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Banking Crises

Banking Crises. Regulation & Performance Economics 102 Winter 2002. Early Regulation. Scams, Bank failures ==> bank licensing from early 1800s Minimum capital requirements Attempt to exclude criminals But US had 20,000+ banks In much of midwest, branch banking prohibited

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Banking Crises

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  1. Banking Crises Regulation & Performance Economics 102 Winter 2002

  2. Early Regulation • Scams, Bank failures ==> bank licensing from early 1800s • Minimum capital requirements • Attempt to exclude criminals • But US had 20,000+ banks • In much of midwest, branch banking prohibited • Interstate banking prohibited • Federal Reserve System from 1913 • Smooth interest rate swings • Support faith in money, quell banking panics • Foster national market

  3. Great Depression • Big swings in prices: deflation • Debtors hurt, many default • Real GDP fall likewise leads to defaults • Banking “panic” • Fears lead to bank runs • 9755 banks failed in 1929-33 • FDR declared bank holiday in March 1933 to stop panic • Sum • Illiquidity issues • Insolvency issues

  4. Regulation • Promote “sound” banking practice • More below... • Depositor insurance (FDIC, 1933) • Restores confidence • But insurance has side effects • Moral hazard • Encourages risk taking • Heads I win … tails you lose

  5. Safe Banking • Sound practice • Glass-Steagall (1933): segment services • Insurance - banking - securities - underwriting • NOW DEFUNCT cf. Enron issues • Bank supervision (gradual from 1800s, state & federal) • Inspection • Case study: Bank of Tokyo NY, 1979 • Regulation Q (1933) • Prevent competition for deposits • Help guarantee margins

  6. Banking Crises • Structural change is the enemy of sound banking • Managing risk is undermined • Mix of products / operations undermined

  7. 1970s shifts • 1970s • Inflation rose ==> disintermediation • MMMFs developed • Donahue and money market [mutual] funds • Incentive to pull money from term savings accounts • Also could buy bonds directly …. such as I did. • Regulation Q broke down [for S&Ls from 1982] • Banks were freed to pay market interest rates

  8. S&Ls • Savings & Loan Institutions • State-chartered banks (initially) • Restricted to local residential real estate ca. 1936 • No geographic or industry diversification • Typical product fixed-rate 30 year mortgage • Core of business • Borrow short • Lend long • “Maturity transformation”

  9. Demise of S&Ls • 30 year mortgages • Collecting 4% • Short-term deposits • Paying 10% • Entire sector rendered insolvent

  10. Further deregulation • So rechartered as federal institutions • Freed S&Ls to lend to new business • Allowed to enter new, more profitable types of lending, such as commercial real estate development in other states

  11. S&Ls in the New Age • But the same old regulators - and understaffed • And the same old bankers • In a brave new world • California S&Ls in Texas … ….. Dentists as Bankers?! • No ability to practice or assess sound banking • Outright fraud • Ex: Over $1 billion in fraud at one S&L in Colorado • Chs Keating bought 5 US Senators to protect himself, with $2 billion in losses and (for him) a brief stint in jail

  12. Bottom Line • Initial $250 billion cost to taxpayers • Liquidation of real estate recouped $90 bil thereof • Lots of bad assets • Lots of unmitigated waste • Local business cycle accentuated (Tx, Fl, La) • Ultimate total elimination of S&L segment • Commercial banks alternatives • floating rate mortgages [undermined S&Ls in their latter days] • so it’s still possible to finance a home purchase

  13. More recent crises • Japan • Traditional business disappeared • Growth slowed from 10% pa to 5% pa • Less Investment • business borrowing fell by 10% of GDP • savings (deposits) continued to rise • So need new business • Small firms (60% of economy) • Real estate (good collateral, prices always rise)

  14. Japan’s Crisis • New business plan a failure • Good small businesses already had bankers • Real estate prices could fall, too • Began shift in a boom, hiding bad practices • Banking crisis from 1992 • Real estate prices fell • Stock-market based financing backfired • Japan in 2001 is back in recession, with only one year of good growth since 1990.

  15. Thailand, Argentina • A supposedly fixed foreign exchange rate • But domestic interest rates high! • Answer? • Borrow in US $ from foreign / offshore banks • But the exchange rate depreciated • Suddenly instead of owing B20,000 you owe B40,000 • And interest payable doubles too • Widespread defaults / bankruptcies

  16. Tomorrow’s crisis? • Citigroup gone awry? • Home mortgage loans in a falling real estate market? • Etc .. ? • Why worry? • Structural change • but management change? • Expansion in up cycle when hard to lose money • Mistakes now coming home to roost

  17. Summary • Leverage: • a little is very powerful • Try to move too much and something will snap - or spring back and slap you • Institutional change: both regulators & lenders find hard to handle • Regulation • Regulations generate side effects • Moral hazard • Heads I win, Tails you lose • Adverse selection: if you try to expand quickly, you have to lower standards, and (like grade inflation) those rejected by conservative banks will seek you out! Losses always prove worse than average!

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