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May 14, 2003

What Triggers a Systemic Banking Crisis?

A systemic banking crisis is one in which all or substantially all of the banking capital in a country is wiped out. You might have expected that such crises would be rare events, but researchers at the World Bank have compiled a listing of 113 such crises in 93 countries during 1975-1999.
David Beim

A systemic banking crisis is one in which all or substantially all of the banking capital in a country is wiped out. You might have expected that such crises would be rare events, but researchers at the World Bank have compiled a listing of 113 such crises in 93 countries during 1975-1999. They are nearly universal, hugely expensive and should be a public policy issue of the first magnitude. Never before in history have banking crises been so frequent or so devastating.

In general, such crises go through two phases. In the first or silent phase, banks make a great many bad loans, for any number of reasons alone or in combination, and consequently develop a large number of non-performing loans (NPLs) on their balance sheets. Generally these are not publicly acknowledged nor reported; they simply build up, quietly destroying the banks' capital base. Then in the second or critical stage it is publicly acknowledged that the banks are insolvent and agents take action to remedy the situation as best they can.

The two-phase structure arises because governments typically protect banks by guaranteeing their deposits and often by concealing the depth of their problem loans. In principle, a government can go on doing this for a very long time - so long as the government's credibility is not in doubt, people will continue to hold government-guaranteed deposits. So the question arises, why does the first phase ever give way to the second? What finally triggers the crisis? This is an important question for those eager to spot the next crisis or to assess the financial stability of countries.

The author's answer is that any one of four agents can trigger the crisis: depositors, government, external lenders and intergovernmental financial institutions, because each is a supplier of bank funding. To put it simply, the crisis is triggered when a significant funder withdraws support. This paper reviews the entire list of 113 crises and classify them according to their triggering events. Depositors can trigger the crisis in those situations where the government's deposit guarantee is either flawed or loses credibility. The government itself may trigger the crisis at any significant regime change, so that the previous regime can be blamed for the problem. External lenders can trigger the crisis whenever the banking system is significantly dependent on external funding; for example, the East Asia crisis of 1997-98 can be viewed as a run on Asian banks by international banks. Finally, intergovernmental financial institutions such as the World Bank and IMF (which often work in concert) can trigger the crisis for any country significantly dependent on their funding.

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David Beim

"What Triggers a Systemic Banking Crisis?"

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