General list of crisis indicators to watch:
Type of exchange rate regime
Regulatory and monitoring structures
Type of financial opening
Environment in which financial opening takes place
Independence and competency of asset rating companies
Current account and fiscal deficits
Level of inflation
Level of public debt
Currency and maturity mismatches in foreign borrowing
Size of financial sector relative to real sector
Size of banks
Exposure to real shocks, such as commodity price spikes
RECOGNIZING A FINANCIAL CRISIS
Cory Aldean, Brooks AFB, San Antonio, Texas
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The question for each individual initially is how to determine whether we are actually facing a crisis, isolated incidents, or just economic noise. There are several economic indicators which would lead both academics and politicians alike to feel in their “gut” the current economic situation. The indicators are varied, some are quantifiable, some are subjective, and a financial crisis may contain all or none.
Several economists and writers have quantifiably demonstrated that there are several indicators, each with relative correlation to the incidence of a financial crisis. Kaminsky & Reinhart (2009) made an extensive study on indicators of a crisis, and found that most crises include multiple indicators. The study produced a list of indicators that can be associated with financial liberalization and a financial crisis, to include: M2 multiplier, the ratio of domestic credit to nominal GDP, the real interest rate on deposits, and the ratio of lending-to-deposit interest rates. Other financial indicators include: excess real M1 balances, real commercial bank deposits, and the ratio of M2/foreign exchange reserves. The ones that showed the likelihood of a financial crisis in order of correlation are: real interest rates, real interest-rate differential, terms of trade, reserves, outputs, exports and stock prices.
In addition to Kaminsky & Reinhart (2009), Reinhart & Rogoff (2008) studied early warning indicators for both banking and currency crises. The best banking indicators are: real exchange rates, real housing prices, short term capital inflows/GDP, current account balance/investment, and real stock prices. The worst indicators are ratings and terms of trade. As for a currency crisis, the best indicators are real exchange rates, banking crisis, current account balance/GDP, real prices, exports, M2/international reserves. The worst for a currency crisis are ratings and domestic-foreign interest differential. Some of these indicators from Kaminsky & Reinhart (2009) as well as Reinhart & Rogoff (2008) are also considered causes of a financial crisis and are dealt with in the next section.
There are various characteristics of a banking crisis, according to the World Bank (2009), which include periods of high international capital mobility, preceding period of sustained surges in capital inflows, preceding boom in real housing prices with a marked decline, and preceding expansion in the number of financial institutions. On average, for past crises equities fall 55% over 3.5 years on average, while housing prices decline 35% over 6 years, and unemployment rises 7% over 4 years. Output falls by 9% over 2 years, and the real value of government debt rises an average of 86%. Any combination of these types of economic indicators is a good bet that a crisis is underway.
Banking Crisis vs. Financial Crisis
Financial crisis and banking crisis often go hand in hand; in some cases the words are synonymous, though banking crisis usually deals solely with events in the financial sector. In many instances, especially in recent history, banking crisis precedes the financial crisis. Often times it will be coupled with a currency or exchange crisis. Kaminsky & Reinhart (2009) describe the beginning of a banking crisis by one of two events: (1) bank runs that lead to its closure, merging, or takeover by the public sector; and (2) if there are no runs, the closure, merging, takeover, or large-scale government assistance of a major institution. Major changes in the landscape of the financial sector typically mark a banking crisis. We can often see a banking crisis develop in stages as described by Nakaso (2001), who describes four stages; (1) market participants become reluctant to do business with troubled banks, resulting in higher risk premiums for those banks, and generally appearing 2-3 years in advance; (2) troubled financial news erupts, and the average maturity of deposits grows shorter; (3) retail depositors begin losing confidence in the banks, and a decline of “deposit surplus ration” is noticeable; and (4) liquid assets for sale are exhausted and the bank becomes insolvent. This can happen over several years, and others in weeks or days, in the case of most bank runs.
With the bursting of a financial bubble, we see an outflow of the money supply. Kaminsky & Reinhart (2009) observed that during numerous financial crises, the M2/Reserves and M1 Excess Balances indicators shot up prior to crisis, tanking almost immediately after. Bank deposits also decreased post-crisis. Much of the money supply prior to the bursting of the bubble was on borrowed assets. The US total household debt to disposable income ratio in 2006 was 1.4, higher than the Nordic and Japanese pre-crisis levels (World Bank 2009). Not just the average citizen, but governments are engaged in excessive borrowing. Kaminsky & Reinhart (2009) note that “…crisis occurs because a country finances its fiscal deficit by printing money to the extent that excessive credit growth leads to the eventual collapse of the fixed exchange rate regime.”
The most obvious marker of a potential financial crisis to come in developed countries is a downturn in equity markets. Often times the stock market crash and banking crisis are not related, as in the Dot-com market busts in 2000, where over-valued asset prices pulled the market down. Although stock price movements are more skittish and susceptible to multiple factors than other indicators, they are what politicians pay particular attention to. As we saw in September 2008 in the US, we witnessed declines in markets around the globe. In Japan, major financial institutions collapsed almost on a weekly basis in the month of November 1997, and stock prices took a nose-dive to indicate trouble in financial markets and the real economy. Similar events occurred in the Nordic crisis.
A severe decline in trade usually precedes a crisis, or it can occur during the crisis, due to lack of credit and business. Looking at trade between nations that are both experiencing a financial crisis, both equally may be affected, so the balance of trade may be moot. A country experiencing an isolated crisis will show a larger balance of trade problem. Prior to a crisis, it was demonstrated that on average, exports decreased significantly during balance-of-payment crises (Kaminsky & Reinhart 2009). A banking crisis may not see as much of a decrease in exports, which shows the crisis usually hits the financial sector first, though later exports may drop.
Some countries can get away with a balance of trade crisis for several years or even decades without turning it into a financial crisis, but the danger lies in not being able to control your monetary policy, when countries around the world are controlling your currency and own your debt. The Fed can lower rates to allow the government to proceed with funding its massive expansionary fiscal programs, but it runs the risk of causing foreign central banks of dumping its currency, leading to inflation. However, having a surplus does not prevent a country from experiencing a financial crisis, especially if they invested in countries that are experiencing trouble. According to the World Bank (2009), the US trade deficit sits at $749 billion, and it accounts for 57% of world’s trade deficits. Contrast this with the top trade surplus countries: China $372 billion (10% of GDP), Germany $256 billion (6% of GDP), Japan $210 billion (4% of GDP), Saudi Arabia $95 billion (27% of GDP), and Russia $76 billion (8% of GDP). The trade surplus of China went from $0.2 trillion to $1.6 trillion between 2000 and 2007 (World Bank 2009). Some of these countries had a lot of money invested in the US and financed the US trade deficit, notably China, Japan and Germany and they will be anxiously watching their investments in a USD that has no clear direction.
There are many ways that governments attempt to fix their trade issues via tariffs, such as the Smoot Hawley tariff during the Great Depression, though other countries will likely reciprocate. Besides protective tariffs, governments can devalue their currency to promote trade. With the Nordic countries, this was certainly the case, and exports were propped up with a devalued currency after removing itself from the Exchange Rate Mechanism (ERM).
Public Identification of a Crisis
Many members in the financial sector will know a financial crisis is brewing well before the government, since they have the research, education and experience, or it may be that they are involved in the particularly questionable behavior that could lead to a financial crisis. Nakaso (2001) describes the behavior leading up to Japan’s crisis, where banks engaged in increasingly risky operations primarily for competition and market share. Profitability and riskiness of loans were neglected; some were extended at negative lending spreads. Not only banks, but even the general population can sense a crisis before the Federal Reserve or other governmental agencies. Nakaso (2001) further describes the situation leading up to several runs on the banks on 26 Nov ’97, where rumors were rampant surrounding several banks on the verge of collapse. This occurred prior to the Bank of Japan issuing a statement of their commitment to stability. Following several collapses in the fall of 1997, this time was considered by many to be the day that Japan’s financial system was closest to a systemic collapse.
CAUSES OF A FINANCIAL CRISIS
Indicators are useful in prediction, however they do not provide the underlying reasons for a financial crisis, and those reasons can be endless. Crises usually come with the convergence of multiple external and internal factors, which overwhelm the economy. Some causes tend to lead to crisis more than others, as stated by Allen & Gale (1999), but most crises have several market failure causes in common. In preparing a financial response plan, an understanding of the various causes is crucial to that effort.
One of the major causes to many crises for developed countries in the last several decades has been the lack of regulation or financial liberalization. That came as a result of lax government regulations of banking and financial institutions as well as other regulatory tools. Many countries had been following the “Washington Consensus”, which promotes liberal financial regulation to create easy credit and money across all countries to develop their economies. Up until recently, this policy seemed to work, however recent events have shown that liberalization can go too far. The problem is that it takes years to see the affects of deregulation, so no warning or downside was visible to other countries including our own. In the case of the Nordic and Japanese crises, these governments cite several instances of liberalization leading to asset bubbles and financial crisis.
The two ingredients to these asset bubbles were financial deregulation by the government, coupled with a funding catalyst like low interest rates. Again, the US led the way showing growth through low rates, especially during the 1990s to mid 2000s. Former Federal Chairman, Alan Greenspan, allowed for unprecedented low rates over the course of nearly two decades. In the US, this fueled the technology equities, real estate, and even derivative market bubbles. The Chairman was seen as a financial oracle, and American and even foreign governments failed to question these actions. There’s no incentive for banks or corporations to protect against risk. As explained by Goodhart (2007), financial institutions had become careless and taken excessive risk driven by the belief that the Federal Reserve would prevent a financial collapse, otherwise known as the ‘the Greenspan put.’ Since raising or lowering interest rates is one way for the Fed to combat inflation, if that becomes a problem in the future, the Fed will have to make a difficult decision about how to fix the economy.
The current crisis certainly is not the first time the US attempted to tweak interest rates to promote growth, thereby leading to a crisis. The Garn-St. Germain Depository Institutions Act (1982) led to a variety of new investment powers for financial institutions; one way was through removing interest rate ceilings and allowing adjustable rate mortgages. The subsequent bubble in investment was a contributing factor to the Savings & Loan crisis. Globally, central banks followed suit. Moe, Solheim & Vale (2004) describe artificially low interest rates across all Nordic countries to the point that the real rate became negative. The money supply for developed countries actually outpaced the US in the 2000s with low interest rates (Goodhart 2007). The question that jumps out during the US response to the crisis of 2008 is why are rates allowed to remain so low, and what will be the fall-out from failure to correct.
Non-Performing Loans (NPLs)
Low interest rates and cheap money inevitably lead to asset bubbles, and when they burst then investors get burned, and in the case of the US, as with the Nordic and Japanese crises, the main catalyst was the prevalence of non-performing loans (NPLs). There are several causes of NPLs, which will be discussed below, such as real estate or commodity booms and busts, currency crisis, false sense of value derived from inaccurate ratings, and abnormal or complicated accounting practices or financial products, i.e. derivatives. Of the 33 banking crises from 1977 to 2002 studied by Hoggarth, Reidhill & Sinclair (2004) NPLs were between 17 and 33% of total loans. As for Japan, in the midst of their crisis, their NPLs were estimated at $469 billion in 1995 to $725 billion in 1998, and in 2002 they comprised 35% of total loans (Reinhart & Rogoff 2008). Sweden too had its share, estimated at 13.2% of total loans; however Nakaso (2001) makes the distinction that the reason for a higher incidence of NPLs in Sweden was due to their stringent definition of what constitutes a NPL. A further distinction comes from what institutions were affected. In Sweden NPLs were concentrated across a few major banks, while in Japan they were spread almost evenly across all types of financial institutions. NPLs in every financial institution make it difficult to pin-point the problem, and increase manpower and research requirements.
The issue of default in the US seems to stem from the subprime market. While the probability of default of a prime mortgage borrower is typically less than 0.003% per year, sub-prime loans were estimated to default at a rate of 5 to 7% per year (Goodhart 2007). Looking back, the probability could be higher for subprime borrowers, and some of them might have become serial defaulters. What encouraged the lending to subprime borrowers in the 1990s was politically motivated, where politicians had been encouraging subprime households to seek loans after setting quantifiable targets for lending increases from the mortgage institutions (Oberg 2009). There is also the danger of contagion between borrowers as Goodhart (2007) further states, “…when housing prices go down, particularly at a time when effective interest rates are rising…the probability of default on the loans of the individuals in the pool ceases to be independent of each other; the correlations rise as well as the probability of default themselves.” When the NPLs started taking their toll, the interbank liquidity dried up, and the TED spreads, or what Oberg (2009) describes as the difference between three-month interbank rates and government security rates, skyrocketed. Each time a bank collapsed or was on the verge of collapse, one could see at the same time a peak in the TED spreads.
There seems to have been a dearth of experienced lenders, resulting from the Cost of Credit Intermediation (CCI), which could have lessened the amount of subprime lending. “CCI includes screening, monitoring, and accounting costs, as well as the expected losses inflicted by bad borrowers…This is done by developing expertise at evaluating potential borrowers; establishing long-term relationships with customers; and offering loan conditions that encourage potential borrowers to self-select in a favorable way” (Bernanke 1983). When the incentive to do their homework on borrowers is removed (i.e. losing their job), institutions make many poor choices in lending. The mortgage and real estate markets have amassed huge fees for services, dependent largely on volume and not on quality of loans.
Adding to the problem is the lack of fair assessments on loans from the ratings agencies for several reasons. Goodhart (2007) brings up the issue of insufficient competition in the field of ratings with only the two big American ratings agencies, Moody’s and Standard and Poors, plus the European agency, Fitch. Also contributing to inaccurate ratings reports is that ratings agencies are paid by the investment banks, creating a conflict of interest. Without oversight from the government, ratings agencies have no motivation to protect the consumer, something that has become increasingly evident by politicians advocating for a consumer protection agency paid for by the government. Not every loan, fund, country, or other subject a rating agency is reporting on, can get a stellar rating. To illustrate, the World Bank (2009) reports that in 2007, there were 12 triple-A rated companies in the world, but at least 64,000 structured finance instruments were rated triple-A. The ratings are rendered meaningless if everything comes up with a top rating, especially when so many were of the derivative market. In 2005, more than 40% of Moody’s revenue came from rating securitized debt with questionable products such as mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) (Crotty 2008).
Real Estate Bust
A significant real estate decline, beginning in 2006, led to the US financial crisis, much the same way real estate declines did for the Nordic crisis and others, contributing to the number of NPLs. Reinhart & Rogoff (2008) show that real estate prices went down for 4 to 7 years during all banking crises studied. Low interest rates, de-egulation, adjustable rate mortgages, lack of consumer protection or education programs, and lack of due diligence by institutions all played their part in exacerbating the problem. Overvaluations in real estate, much like the tech stocks of the ‘90s, were unsustainable. Real estate in 2008 was like the stock market in 1929, where billions (or trillions in 2008) of dollars from the economy evaporated.
Subprime loans were placed into various derivative products such as the Collateralized Debt Obligations (CDOs), which when the real estate market prices came down, were affected by NPS, contracting balance sheet margins. To illustrate the size of the problem, the International Monetary Fund (IMF) estimated potential losses in 2007-2010 from US-originated derivatives held by banks at $2.7 trillion (Crotty 2008), which may be conservative for a market with a notional value estimated at $684 trillion in 2008. To clarify that number, we could estimate the replacement costs of all such contracts, which the World Bank (2009) estimated at $2.5 trillion in June 2000, rising to $20.4 trillion in June 2008 (World Bank 2009). Although most derivatives are interest rate contracts, over $400 trillion of worldwide derivatives, the impact of the CDOs on banks’ solvency has just barely become apparent.
CDOs and other derivatives are not a new phenomenon. Derivatives were used as a way to package bad loans by the Resolution Trust Corporation (RTC) during the Savings & Loan crisis, which attracted new market players into a “secondary market for non-performing loans” (Nakaso 2001). For decades, derivative and other “shadow” proprietary type markets went unnoticed by regulators, with one exception: the Commodity Futures Trade Commission Chair, Brooksley Born. In 1998 when someone outside the financial circles noticed the bubble, Born was quickly subdued, and the issue garnered little public notice until 2007-08 (Born 2009). The failure of Long-Term-Capital-Management, notorious for trading derivatives in the 1990s, paled in comparison to the size of the Tech Boom and Bust, so derivatives went back in the shadows. Crotty (2008) described the resulting lack of regulation of derivatives market; “the New Financial Architecture is based on light regulation of commercial banks, even lighter regulation of investment banks and little, if any, regulation of the ‘shadow banking system’ –hedge and private equity funds and bank-created Special Investment Vehicles.”
Derivatives are not unique to the US. The Bank of Japan was concerned with the LTCB’s currency swaps. During the take-over, the concern was that counterparties of LTCB would close out open contracts in mass, which could trigger cross defaults and disrupt other markets (Nakaso 2001). The Japanese issued a blanket guarantee for all obligations of the nationalized bank including derivatives contracts with liquidity support from the Deposit Insurance Corp. The Nordic countries also recognized these “shadow” markets, and the contagion from one bank spilling over into another and across borders. Many banks’ behavior could be described as “herding” where banks copied the strategy of a leading (aggressive) bank (Moe, Solheim & Vale 2004). If one bank is making money doing it, then the others follow suit. One market that has not been mentioned is currency derivatives, of which China owns approximately $350 billion (World Bank 2009). This market, like the real estate derivative market, could lead to the next crisis following a devaluation of either the US or Chinese currency.
In addition to a run-up and subsequent drop in real estate, commodity prices have had major effects on financial crises. World-wide oil price spikes led to an economic slowdown in Norway. In 2008, there were rapidly increasing prices one year prior. Food prices rose due in part to the production of ethanol from corn and other food crops (World Bank 2009). Speculation in energy and the volatility of the dollar drove up oil. The turnaround of price trends took place since July 2008 for most commodities and since August for energy products; preceding the financial collapse of mid-September, however the world-wide credit freeze led to a free fall for most commodities (Griffith-Jones & Ocampo 2009).
Not only businesses and banks took a hit, but gas prices affected everyone in the economy. Once gas began flirting with the $4/gallon national average, there were fewer vehicles on the road. As for the government, the increase in transportation and manufacturing costs translated into lost tax revenue.
The US economy is vulnerable to economic actions worldwide, especially from speculators and hostile governments who find it more prudent to strike back at the US economically rather than militarily. In addition, most of our allies are in no position to aid the US, so now the question to US policy makers becomes, who can we turn to for help internationally? Shortly after the US equities markets went bust, we saw within a short time, the fall of several economies world-wide, including government bankruptcies in Iceland, Dubai, and Greece.
All these causes are amplified by psychological factors. Fear is manifested by the bank run. It can happen to solvent healthy banks as well as to the insolvent. Hoggarth, Reidhill & Sinclair (2004) warn that, seeing the liquidation of a bank could trigger fear among depositors at other banks, despite being sound. Fear can be exported overseas. In the case of the credit default swaps, Crotty (2008) says, “new and complex instruments to transfer credit risks in combination with large banks engaging in an ‘originate and distribute’ business model have amplified the consequences of the undeniable excesses in the US mortgage market…In the end, the new instruments of credit risk-transfer distributed fear instead of risk.”
The strength of the “Safety Net” is also a source of consternation. The Deposit Insurance Fund is mandated to have 1.15% of insured deposits. In 2007 the FDIC fund balance at the end of year sat at $52.4 billion, with a capital ratio (CR) of 1.22% of exposure to insured deposits totaling $4.29 trillion. In March 2009 it was $13 billion with a CR of 0.27%. The FDIC imposed an emergency fee, which raised a minimum level of capital, and on Aug 7, 2009 it was down to $648 million. It was estimated that insured banks held $7 trillion in total deposits (including insured and uninsured accounts). The FDIC in January 2009 stated that the FDIC deposit insurance “is backed by the full faith and credit of the US government”, but there appear to be no laws strictly binding the government to make good on any insurance liabilities unmet by the FDIC. The danger of the FDIC becoming insolvent is real. Similarly, during the Savings & Loan crisis, where funds available from the FSLIC (Federal Savings and Loan Insurance Corp) ran out as it dealt with the crisis in the 1980s (Nakaso 2001). This led to the enactment of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989 under which the RTC was established and $200 billion of public funds were used to clean up the aftermath. The sheer scale of what the FDIC faces is daunting should bank failures continue.
The longer a recovery is delayed, the more public fear grows, though recoveries do not usually occur overnight. Goodhart (2007) tells us that financial markets usually decline faster than they rise. If the government’s response is inconsistent, that can trigger a panic. For example, the Bank of Japan’s action was contradictory to the Governor’s speech a few months before. The Bank insisted that the central bank’s funds were being used to maintain financial stability and not to bail out the failed institutions. The government can get the right response, but not appease the public, which opposed government interference until the autumn crisis of 1997 (Nakaso 2001). Also, the fear of foreigners can play a role, especially if governments act in their behalf.
Just as dangerous as the public’s fear is the government’s own fears of a financial crisis. They see a massive drop in equities, but Wall Street does not always equal Main Street; reference the events of Black Monday from the 1987 stock market crash. It is not the government’s job to make sure everyone makes money in a highly speculative market, but rather to ensure that the cash to fuel such a market from bank depositors is safe. People need to see that an insurance fund can cover their deposits. For most citizens that do not have savings, their concern from the government is fiscal stimulus. Some of the worst responses come from the government’s knee jerk reactions or with them trying to cater to everyone in the economy. The public and politicians need to remember that 2008 was not the first US crisis. There have been 15 since the founding of our nation; 4 in the last century (1907, 1914, 1929, 1984) according to Reinhart & Rogoff (2008). The lack of education on the subject usually leads to fear--fear of the unknown, with the unknown being the causes of the crisis, future of the economy and future of one’s own financial well-being.