The Roots of Banking Crises the Macroeconomic Cont

Inter-AmericanDevelopmentBankOfficeoftheChiefEconomistWorkingPaper318January1996____TheRootsofBankingCrises:TheMacroeconomicContextMichaelGavinandRicardoHausmannOfficeoftheChiefEconomistInter-AmericanDevelopmentBankJanuary27,1998DiscussionpaperfortheInter-AmericanBank/Groupof30conferenceonBankingCrisesinLatinAmerica,October6and7,1995.Theviewsexpressedherearetheauthors'only,anddonotrepresentthoseoftheInter-AmericanDevelopmentBankorothermembersofitsstaff.CommentsfromGuillermoCalvo,MorrisGoldstein,SteveWeisbrodandRobertoZahler,andresearchassistancefromErikWachtenheim,areverygratefullyacknowledged.______81997Inter-AmericanDevelopmentBank1300NewYorkAvenue,N.W.Washington,D.C.20577TheviewsandinterpretationsinthisdocumentarethoseoftheauthorsandshouldnotbeattributedtotheInter-AmericanDevelopmentBank,ortoanyindividualactingonitsbehalf.Page2IntroductionMostdiscussionsofbankingcrisesbegin,notunreasonably,withanexaminationofthespecialcharacteristicsofthefinancialinstitutionsthathavefailed.Often,wefindthatthebankruptinstitutionswerepoorlymanagedand,insomeinstances,evenvehiclesforoutrightfraud.Itistypicallypossible,withthebenefitofhindsight,topointtowardspecificfailuresoftheregulatorysystemthatpermittedthemistakesormalfeasancethatweretheproximatecauseofthefailures.Frominquestsofthissort,valuablelessonscanbedrawnaboutthedesignofregulatorymechanismsforprevention,orattheveryleastearlydetection,ofdangerousormalfeasantbehaviorbymanagersofindividualbanks.Thisisasensibleandnecessarylineofinvestigation.Therecanbenodoubtthatmanybankfailuresaredueinlargeparttobaddecisionsbybankersthatarepossibletounderstandafterthefact,andthatmayevenbepredictableandthuspreventablebycompetentbanksupervisionandregulation.AndinmanycasesofisolatedfailuressuchasthoseofBaringsandBCCI,thismayevenbethewholestory.However,particularlywhentryingtounderstandamajorcrisisinwhichasubstantialfractionofthebankingsystemisendangered,thisfocusonthecharacteristicsofinstitutionsthathappenedtofailisincompleteandpotentiallymisleading.Thequestionariseswhetherobservedshortcomingsofthefailedbanksactuallyexplainthecrisis,ormerelywhichbanksfailedasaresultofthecrisis.Ametaphormaybeusefulhere.Chainsbreakattheirweakestlink,butthatdoesnotmeanthatthespecificflawsintheweakestlinkfullyexplainwhythechainbroke:oneneedsalsotounderstandwhatcausedthetensiononthechain.Indeed,strengtheningweaklinksinthechainonlyworksifonesucceedsinidentifyingtheweakestlinkbeforeitsnaps,andeventhenwillaccomplishnothingmorethancausingthechaintobreakatanotherlinkifthetensiononthechainissufficientlyhigh.Inourmetaphor,theindividuallinksinthechainrepresentthespecificinstitutionsthatcomprisethedomesticfinancialsystem.Theirstrengthisdeterminedbytheirinvestmentandfundingdecisions,whichcanbeinfluencedbysupervisoryandregulatorystructures.Tensionisplacedonthechainbyeconomy-widefactorsincluding,inparticular,macroeconomicdevelopments.Whenmacroeconomicforcesplacegreatstrainonthebankingsystem,theweakestbanksaretheonesmostlikelytofail,butitisthemacroeconomictension,asmuchastheweaknessofindividualbanks,thatcausesthefailures.Aswithachain,thequalityoftheinstitutionalandregulatoryregimeandmacroeconomicfactorsclearlyinteract:totheextentthatregulationandsupervisionstrengtheneachbankinthesystem,theypermitthesystemtowithstandlargermacroeconomicstresseswithoutfallingintocrisis.Butinstitutionalarrangementsandsupervisorysystemsthateliminatetheriskofbankfailureandfinancialcrisisdonotexistinanyregion,certainlynotinLatinAmerica,andwouldprobablybecounterproductiveiftheydid.Thus,nomatterhowwellregulatedandsupervised,bankingsystemsarelikelytoremainvulnerabletomacroeconomicshocks.Thequestionthereforeariseshowpolicyshouldrespondtothisvulnerability.Thispaperdiscussesthewaysinwhichmacroeconomicdevelopmentscanputstressonbanks,andinextremecasesleadtobankingcrises.1Justastherearemanywaystodie,therearemanywaysinwhichmacroeconomicdevelopmentscancontributetofinancialcrisis,andwedonotargueforthespecialimportanceofanyspecificmechanism.Adversemacroeconomicshocksmaymakeitdifficultforbankborrowerstopaytheirdebtsinfullandontime,thusthreateningthesolvencyofbanks.Adverseshockstodomesticmoneydemandorinternationalcapitalflowsmayunderminedomesticbanks'abilitytofundtheirlendingcommitments,leadingtocrisisthroughanotherchannel.Asuddenincreaseindemandforbankdepositsorsurgeofforeigncapitalmaytriggerabanklendingboom,attheendofwhichbanksmayfindthemselvesholdingalargenumberofdoubtfulloans,makingthesystemhighlyvulnerabletoevenasmallshock.Thesemacroeconomiccausesofbankvulnerabilityandcrisishaveimportantimplicationsforregulatoryregimes,andformacroeconomicpolicyitself.Someimplicationsthatwediscuss:PTherecognitionthatmacroeconomicshocksareanimportantsourceofbankcrisisraisesquestionsabouttheappropriateframeworkforbankregulationandsupervisioninLatinAmerica.IsaregulatoryenvironmentthatisadequateforbankslocatedintherelativelystableindustrialcountriessufficientforaregionasvolatileasLatinAmerica?AretheBISstandardsforbankcapitalizationconservativeenoughforLatinAmerica?Areindustria