Sapienza Università di Roma International Banking Lecture Ten Financial crises Prof. G. Vento

Agenda Introduction to financial crises Bubbles The South East Asian Financial Crisis April 2013

1. Financial crises: an introduction Financial crisis is normally associated with a banking crisis and when the stability of the banking system is threatened, the financial infrastructure could collapse in the absence of central bank intervention The collapse of a key financial firm normally prompts runs on the banks; customers are unable to distinguish between healthy and problem banks and withdraw their deposits In the absence of central bank intervention, providing liquidity to solvent but illiquid banks, healthy banks are also threatened April 2013

1. Financial crises: bubbles 1/2 A bubble occurs when prices increase over an extended range Agents with savings or credits shift their finance to the new profit areas An increase in credit finances a boom, and expands money supply; investors euphoria sets in The financial system becomes increasingly fragile: - banks make insufficient provisions for risk, possibly because of an optimistic view of the collateral’s value; - demand outstrips supply in the new profitable sectors. Prices increases; - group behaviour together with increasingly speculative activity is observed, involving inexperienced agents who do not normally undertake investment April 2013

1. Financial crises: bubbles 2/2 Unit’s financing shifts from hedge finance to speculative finance The speculative boom continues until it snaps ‘Distress selling’ begins when firms or households, unable to repay their debt, are forced to liquidate their assets Sellers outnumber buyers causing prices to fall; rush to liquidate The bubble implodes and panic erupts April 2013

1. Common trends in financial crises Agents starts to be excessively optimistic about the future price of certain assets, but at some points grow excessively pessimistic Are agents irrational? Is it consistent with the efficient market hypothesis? According to the school of “behavioural finance” bubbles are the demonstration of irrational behaviours Financial crises require injection of public funds, together with, in some cases, private funds from banks and international funds April 2013

1. Financial crises in emerging markets A crisis occurs when a central bank is about to run out of reserves, or cannot service foreign debt obligations, denominated in another currency Once this unexpected news is made public, there is a rapid outflow of foreign capital, a collapse of domestic equity bond markets, and a decline in the value of the home currency High net inflows of foreign capital can trigger a crisis, which is even more severe if the foreign capital is largely in the form of short-term debt denominated in dollars Foreign lenders become excessively optimistic, the capital market overshoots, but some event causes concern among lenders, who start cutting back on loans to the country that triggers the crisis April 2013

1. Common trends in financial crises Agents starts to be excessively optimistic about the future price of certain assets, but at some points grow excessively pessimistic Are agents irrational? Is it consistent with the efficient market hypothesis? According to the school of “behavioural finance” bubbles are the demonstration of irrational behaviours Financial crises require injection of public funds, together with, in some cases, private funds from banks and international funds April 2013

The South East Asian Financial Crisis April 2013

2. The South East Asian Financial Crisis (1997 – 99): the environment Originated in Thailand, then spread quickly to South Korea, Indonesia, Malaysia, and other Asian economies The speed and seriousness of the crises took expert by surprise: - spread on Asian bonds had substantially narrowed during 1996 and for most of credit ratings remained largely unchanged - fiscal and monetary indicators were relatively stable April 2013

2. The South East Asian Financial Crisis (1997 – 99): Thai crisis 1/2 The first sign of trouble was when the prices of the Thai stock market began to fall in February 1997, and by the year-end had declined by more than 30% Pressure on Thai bath quickly turned into a currency crisis, which spread to the financial sector Thailand has experienced a massive net capital inflow during the previous three years (13% of Thai GDP) The year 1997 saw this inflow at first stop, and by the second and third quarters, sharply reverse An unexpected fall in exports in early 1997 heightened concerns about the sustainability of the bath The Thai bath was pegged to the US dollars; it depreciated through 1996 and 1997, but within the intervention band April 2013

2. The South East Asian Financial Crisis (1997 – 99): Thai crisis 2/2 The Thai central bank intervened heavily, buying bath to maintain the peg Thai government imposed capital control in May; overnight interest rates soared an by July the government allowed the bath to float Meanwhile, pressure was building on other pegged currencies (Malaysia, Indonesia, etc.) April 2013

2. The South East Asian Financial Crisis (1997 – 99): Industrial, trade and exchange rate policy All these economies have experienced rapid, although declining, growth rates Exports trebled between 1986 and 1996 in the region and made up about 40% of each country’s GDP by 1996 Firms were frequently foreign owned Restriction on capital movements had been liberalised and in 1996 were completely free Increasingly, foreign firms were looking to China as the Asian base for their manufacturing plants These countries had all adopted some type of US dollar peg April 2013

2. The South East Asian Financial Crisis (1997 – 99): The financial sector All of the Asian economies were bank dominated, with underdeveloped money markets Between 1990 and 1997, bank credit grew by 18% per annum for Thailand and Indonesia Increasing reliance on short-term borrowing as a form of external finance The almost unlimited availability of bank credit led to over-investment in industry and excess capacity (especially in property sector) Asian banks borrowed in yen and dollars from Japan and the west, and on- lent to local firms in the domestic currency A tradition of forbearance towards troubled banks and the widespread impression that governments would support the banking sector Name lending had been opposed to analytical lending Links between financial companies and industrial companies Weak financial institution/sector used to be supported by the states In the Korean financial sector, activities were strictly segmented by function April 2013

2. The South East Asian Financial Crisis (1997 – 99): The contagion effect Initially the currency crisis spread from Thailand to other countries because investors tended to group these countries together The currency crisis spread rapidly because of the high substitutability of many of each other’s exports, the absence of capital controls, and the perceived similarity of financial conditions High interest rates and a deteriorating economic outlook caused a steep decline in the property and equity market Sound loans looked problematic, causing concerns on the viability of the banks with high percentage of non-performing loans, backed by collateral, the value of which was collapsing April 2013

2. The South East Asian Financial Crisis (1997 – 99): policy responses IMF package included: Closure of insolvent banks/fianncial insituttions Liquidity support to other banks, subject to conditions Purchase and disposal of non-performing loans, normally by an asset management company Loan classification and provisioning rules were raised to meet international standards Review of bank supervision laws New, tighter prudential regulation Introduction of deposit insurance schemes April 2013

Scandinavian Banking Crises April 2013

3. Scandinavian Banking Crises They are usually mentioned as successful examples due to the ways authorities managed the crises. Finland, Norway and Sweden experienced systemic banking crises in the late 1980s and early 1990s. Largest banks in each country required capital injections and many smaller banks were affected. April 2013

3. Scandinavian Banking Crises: the Macroeconomic Situation Prior to the onset of the crises, real GDP growth rates were steady (between 4% and 6% for each country). The growth of credit was regulated by the governments, but these were removed in the 80s. Real interest rate was low and, in some years, negative. Boom of lending, that generated a rapid rise in property and stock market prices. Property was the main collateral. April 2013

3. Scandinavian Banking Crises: Some Mistakes Banks wanted to lend, after many years of restrictions Illusion that collateral could substantially reduce risk The bubble burst as a result of economic shocks: – Norway: oil prices dropped in 1985 – 86; – Finland and Sweden: crash in export due to Soviet Union implosion. The recession, combined with the rapid depreciation of real estate prices, caused large credit losses for financial institutions. The first to be affected were finance companies. April 2013

3. Scandinavian Banking Crises: Some Evidences Several bank defaulted. Central banks injected liquidity. A massive government rescue operation was required to prevent the collapse of the financial system. Support amounting to 4% of GDP was given to the banks. The crisis was rapidly resolved. April 2013

3. Scandinavian Banking Crises: Some Policy Responses in Sweden Sweden. The total amount paid by the Banking Supervisory Authority to the banks was SEK 65 billion. However, part of that money, was paid back to the government through dividends, selling of shares, and the value of retained shares. April 2013

3. Scandinavian Banking Crises: Some Policy Responses in Norway April 2013

BANKING IN USA Next Lecture : April 2013