of the early 1980s. Like many emerging markets, Chile had a nationalized banking system. In the 1970s, Chile’s banking system was privatized, even to the extent that authorities repeatedly warned the public that deposits were not guaranteed. In early 1981, however, following the cessation of credit payments by a troubled Chilean sugar company, the central bank bailed out several private banks to stem incipient bank runs. Realizing that the Chilean Central Bank stood ready to protect domestic bank deposits, foreign capital rushed in to take advantage of high Chilean interest rates.
By January 1983 the value of the peso fell as the official Chilean exchange rate rose from39 pesos per U.S. dollar to 75 pesos. Chilean companies and banks with dollar-denominated debt came under great stress.Nonperforming loans of banks rose from 11 percent of their capital at the end of 1980 to 113 percent by May 1983. Foreign depositors became worried and started to withdraw their funds, rapidly depreciating the Chilean peso. The Chilean Central Bank had no choice but to intervene again, formally guaranteeing all deposits to stem the bank runs and injectingmassive liquidity into the banking systemto recapitalize the banks.
The Chilean experience illustrates the dangers of capital market liberalization with blanket government deposit guarantees. Such blanket guarantees can lead to moral hazard (in which a party insulated fromrisk engages in riskier behavior), with too much capital flowing in, excessive bank lending, a rise in nonperforming loans, bank failures, and finally, a currency crisis. See also asymmetric information; bail-ins; bailouts; balance sheet approach/effects; Bank of Japan; capital controls; contagion; currency crisis; deposit insurance; financial crisis; financial liberalization; lender of last resort