The Causes of Financial Crises: What We Know and What We Can Do About It

The Causes of Financial Crises:What We Know and What We Can Do About It

Antoinette McKainChief Executive OfficerJamaica Deposit Insuance Corporation (JDIC)Global Association of Risk Professionals

October 2016

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

3 | © 2014 Global Association of Risk Professionals. All rights reserved.

Definition of Financial System Crisis

A financial system crisis can be considered to exist where there is a severe loss value of the

assets of corporate and financial institutions; loss of access to funding; and significant

diminution of their customer’s trust - to the point of endangering the financial system’s

sustainability.

The systemic crisis occurs where financial institutions’ or other corporates business are so

interconnected with that of other each other and /or the performance of the macro economy such that

the insolvency of one so adversely impacts either the balance sheets or perception of the others

causing contagion effects where short term funding is pulled from the institutions or becomes

unavailable.

A pure banking system crisis can be caused by a run on a bank where depositors fear the loss of their

funds and which so adversely affects the confidence of the depositors of other banks that they in turn

run on their banks. The business model of banking being fractional , the institutions cannot withstand

the run and consequently can go into insolvency.

Individual corporate entities and financial institutions can experience insolvency and be closed in the

course of ordinary commercial activity with the development, growth and contraction of markets.


Causes of Financial System Crises

Unlike what is often believed, when the memory of a financial crisis wanes, they

have been relatively common, in the context of their impact on national and global

economies.

One of the more modern financial crises was the Wall Street Crash of 1929 and the Great Depression

of 1933 in the United States. The analysis of this became important again because of the recent

Global Financial Crisis of 2008 and 2009. The latter has been compared in terms of the magnitude

of the impact to the global financial system. Comparisons allow for the assessment of the respective

policy actions of the monetary and fiscal authorities in crisis periods to better identify and manage

future ones.

Financial crises have been recorded since the 17th Century. The recurring causes have been:

- Boom and bust cycles (bubbles)

- Economic recessions

- Shortsighted monetary and fiscal policies

- Financial deregulation and liberalization

- Poor and unresponsive regulatory oversight

- Inexperienced management of financial institutions and where there are incentives for excessive risk taking,

- Inadequate risk identification, management and controls

- The herd mentality and “irrational exuberance” of market participants who overestimate existing and future

market values in particular after innovations in technology


Important Rudiments of The Bubble Phenomena

The definition of an economic bubble can be restated in a number of ways but the

basic conditions are appropriately defined in a Financial Times Article:

“A bubble is considered to exist where the price of an asset that may be freely

exchanged in a well-established market first soars then plummets over a

sustained period of time at rates that are decoupled from the rate of growth of

the income that might reasonably be expected to be realized from owning or

holding the asset.”

Colloquially it is argued that bubbles emerge because each trader hopes to pass the asset on to

some less rational trader (greater fool ) in the final trading rounds. Similar patterns emerge when

investors have no resale options and are forced to hold the asset to the end. Bubbles are due to the

combination of declining fundamental value – which leads to mispricing-and an increasing cash-to-

asset-value ratio – the overvaluation. [Bubbles, Financial Crises, and Systemic Risk – Brunermeier

and Oehmke – Handbook of Economics and Finance, Volume 2]


Selected Crises –All Kind of the Same

Wall Street Stock Market Crash 1929

The pre-crisis period was characterized expansionary monetary policy actions resulting in surplus

growth fueled by real estate and stock market growth and significant innovations in electrical and

transportation technologies. Heavy stock market activity fueled even more investment making these

investments seem more and more valuable. Stock purchasing was also made cost effective through

the ability for margin purchases, then borrowing the price of the stock at low interest rates to finance

the purchase with the securities used as collateral for the loan. When prices rose dividends were

available. Any potential drop in the price of stock was covered by the expectation that the stock prices

would rise again. There was the incentive to mimic the behavior of others in the purchasing of stock

(the herd mentality). Even when the market dropped sharply (September 3, 1929) it rose again even

stronger and a precipitous decline began again by October 21, 1929. There was so much margin

purchases by 1929 the debt was $6 billion. By the end of the market decline $30 billion had been

lost. This was two times the national debt. The country slipped into the Great Depression.

[Summary from “The Wall Street Crash,” EyeWitness to History, www.eyewitnesstohistory.com

(2000). Reference Allen, Frederick, Lewis, Since Yesterday: the 30’s in America (1972)].

The Great Depression was characterized by high consumer debt, where badly regulated markets

permitted the writing of bad loans and lack of new growth industries which caused a downward

economic spiral. The period was characterized by bank runs. By 1933 nearly 11,000 of the 25,000

banks had failed and 9 million savings accounts were lost. In addition the decision was for tight

monetary policy reducing the potential for fuelling a speedy recovery.

http://www.eyewitnesstohistory.com/



The dot com bubble 2001

The early 1990’s was characterized by the start up of several internet based companies referred to as

dotcom. Companies could raise the price of their stock by adding the prefix “e-“ or the suffix “.com”

There was therefore a combination of rapidly increasing stock and market confidence that the

companies would turn future profits; speculation and available venture capital that would create an

environment where investors overlooked the traditional P/E ratios, basing confidence on technological

advancement. These companies could make a great deal of money through the stock markets

without actually showing a profit. The “Silicon Valley” effect was sought to be replicated in other parts

of the United States outside of Silicon Valley and in Europe.

It is argued that much of this speculation was facilitated by loose monetary policy actions by the

Federal Reserve Bank of the USA, often referred to as Greenspan’ Bubbles.

It is also argued that the unnaturally rapid growth in the dotcom internet companies was also fuelled

by tax policies on capital gains tax cuts under the Taxpayer Relief Act of 1977, as growth companies

would not ordinarily pay dividends.



Mexican Financial Crisis of 1994 – 1995

In the second half of 1980 Mexico undertook large scale reform and deregulation of its economy

consistent with economic reforms made conditional on multilateral support. Trade liberalization and

capital flows were seen as integral to Mexico becoming a part of the developed world. This new

approach came out of a balance of payments crisis and caused the Mexican Government of the day

to seek a less protectionist development model.

There was deregulation and privatization of a number of government owned industries. Foreigners

were now allowed to invest in the Mexican Stock Market and Mexican companies began to finance

expansion through foreign currency loans.

The Mexican Peso was pegged to the US dollar to encourage borrowings on the international capital

markets and to facilitate expected trading with the United States in particular. It was expected that in

order to deal with inflation monetary policy would fluctuate according to balance of payments

considerations. There is a presumption of macroeconomic stability and investor trust in the currency.

The largest banks were privatized, facilitating a credit boom. Unfortunately the privatization was an

inefficient process with the Government concentrating on the highest bidders without taking into

account experience of the bidders except some groups with experience in the stock market. The

privatized banks then began competing for larger market share making risky mortgage and consumer

loans and borrowed in US dollars to make some loans.




International best standards were not adopted simultaneously and the risks in banks balance sheets

were underreported . Banks would lend or buy securities without keeping proper reserves against

losses:

- Risky loans were underreported and accounting rules allowed that where loans were non-performing only

the interest was counted as being in arrears.

- In addition bank regulators were inexperienced and lacked sufficient legal authority and autonomy to

properly supervise the banks. [Musacchio, Aldo. “Mexico’s Financial Crisis of 1994 – 1995” Harvard

Business School Working Paper, No. 12 -101, May 2012]

Investors now saw Mexico as a great place to invest with higher interest rates (than the US) and

safety. A bubble effect was created as investors moved money to Mexico for the purchase of

Mexican assets causing the value of these to rise along with the high returns to investors. The

actual growth rate of the country did not reflect this. In 1992 the growth rate was 3% but in 1993 it

was approximate 2%. Households were not increasing savings and the country’ s GDP fell to 15%

by 1994 down from 18% in 1989 before the lead up to the crisis. Foreign borrowings were not

increasing the wealth of the country or its people.




The bubble burst in 1994 when in-fighting with rebel groups and a series of political assassinations

caused investor disquiet. Along with this US interest rates began to rise and the dollar peg no longer

had investor confidence. As easily as capital had come in it left notwithstanding Government efforts

of issuing debt indexed to the value of the US dollar.

With investors leaving the country interest rates began to rise causing defaults from consumers and

businesses. A banking crisis ensued with the Government bailing out the Mexican banks and the US

and multilateral agencies having to come to Mexico’s aid.



Jamaican Financial Crisis of 1996

Liberalization of the Jamaica economy started in1986 in an attempt to create an environment more

conducive to efficient financial intermediation and the strengthening central bank ability to influence

money and credit variables. Interest rate policies reform and the development of money and capital

markets were also two areas of focus at the time.

There was rapid asset expansion and deepening of the financial system with conglomeration among

banks and non-bank operations. By the end of 1997 three large banks accounted for 75 percent of

the banking system which assets accounted for 50% of the total assets of the banking sector. Non-

banks also increased from 8 in 1985 to 25 in 1993.

Financial institutions conglomeration was usually undertaken by insurance companies which were

taking advantage of financial arbitrage where there was beneficial cash reserve ratio differential

relative to banks. These conglomerated entities also branched out into the acquisition of

agricultural and tourism ventures, increasing risk and contagion causing the entire sector to become

vulnerable to financial instability.

Commercial bank balances grew 55 per cent from 1993 to 1995 and the category referred to as

merchant banks grew by 200 percent. Foreign currency loans increased by over 100 percent each

year from between 1992 and 1994.



Jamaican Financial Crisis of 1996

The liberalization was also characterized by rapid depreciation of the exchange rate moving form

US$1.00:$7.90 to US1.00:J$27.38 in less than two years. Whereas private sector credit grew by

almost 70 percent in 1993 it slowed to 25 percent growth in 1996 and actually declined in 1998. The

flaws began to show up with declining profitability of the banking sector and a reduction on the return

on assets of the commercial banks and capital adequacy ratios then 8 percent by international

standard was below 3 percent in Jamaica.

These problems were also reflected in the non-performing loan ratios (NPLs’). NPL’s as a

percentage of total loans in commercial banks grew from 7.4 percent in 1994 to 28.9 percent in 1997

with evidence of high levels of problematic related party loans a significant portion of which was

associated with relationship between the insurance companies and commercial banks. In the early

1990’s life insurance companies aggressively marketed short-term equity-linked products by offering

high rates of return.

Although there was legislative reform in 1992 the rules did not address consolidated supervision and

whereas there was no requirement for senior bank officers to have any special educational

background or actual competence to run a bank. There was no expressed powers for either the

Minister or the regulator to deal with a bank that had, or was about to become insolvent. The local

banks were characterized by poor management.



Japanese Financial Crisis 1990s

Japan is considered a developed country and in the 1970’s and 1980’s was considered one of the

strongest in the world. In the middle 1980’s economic growth was above trend with near zero

inflation. The country’s risk premium was low and marked upward adjustment in growth

expectations, boosting asset prices and fueling rapid credit expansion.

In the second half of the 1980’s there was financial liberalization and deregulation which saw:

relaxation of interest rate controls and capital market deregulation. Price competitiveness reduced

banks’ risk-adjusted interest margins causing them to seek expansion through assuming riskier

segments in their loan portfolios. Consumer lending and lending to the real estate market and to

small and medium sized enterprises increased sharply. Credit standards were loosened while

banks focused on market share with increased risk as lending was based on collateral rather than

on cash flows. It was noted that banks’ preoccupation with market shares was a vestige of the

interest rate control regime where banks’ lending spreads were more or less fixed and they derived

most of their income from their interest earning. This meant that their outstanding loans would

determine the size of their net income.




The collapse of the bubble was described as occurring in 1990 when the Japanese stock markets

collapsed having now become overvalued from the previous period of expansion and the Bank of

Japan had successive increases in its discount rates. To contain rising land prices, the Ministry of

Finance introduced guidelines limiting total bank lending to the real estate sector. This caused a

leveling off of asset growth in banks. There was a subsequent slowdown in economic growth,

together with drastic declines in stock and real estate prices which weakened the health of banks

and other financial institutions. The weakening, among other things saw the quality of loans to the

real estate sector deteriorated rapidly with the value of collateral eroding; and the decline in the

value of banks’ equity holdings putting pressure on bank capital. With the deceleration in economic

growth the ability of debtors to continue to service their loans was greatly reduced.

With the consequent downgrading of Japanese banks by the ratings agencies their marginal costs

of funding rose above those of many of their borrowers. This, together with the incremental lifting of

restrictions on the access of Japanese corporation to the domestic and euro bond markets, led to

acceleration in bond issues which put further pressures on banks.

Corporate governance practices of banks was also poor where there existed a symbiotic

relationships between shareholder, employees and managers and governing boards causing self

interest to cover up the impending failures of banks. Bureaucrats from the Ministry of Finance and

the Bank of Japan on retirement would take senior positions in banks resulting in conflict of interest

and slow action by supervisor.




• In terms of compliance with international best practice standards, Japan had fully implemented the

Basel Capital Accord for the fiscal year 1992 but the international standard of 8 percent for capital

adequacy was only applied to banks with international operations while regional banks were

permitted to hold only 4 percent. It was noted despite the sharp decline in stock prices many banks

could be deemed to meet the Basel capital standards partly because book values of the stocks

were well below the market values. Loan loss classification was designed not to send signals to the

markets about the performance of banks and consequently provisioning for problem loans and loan

losses was poor.



Icelandic Financial Crisis 2006-2008

A small economy which had relied primarily on financial services where financial institutions were

mostly nationally owned. There was financial sector deregulation in the early 1990’s. The banking

sector was dominated by 3 main commercial banks and a large fringe of savings banks and pension

funds that offered other financial services. After privatization of the banking sector in 2003, assets

increased from 100 percent of GDP to 1000 percent of GDP with the take off of internet banking in

2006. They used internet banking to attract foreign deposits using the cost savings from on-line

banking to offer higher savings to customer. This level of deposit base and heavy concentrations was

seen as the Icelandic banking systems key fragility.

By 2006 ratings agencies had noted high levels of debt and large exposures of financial institutions to

house prices, share prices and the exchange rates with the Krona and share prices falling by about

20 percent. From as early as 2006 Icelandic economy had been downgraded by the ratings agencies

because of its current account deficit with rising global interest rates and tightening liquidity. Iceland

had begun to see large capital outflows which had repercussions throughout the world as traders

needed to liquidate profitable positions to fund Icelandic losses. By the onset of the global financial

crisis in 2008 the regulatory authorities had taken control of the largest bank as a rescue measure

and legislation passed allowing the government to intervene in Iceland’s banking system.


Global Financial Crisis 2008

IMF research on the cause of the Global Financial Crisis has noted four

underlying conditions:

- Particular structural changes within the macroeconomy such as economic and financial

liberalization and/or weaknesses in financial regulation where financial innovations are not

adequately understood or regulated

- Ensuing asset price bubbles, credit booms and economic expansion not supported by

underlying real sector fundamentals

- Institutional weakness in governance of financial institutions and breakdown in their delegated

monitoring functions

- Too slow regulatory responses. Internationalization of financial institutions and systems provide

channels for these crises to cross borders and assume global proportions


What We Will Do About Averting Crises

Post Crisis International Standards

Prudential Standards

– Basel III

• Minimum Capital Requirements - tighter capital requirements in comparison to Basel I and Basel II

• Countercyclical Measures - new requirements with respect to regulatory capital for large banks to

cushion against cyclical changes on their balance sheets

• Leverage and Liquidity Measures - safeguard against excessive borrowings and ensure that banks

have sufficient liquidity during financial stress

• Counterparty Credit Risk Exposures

• Risk‐Based Regulatory Capital Framework for Securitization Exposures

Financial Stability Board Total Loss Absorbing Capacity (TLAC) for global systemically

important banks - Failing G-SIBs will have sufficient loss-absorbing and recapitalization capacity

available in resolution for authorities to implement an orderly resolution that minimizes impacts on

financial stability, maintains the continuity of critical functions, and avoids exposing public funds to

loss.



Macro prudential Policies

- IMF Research notes that having recognized the causes of crises is now growing consensus of the

need for macro prudential policies and regulation which has financial stability objectives and that

they should work with micro prudential policies and monetary policies and fiscal policies to deal

identify and deal with systemic issues.

- Macro prudential policies should also address the issues in competition policy. These policies

recognize that there are key externalities within an economy and the financial system that can

lead to excessive pro-cyclicality and the build up of systemic risk which might occur from micro

prudential regulation and from monetary policy applications. These externalities can be

described as those relating to:

• Strategic Complementarities - the interaction of banks and other financial institutions and agents

and which cause build up of vulnerabilities during the expansionary phase of financial cycle

• Credit crunches and fire sales that arise when there is a generalized sell-off of assets cause

decline in asset prices and drying up

• Interconnectedness caused by the propagation of shocks from systemic institutions or financial

market or networks (contagion)



Macro prudential Policies

- Some macro prudential policy tools include caps on loan to value ratio, limits on credit growth and

other balance sheet restrictions and counter cyclical capital and reserve requirement and

surcharges and Pigouvian levies. The costs of these tools need to be analyzed.

- Macro prudential policy and monetary policy must work synergistically or they can negate the

effectiveness of each other. Monetary policy concerned with price stability and liquidity while macro

prudential policy focused on systemic stability might not be immune from political pressures and

time inconsistencies. The authorities for the use of the tools must be clearly defined in law.

- Systemic Risk Measurement

- There should be methodologies for systemic risk measurement which should identify individually

systemically important financial institutions (SIFIs) that are so interconnected and large that they

can cause negative spillovers on others. In addition it should identify institutions that are systemic in

the context that they are part of a herd. The second point is important because of a group of 100

institutions that act in a correlated fashion can be dangerous to a system as one large entity. This

also means that splitting a SIFI into 100 smaller institutions does not stabilize the system as these

100 smaller ‘clones’ continue to act in a perfectly correlated fashion. Source: “Bubbles, Financial

Crises, and Systemic Risk: Markus K. Brunnermeier, Martin Oehmke”



The IADI Core Principles for an Effective Deposit Insurance Systems, November 2014 states:

“Resolution” refers to the disposition plan and process for a non-viable bank. Resolution may include:

liquidation and depositor reimbursement, transfer and/or sale of assets and liabilities, the establishment

of a temporary bridge institution and the write down of debt or conversion to equity. Resolution may also

include the application of procedures under insolvency law to parts of an entity in resolution, in

conjunction with the exercise of resolution powers.”

The Financial Stability Board (FSB) Key Attributes for an Effective Resolution Regime, October

2014 states:

“The objective of an effective resolution regime is to make feasible the resolution of financial institutions

without severe systemic disruption and without exposing taxpayers to loss, while protecting vital

economic functions, through mechanisms which make it possible for shareholders and unsecured and

uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.”


The Banking Services Act 2014, now gives the Supervisor, in addition to the general prudential

regulatory powers over banks, power over bank holding companies and the powers to take prompt

corrective action where capital ratios are compromised below prescribed limits. These actions include

taking temporary management of the financial institution and in the case where non-viability of the

institution is determined the Minister with responsibility for finance can through the Accountant General

of Jamaica vest the shares of the institution to undertake a private sector solution for the resolution of

the institution.

The Central Bank through the Bank of Jamaica Act now has the express power for financial stability and

for macro prudential regulation and emergency liquidity funding for the purposes of maintaining financial

stability.

Some New Aspects of the Jamaican Regulatory Framework


THE CAUSES OF FINANCIAL CRISES: What We Know and What We Can Do

About It

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THE CAUSES OF FINANCIAL CRISES: What We Know and What We Can Do

About It

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The Causes of Financial Crises: What We Know and What We Can Do About It

Economy & Finance

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