Why is Banking Sector Prone to Crises?

By: Lumber Joe

There are some special characteristics of banks that make them vulnerable to crises. Firsts, banks are leveraged, much more than a typical non-financial firm. In managing their investments they are putting people’s money at risk. Leverage and limited shareholders liability make bank managers to undertake excessively risk portfolio on behalf of shareholders. Another problem that arises from this feature of banks is that depositors are ill-posed to perform control over their banks. Secondly, a bank is illiquid i.e. loans are longer term than deposits. In this sense the cost of rapidly liquidating its portfolio is the decreased value of its assets. Thirdly, banks manage information problems. In this instance, banks are seen as financial intermediaries that perform information processing. Along the time, they gather information about their clients by testing their ability to service the short-term credits.

A fourth feature stems from the fact that there is an interaction between bank solvency and their liquidity. Very often bank liquidity problems can be transformed in solvency problems. A real or imaginary solvency problem can degenerate a liquidity shock that further motivates bank runs driving even the healthy banks into solvency problems. The fifth characteristic of banks can be mentioned, namely banks manage the payment mechanism. For this characteristic to be fulfilled deposit claims on banks must be highly liquid, otherwise depositors will run to safer banks or will transform their deposit into cash.

Another important characteristic of banks is that their depositors are protected against the risk of bank mismanagement because depositors are not in the position of performing control over their deposits. Thus, in order to reduce the likelihood of runs, governments provide deposit insurance, in an implicit or explicit manner, for protecting the small depositors. Finally, banks are regulated by rules, restrictions, and standards. Banks must obey the rules about the degree of loan concentration, to restrictions about the composition of their portfolios as well as about their international activities and standards concerning their liquidity and capitalization. Because the regulators are debtors in the case of bankruptcy, they have to exert control on bank’s assets in case of bankruptcy.

Banking crises have become increasingly common especially in developing economies. Over the 1980–96 period at least two-thirds of IMF member countries experienced significant banking sector problems. Moreover, in many regions, almost every country has experienced at least one major.

appear mainly because of the banks’ failure to deliver funds that their depositors are entitled to demand. This is a liquidity problem for banks and the situation is referred to as a bank run. Banks can experience runs and panics due to various reasons. Panics may occur because of regional economic problems as well as because runs to insolvent banks can also trigger runs to otherwise solvent banks. The later type of panic is called contagion. Bank runs can also be provoked by pure speculative reasons or imaginary insolvency because in periods of financial distress depositors are sensitive at any kind of news.

There are, however two possibilities for a bank not to face this kind of problem. On one hand, if the rate of growth of deposits is higher than the interest rate, the liquidity problem will not arise because in this case depositors are transferring financial resources into the banking system and the banks are able to remain liquid. On the other hand, in order to overcome the liquidity problem, banks can reduce their stock of liquidity or they can extract resources from their borrowers. The bank can start liquidating some of its long-term assets at “fire sale” price on a secondary market, before they reach their maturity, but this is a costly operation for any bank. Moreover, nowadays banks are increasingly liquid because of innovations in financial markets, which permit banks to construct liquid portfolios.

There are two components of a bank crisis. First is the magnitude of the net resource transfers and the second is the threshold of the resource transfers above which the system will break down. The first component is a shock in the banking system because in normal conditions net resource transfers should not constitute a problem. The second component is connected with the vulnerability of the banking system. Hence, banking crises are due to both shocks and vulnerability. The same authors argue that the bank crises are usually preceded by a generalized deterioration of the macroeconomics conditions in a country. Specifically, recession appears a year or two before the crisis actually come into place.

Macroeconomic shocks are very likely to negatively affect the bank balance sheets and the solvency of most of the banks. For example, the financial panic from Argentina in 1980 was preceded by an unstable macroeconomic and financial policy during which peso overvaluation triggered a period of decreased borrowing that put a downward pressure on the quality of bank assets.

The probability that a macroeconomic disturbance succumbs in a back crisis is determined by the policy regime in place at the time of shock. More specifically, the alternative exchange rate regimes have a particular role here. For example, in a fragile banking environment, banks become insolvent due to inability of their domestic borrowers to pay their debts. Consequently, depositors will leave the troubled banks and move to solvent banks. This situation can create a high destabilization threatening the banking system as well as the exchange rate regime.

But, as has been shown before, not only macroeconomics shocks are sources of banking crises but also the vulnerability of the banking system. Vulnerability is present when the bank’s “buffer stocks” of capital and liquidity is small in relation to the risk associated with its assets. In addition, empirical data show that banking crises are preceded by rapid growth in banking credit or lending booms. Lending booms can increase financial vulnerability of a banking system by contributing to the decline of the quality of bank assets.

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Source: Offshore Banking and Small Business Credit Cards

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