Analysis of recent financial crises in both developed and less-developed countries indicates that they are not exclusively (or even mainly) a problem of the rules being wrong (see, for instance, Brealey, 1999; Corsetti et al., 1998; and Lindgren et al., 1996). Five common characteristics have been: weak internal risk analysis, management and control systems within banks; inadequate official supervision; weak (or even perverse) incentives within the financial system generally and financial institutions in particular; inadequate information disclosure; and inadequate corporate governance arrangements both within banks and their large corporate customers. An unstable or unpredictable macroeconomic environment is not a sufficient condition for banking crises to emerge: it is an illusion to ascribe such crises to faults in the macro economy alone. The fault also lies internally within banks, and with failures of regulation, supervision and market discipline on banks.
While each banking crisis has unique and country-specific features, they also have a lot in common. Several conditions tend to precede most systemic banking crises. A period of rapid growth in bank lending within a short period, and unrealistic expectations and euphoria about economic prospects, often form the backdrop to subsequent crises. These are frequently aggravated by sharp and unsustainable rises in asset prices (part of euphoria speculation), which lead to unrealistic demands for credit and a willingness of banks to supply loans. In the process, inadequate risk premia are often incorporated in the rates of interest on loans. This is a version of the standard Fisher and Minsky thesis: debt accumulation in the upswing leading to problems for banks in the downswing.
During the period of substantial growth in bank lending, concentrated loan portfolios (often with a high property content) often emerge. This is partly because, in periods of rapid asset-price inflation, property appears to be either an attractive lending proposition or a secure form of collateral against bank loans. However, it is in essence speculative lending and the bubble bursts when the overcapacity in the property sector becomes evident. This means that, while individual project risks may be accurately assessed, overall portfolio risks are often not. It is also the case that, in periods of rapid growth in bank lending, insufficient attention is given to the value of collateral, most especially in periods of asset-price inflation.
Banks do not always operate as totally independent agents and in many crisis countries bank decisions have involved political influences and insider relationships. Such government involvement in lending decisions has the effect of weakening incentive structures, and eroding discipline on lenders through the perception of an implicit guarantee.
The origins of crises have been both internal to banks and external. To focus myopically on one side misses the essential point that systemic crises have both macro and micro origins. In the final analysis, weak internal risk analysis, management and control systems are at the root of all banking crises. Instability elsewhere should not conceal, or be used to excuse, weaknesses in this area of bank management.
It is also the case that banking crises often follow major changes in the regulatory regime which create unfamiliar market conditions. Periods of rapid balance sheet growth, most especially when they occur after a regime shift and in a period of intense competition, almost inevitably involve banks incurring more risk. There are several reasons for this: banks begin to compete for market share by lowering their risk thresholds; risks are under-priced in order to gain market share; internal control systems tend to weaken in periods of rapid balance sheet growth; growth itself generates unwarranted optimism and a growth momentum develops; and portfolios become unbalanced if new lending opportunities are concentrated in a narrow range of business sectors. When, as is often the case, fast-growth strategies are pursued by all banks simultaneously, borrowers become overindebted and more risky, which in turn increases the vulnerability of the lending banks.
Was this article helpful?
How to profit from the global crisis and make big bucks big time! The current global financial crisis has its roots embedded in the collapse of the subprime markets in the United States. As at October 2007 there was an estimated loss on the subprime market of approximately 250 billion. If you want to come out on top, you have come to the right place.