Curtains

We have compared the current financial crises with those which have occurred in the past and considered some of the factors which influence and trigger banking crises. These include the asset price bubbles, government, banking management and the general public. We can see that crises are the product of unfavourable combinations of unexpected events in the market place, and are difficult to predict.

This final blog will briefly look at what is being done to recover from the financial crises and how we can avoid similar situations in the future. We have seen recent improvements in the markets. Our economy will recover, and be resilient to housing market crashes in the future and the problems associated with having banks which partake in high levels of risk shifting. However it is inevitable that there will be other crises, triggered by new combinations of harmful events. Like the human body responding to infection, it will remember how to produce the financial antibodies to fend off this crisis, but is still vulnerable to new unknown diseases.

Reinhart and Roghoff (2009) look at the aftermath of recent and historical banking crises around the world. They highlight that during a financial crises the real equity price decline crash the average historical crises period is 3.8 years, that is from the start of the economic downturn until the market is considered to be recovered. This follows an average 55.9% decline in asset prices. This paper also looks at individual housing market crashes. The average recovery time for a housing market crash is found to be over 6 years. With this in mind we would expect our current financial crises to be winding down soon, however due to the size and global contagion of the great recession it is taking longer to recover.

We are seeing signs of improvements however, markets are very slowly recovering and also an increased public calling for stronger banking regulation will put pressure on the banks to be more careful in the future. We have witnessed the government’s crunch on spending, in a bid to reduce the debt, and also the public anguish created by the decrease in jobs and increase in prices and decrease in public services. Of course these actions, however unpopular are necessary to try and restore our economy.

In a perfect world a combination of responsible borrowing and lending, good regulation and banking management would be able to remove the risk of bank failures, but this is not realistic. I believe that financial crises are like any natural disaster, you don’t know when or where they will happen next, all you can do is be prepared for the worst.

FIN

Reinhart C. M. & Roghoff K. S. “International Aspects of Financial-Market Imperfections, The Aftermath of Financial Crises” American Economic Review: Papers & Proceedings 2009, 99:2, 466–472

Post-Crisis Consumer Behaviour

Consumer Behaviour

So far we have looked at bubbles and government lending and how they influence banking crises. This blog will look at what part consumers and popular media play in banking crises. Banking panic occurs when depositors lose faith in their bank which they believe is going to fail, putting their deposits at risk. In theory this seems irrational as most general customers have limited knowledge about the banks dealings, and most banks offer deposit insurance to reduce the risk of anyone losing their entire deposit. With this in mind it can be shown that in times of economic uncertainty, such as in the early stages of a recession, bank customers are likely to run a bank when they hear bad new about their bank from the media or other customers.

Gorton (1988) investigates the reasoning behind banking panics. He performs empirical tests to find underlying variables to explain why panics occurred. The tests looked at the variables which influenced a depositors perception of the riskiness of a bank, which is known to change depending on the state of the economy. He finds a positive relationship between banking crises and the variables which often forecast a recession, suggesting that in time of likely recession depositors are more likely to lose faith in their bank and panic.

In 2007 Northern Rock was the first bank to be subject to a run for over 150 years. The bank did not have the reserves to meet the increasing number of customer withdrawals, forcing them to liquidate assets to raise funds, and eventually making them bankrupt. What aggravated thed situation was the fact that Northern Rock had previously borrowed from the BoE to ease some of its debts, a move not uncommon in modern banks, however this information may have helped cause panic among depositors, resulting in a run on the bank.

In hindsight bank runs seem very avoidable. Fear of losing their investment is a reasonable excuse to withdraw, however I get the impression that banks runs are a case of depositors shooting themselves in the foot. When an individual is standing in a line a mile long outside a bank, do they not realise that running the bank will inevitably drain all its reserves and effectively ruin a business which they have invested in? Banks offer deposit insurance to try and avoid these situations, but if the customer is not properly informed, there is no reason to expect that they will not run to withdraw when they think they are going to lose their deposit. There is also a moral hazard issue with deposit insurance, removing the banks liability results in irresponsible banking strategies. 

Diamond and Dybvig 1983 look at banking deposit contracts, both insured and uninsured demand deposit contracts and explored ways in which banks can share risk between customers and reduce the risk of bank runs by careful management. Their findings suggest that there is a optimal contract which balances risk sharing and liquidating assets to prevent runs. These contracts also include Suspension-of Convertability clauses which prevent bank runs by allowing the bank not to return a customers deposit. This needs to be carefully managed as these precautions to avoid bank runs could lose them customers in the long run who want their deposits assured.

Gorton, G. 1988, “Banking Panics and Business Cycles”, Oxfort Economic Papers 40, pp.751-781 Diomond, D.W. & Dybvig, P.H. 1983, "Bank Runs, Deposit Insurance, and Liquidity", The Journal of Political Economy, ,pp.401-419.

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Deal Wi' It and Move On

It’s easy to blame the government for a lot of things, and often rightly so. I guess the government is the most obvious link between the public and corporations who are affecting the state of the economy. However in recent times governments have little influence on how banks behave.  

It is government debt which will really affect the general public. In the aftermath of a market crash the government needs to get its debt under control. This involves raising taxes and reducing spending, both which affects the general public. It’s easy to see why people would point fingers at the government. So why do governments continually bail out banks which they know are in trouble? 

Governments generally bail out banks which get in trouble and run out of reserves generally because it is beneficial to the economy for them not to fail. In a forum paper Fama and McCormick (2009)* explains the theory behind government bailouts and explains why they are acceptable in modern macroeconomics. They say that there is an equilibrium between total global investments and saving which has to hold, however for any given country it is possible for investments and saving not to balance. Government policy will affect this equation and for a bailout to work it needs to satisfy the countries need for savings and investments. Problems with bailouts arises when the increase in government debt absorb potential funds for private investment, further hurting the economy.

Reinhart and Rogoff (2009)* highlight that following a major collapse, government debt skyrockets. This is part due to costs of bank bailouts and recapitalization, but more due to the collapse of tax revenue caused by the decrease in across the board spending i.e. the actions taken to reduce the effect of the crises are helping increase government debt.

In general government bailouts do not result in financial crisis. Crisis occur when bailouts are not managed well. This would suggest that politicians are to blame for financial crises. Gordon Brown took a lot of heat from his piers for the way he dealt with the 2007 crisis. Perhaps rightly so as he was the man with the power and the knowledge to do something about it but failed.

* Fama, E. & McCormick R.R. 2009, Bailouts and Stimulus Plans. Fama French Forum, University of Chicago.

*Reinhart, C.M. & Rogoff, K.S. 2009, The aftermath of financial crises.

Bubbles

What causes bubbles? Bubbles are due to high volumes of inflated asset prices, caused by valuations based on investor expectations. These over-priced stocks have strayed from their intrinsic values and inevitably will be subject to significant price reversals at some point in the future, i.e. the bubble will burst. 

There have been many different explanations for bubbles forming in the marketplace. The main reasoning is irrationality in investor behaviour and mispricing or stocks. 

Allen and Gale (2000) suggest bubbles are an agency problem in the banking sector, the result of risk shifting between investors and banks (borrowing form banks to invest in risky stocks). They characterise bubbles as a 3 stage process;

1)      Financial Liberalization resulting in expansion of credit and accompanied by an increase in the price of market assets such as real estate or stocks. These price rises continue for a set period of time. This is how the bubble inflates.

2)      The bubble bursts and asset prices collapse suddenly, often in the space of a few days, leaving investors not a lot of time to react.

3)      Firms and agents who have borrowed to finance the purchase of inflated assets lose out, often defaulting on their loans. The volume of these defaults has a rippling effect through banks often leading to financial crises.

*Allen, F. & Gale, D. 2000, "Bubbles and crises", The Economic Journal, vol. 110, no. 460, pp. 236-255

Those Who Forget the Past....

OK let’s start. First we need to understand what a crisis is. If we look at a plot of  stock market prices  we can see cyclic price reversal over the course of time, going back as far as records can show. This is the result of pricing bubbles, and the subsequent bubble burst. This does not however define a crisis.

But what turns a bubble bursting into a catastrophic fallout?

There have been many major crises in the last few hundred years which warrant mention. The Great Depression (1929 US Stock market crash), the 1997 Asian Crisis (Collapse of the Thai Bhat), the Eurozone Crises (European government debt) and the Current global recession (2007 US housing market crash) are to name a few. Although it can be seen that all these involve different catalysts (stocks, real assets, currency etc.) there is a common trend which drives all crises. That is investors and banks borrowing and lending at an unsustainable level.

Let’s consider the most recent current economic crises and what caused it. 

This was the result of the housing bubble bursting in 2007 . Banks had issued high volumes of morgages on  properties when the price was increasing, the bubble burst, properties became worth-less, and there was in increase in the number of defaults on loans and the cost of loans went up. The real problems arose when it was made obvious that the banks couldn't sustain their levels of debt  This cost the banks as they had given out more loans than they cost afford to, resulting in defaulting banks, bankruptcy and the need for government intervention. The scale of these problems was unprecedented and unexpected, which is essentially the cause of the crises. What followed was the collapse of one of the four biggest investment banks, Lehman Brothers, and recession which was very difficult to recover from due to the fallout of the banking problems. 

Claessens et. al.(2010)* highlight the similarities and differences between this financial crises and those which have occurred in the past. I have summarized them below;

Similarities to Past Financial Crises	New Conditions to financial Crises
Sharp asset price increase	New, more sophisticated financial intermediaries and instruments meant financial markets where more tightly interconnected. This affected the severity of the oncoming financial crises.
Credit Booms which led to excess debt burden.	Large reliance on wholesale and short term funding in many advanced countries and emerging markets created systemic fragility.  A small shock to the system triggered severe liquidity shortages.
Build-up of marginal loans and systematic risk.	Exposure to US orientated assets allowed problems to spill over into other global markets.
House price sharply rose, reminiscent of the last big 5 financial crises.	Troubles intermediaries were forced to deleverage and the crises spread through the ‘common-lender effect’
Growth in credit coincides with increase in economic activity, current accounts deteriorate with this change in spending .	Unprecendated large household sector financial problems played a more significant role than in the past.
Increase in leverage and declines in lending standards, level of defaulting loans increased, causing problems for the banks.	A feedback look of falling home value and credit shortages set off a trend of reduced consumer spending. This resulted in declines in corporate profitability and staff layoffs, increasing unemployment.

Why was this allowed to happen? Could we not see that banks where operating on the edge? Why is there not adequate regulation to avoid these sorts of problems? What roles does the government play in monitoring the banks? In the next week I will look at Government policy and their role in financial crises.

 Although the western world is suffering difficult financial times, many places around the world are prospering. A good way to illustrate this is by looking at the worlds tallest buildings, which are generally a flagship for wealth. Today only two of the worlds 10 tallest buildings is in the West (Trumph tower, and the Willis building in Chicago). The rest are all in Asia, five of which are in China. This swing of wealth in recent times shows how countries can emerge from financial difficulties in a relatively short period of time. Perhaps a nice reminder that things are not a bad as they seem.

*Claessens, S., Dell’Ariccia, G., Igan, D. & Laeven, L. 2010, "Cross‐country experiences and policy implications from the global financial crisis", Economic Policy, vol. 25, no. 62, pp. 267-293

Welcome to my Blog

Bank Manager - “So what experience do you have in Banking that would make us want to employ you?”
Adam Sandler - “Well, I have a bank account and I like money.” The Wedding Singer 1998.

I think Adam Sandler sums up in sure what a lot of people understand about banking quite well. Today’s media is saturated with stories about the current financial crisis facing the UK, often pointing fingers individuals who should be blamed for the demise of many of our biggest banks, and what they think the problems are that affect our country.

   

Personally I know very little about an Institution which predates 2000BC and influences all aspects of our society, from general public services to individual consumer decisions. This makes it very difficult for me to express an opinion on any issues which involve the UK finance industry.  

Since 2007 the UK has been suffering from recession, which was the consequence of a global banking crisis. This problem affects all of us. Unemployment, housing price increase, government tax increases are only a few ramifications of the global banking crisis which is plaguing the general population.

But what is responsible for these problems? How is this related to the other great financial crises which have happened in the past? And how is it going to be solved?

Over the next 5 weeks I will research and share some insight into the history of financial and banking crises, the theory behind financial crises, and critically assess literature from academic and professional reports in order to try to gain my own understanding of this issue.

I hope you find this blog interesting.
Thanks for reading

Andrew Gilmer

Queens University Belfast

On a lighter note, here's some South Park