Banking Crises

Regulation & Performance

Economics 102

Winter 2002

Early Regulation

• Scams, Bank failures ==> bank licensing from early 1800s• Minimum capital requirements

• Attempt to exclude criminals

• But US had 20,000+ banks

– In much of midwest, branch banking prohibited

– Interstate banking prohibited

• Federal Reserve System from 1913• Smooth interest rate swings

• Support faith in money, quell banking panics

• Foster national market

Great Depression

• Big swings in prices: deflation– Debtors hurt, many default– Real GDP fall likewise leads to defaults

• Banking “panic”– Fears lead to bank runs

• 9755 banks failed in 1929-33• FDR declared bank holiday in March 1933 to stop panic

• Sum– Illiquidity issues– Insolvency issues

Regulation

• Promote “sound” banking practice• More below...

• Depositor insurance (FDIC, 1933)• Restores confidence

• But insurance has side effects

– Moral hazard

• Encourages risk taking

• Heads I win … tails you lose

Safe Banking

• Sound practice– Glass-Steagall (1933): segment services

• Insurance - banking - securities - underwriting• NOW DEFUNCT cf. Enron issues

– Bank supervision (gradual from 1800s, state & federal)• Inspection• Case study: Bank of Tokyo NY, 1979

– Regulation Q (1933)• Prevent competition for deposits• Help guarantee margins

Banking Crises

• Structural change is the enemy of sound banking

– Managing risk is undermined

– Mix of products / operations undermined

1970s shifts

• 1970s

– Inflation rose ==> disintermediation

– MMMFs developed

• Donahue and money market [mutual] funds

• Incentive to pull money from term savings accounts

• Also could buy bonds directly …. such as I did.

– Regulation Q broke down [for S&Ls from 1982]

• Banks were freed to pay market interest rates

S&Ls

• Savings & Loan Institutions– State-chartered banks (initially)

– Restricted to local residential real estate ca. 1936• No geographic or industry diversification

– Typical product fixed-rate 30 year mortgage

• Core of business– Borrow short

– Lend long

– “Maturity transformation”

Demise of S&Ls

• 30 year mortgages

– Collecting 4%

• Short-term deposits

– Paying 10%

• Entire sector rendered insolvent

Further deregulation

• So rechartered as federal institutions

• Freed S&Ls to lend to new business

• Allowed to enter new, more profitable types of

lending, such as commercial real estate

development in other states

S&Ls in the New Age

• But the same old regulators - and understaffed• And the same old bankers• In a brave new world• California S&Ls in Texas …

….. Dentists as Bankers?! • No ability to practice or assess sound banking• Outright fraud

– Ex: Over $1 billion in fraud at one S&L in Colorado– Chs Keating bought 5 US Senators to protect himself, with $2

billion in losses and (for him) a brief stint in jail

Bottom Line

• Initial $250 billion cost to taxpayers– Liquidation of real estate recouped $90 bil thereof

• Lots of bad assets– Lots of unmitigated waste– Local business cycle accentuated (Tx, Fl, La)

• Ultimate total elimination of S&L segment• Commercial banks alternatives

• floating rate mortgages [undermined S&Ls in their latter days]• so it’s still possible to finance a home purchase

More recent crises

• Japan

– Traditional business disappeared

• Growth slowed from 10% pa to 5% pa

• Less Investment

– business borrowing fell by 10% of GDP

– savings (deposits) continued to rise

– So need new business

• Small firms (60% of economy)

• Real estate (good collateral, prices always rise)

Japan’s Crisis

• New business plan a failure• Good small businesses already had bankers

• Real estate prices could fall, too

• Began shift in a boom, hiding bad practices

• Banking crisis from 1992• Real estate prices fell

• Stock-market based financing backfired

• Japan in 2001 is back in recession, with only one year of good growth since 1990.

Thailand, Argentina

• A supposedly fixed foreign exchange rate– But domestic interest rates high!

– Answer?• Borrow in US $ from foreign / offshore banks

• But the exchange rate depreciated– Suddenly instead of owing B20,000 you owe B40,000

– And interest payable doubles too

• Widespread defaults / bankruptcies

Tomorrow’s crisis?

• Citigroup gone awry?• Home mortgage loans in a falling real estate

market?• Etc .. ?• Why worry?

– Structural change– but management change?– Expansion in up cycle when hard to lose money– Mistakes now coming home to roost

Summary

• Leverage: – a little is very powerful– Try to move too much and something will snap - or spring back

and slap you– Institutional change: both regulators & lenders find hard to handle

• Regulation– Regulations generate side effects

• Moral hazard– Heads I win, Tails you lose– Adverse selection: if you try to expand quickly, you have to lower

standards, and (like grade inflation) those rejected by conservative banks will seek you out! Losses always prove worse than average!