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Anatomy of Financial Crises

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By Prof. Oluremi Ogun, Professor of Economics, University of IbadanNigeria

                                               

 

 

 

This article examines a generalised method of analysing financial crises. The first section outlines the identification and symptoms of financial crises, followed by one that briefly describes their models. The final section concludes with a discussion of the analytical technique and data.

Identification and symptoms

As a global phenomenon, a financial crisis appears to be unaffected by countries’ sizes or stages of development. In recent times, crises of different magnitudes have been experienced around the world. The most severe among these crises have included the 1992-93 Exchange Rate Mechanism (ERM) crises in France and the United Kingdom, the Japanese Banking Crisis of the 1990s, the 1994 Mexican peso crisis, the East-Asian financial crises of 1997-98, the 1998 Russian debt crisis, the 2001 Argentina debt crisis and the 2007-09 Global Financial Crisis (GFC). Although the costs of these crises to industrial economies have been tremendous, their effects in developing countries have been even more far-reaching and damaging (Mishkin, 1996)1.

A financial crisis is often associated with one or more of the following phenomena: imbalances in macroeconomic fundamentals, internal and external shocks, substantial changes in credit volumes and asset prices; severe disruptions in financial intermediation and the supply of external financing to various agents in the economy; large-scale balance-sheet problems (of firms, households, financial institutions and countries); and large-scale government support (in the form of liquidity support and recapitalisation).

Types and models of financial crises

Financial crises are classified into four groups: currency crises, sudden stop crises, debt crises and banking crises. The various theories on their causes have influenced the definitions of each group.

Currency crises

This type of crisis involves a speculative attack on a country’s currency resulting in a devaluation (or sharp depreciation) or a situation during which the authorities are forced to defend the currency by expending large quantities of international reserves, sharply raising interest rates or imposing capital controls.

The resulting decline in the currency’s value negatively affects the economy by creating instabilities in exchange rates. When faced with the prospect of a currency crisis, authorities in a fixed-exchange-rate economy try to maintain the current fixed rate by tapping into the country’s foreign reserves. This can be very costly in terms of the level of foreign reserves, subsequently engendering capital flight that worsens exchange-rate management.

Three generations of models have typically been used to explain currency crises. The first-generation models focus on the collapse of exchange-rate regimes, as in Flood and Garber (1984)2 and Tularam and Subramanian (2013)3. They depict a government operating with a fixed exchange rate that has been running excessive budget deficits financed by central bank credit. This leads to capital outflows and pressures for the devaluation of the currency due to the decline in interest rates caused by the increased money supply. The central bank has no choice but to defend the currency by using its foreign-exchange reserves. Rational investors who correctly foresee that this defensive strategy cannot last long, as the reserves will reach a critically low level, will launch speculative attacks on the domestic currency. Investors continue to hold the currency as long as they expect the exchange-rate regime to remain intact but start dumping it when they anticipate a change to the floating-exchange regime. Consequently, the currency collapses as the central bank quickly loses its liquid assets and foreign reserves in a bid to support the exchange rate.

The second-generation models (for example, Willman, 1987)4emerged due to the first-generation model’s inability to fully explain currency crises, particularly the ERM crises of 1992-93. These models assume that governments continually evaluate the pros and cons of maintaining a fixed exchange rate vis-à-vis minimising deviations in real variables (output or inflation rates) from their desired values. The possibility of multiple equilibria and currency crises exists in these models due to uncertainty about policy commitment to maintaining a fixed exchange rate. Devaluation is seen as an optimal response by the government to speculative pressures. Investors factor this into their expectations, and the degree to which such expectations of devaluation vary has a corresponding influence on the costs to the government of either maintaining the fixed exchange rate or devaluing the currency.

The third-generation models were motivated by the need to explain the underlying events observed in the Asian financial crises properly. Contrary to the assumptions of the previous models, severe fiscal problems and current-account deficits were negligible or nonexistent in these Asian economies before the crises. The common thread that runs through these models, such as those of Akerlof and Romer (1994)5, is that financial crises are generally caused by moral-hazard problems. (See Claessens and Kose, 20136 for other models.) The presence of a government guarantee for financial intermediaries’ liabilities provides the incentive to overborrow money at relatively low interest rates and then lend to highly risky investments, leading to real-estate and stock-market bubbles and even fraud. Eventually, the asset bubbles burst, and the proportion of nonperforming loans rises as asset prices fall, triggering large capital outflows.

The knowledge of the existence of government bailouts for affected banks that fail makes a crisis more likely, becoming self-fulfilling. Radelet and Sachs (1998)7 generally argue that self-fulfilling panics hitting financial intermediaries can force the liquidation of assets, which confirms the panic and leads to a currency crisis. The rapid deterioration of balance sheets in the financial and corporate sectors gives rise to currency crises. And if local banks have substantial outstanding debts denominated in foreign currency, this situation may also lead to a banking crisis (Mishkin, 1996)8.

Sudden stop crises

The sudden stop crisis is also known as a capital-account crisis or balance-of-payments (BoP) crisis and can be defined as a large, often unexpected fall in international capital inflows or a sharp reversal in aggregate capital flows to a country, likely taking place in conjunction with a sharp rise in its credit spreads.

Early models that try to explain sudden stops are similar to third-generation models of currency crises because they also focus on balance-sheet mismatches and maturities in financial and corporate sectors, making closer relationships with disruptions in the supply of external finance (Calvo et al., 20069 as cited in Claessens and Kose, 201310).

In explaining the causes of sudden stops in capital flows, greater weight is given to international factors, captured by changes in international interest rates or spreads on risky assets. Although these models could not explain the sharp drops in output and total factor productivity (TFP), the current-account reversals and real exchange-rate depreciations observed in sudden stops were well accounted for.

Recent sudden stop models that introduced various frictions (such as the financial market or labour market) and amplification mechanisms were better fits for the data. Reinhart and Calvo, 200011 and Calvo, 200012 give more insight into these new models and how they can account for output and productivity loss adequately.

Debt crises

This type of financial crisis can be classified into two forms: foreign and domestic. A foreign-debt crisis occurs when a country cannot (or does not want to) service its foreign debt, either in the form of a sovereign or private (or both) debt crisis. A domestic-debt crisis occurs when a country does not honour its domestic fiscal obligations in real terms, either by explicitly defaulting or inflating or otherwise debasing its currency.

The models developed to explain foreign-debt crises and defaults are closely related to those used to examine sovereign lending. Salient economic reasons are necessary to explain the continued existence of sovereign lending, given that lenders cannot seize collateral from a country or employ any legal procedures to ensure a country honours its debt obligations when it refuses to do so.

These models rely on the rationale that before debtor nations decide to default on their loans, they weigh the costs (intertemporal and intratemporal sanctions) against the savings (by way of interest and principal repayments) of choosing that option. Intertemporal sanctions arise from the threat of exclusion from future external borrowing if a country defaults. The defaulting nation will be unable to access foreign funds to finance its domestic investments, limiting its economic growth, and its ability to smooth out the costs associated with adverse shocks by borrowing on international capital markets will be constrained. Intratemporal sanctions arise from the inability to enjoy the gains from trade (for example, foreign-exchange earnings) because trading partners can impose sanctions (protectionist trade measures or bans from international markets) against a defaulting nation. The difficulty is in quantifying these perceived costs and uncertainties about the extent or duration that these penalties could add to the default costs for debtor nations. (See Claessens and Kose, 201313.)

In the case of domestic-debt crises, although the government’s domestic borrowing is often seen as a way to avoid inflation and external crises, it has its own dangers if used in excess. Domestic borrowing leads to credit rationing, putting pressure on interest rates and crowding out private investment. Models often assume that governments always honour their domestic-debt obligations. They make government debt less relevant by also assuming Ricardian equivalence. In an attempt to catalogue episodes of overt domestic public-debt defaults across more than a century, Reinhart and Rogoff (2009)14find that, although rarer than external defaults, this phenomenon is far too common to justify the notion that governments always honour the nominal face values of domestic debt.

Banking crises

Although a banking crisis is generally seen as a significant disruption to banking activity, a widely accepted definition is lacking in the literature. Authors rely on multiple criteria, often in combination with expert judgment, to determine the occurrence of a banking crisis (Chaudron and de Haan, 2014)15. This is relevant, as the ability to draw useful lessons from past banking crises and determine their causes (whether a crisis was caused by factors within the financial sector or external to it) depends on what it is considered to be.

Mishkin (1996)16 defines a banking and financial crisis in the context of asymmetric information theory as a non-linear disruption to financial markets in which adverse selection and moral-hazard problems worsen so that financial markets cannot channel funds to economic agents with productive investment opportunities. Generally, available definitions and descriptions of banking crises emphasise their features. (See Caprio and Klingebiel, 199617; Laeven and Valencia, 200818, 201219; Summers, 200020; Reinhart and Rogoff, 200921; Alashi, 200222; Calomiris, 200923; Calomiris and Gorton, 199124.)

The analytical technique and data

Beyond partial-equilibrium analysis, an illuminating study of financial crises should adopt a comprehensive framework to highlight the importance of factors theoretically adjudged to be relevant explanatory variables. Hence, issues such as macroeconomic fundamentals, exogeneity, microeconomic rules, policy errors, national liquidity, managerial capability and asset-market developments should be adequately captured. Due cognizance should, however, be taken of the dictates of modern econometrics. Being of the nature of time-series analysis of different data frequencies, the general-to-specific methodology should be recognised. Through an iterative process, this methodology generates a congruent model that is theory-consistent and data-admissible and encompasses all rival models. (See Adam, 1992.25)

Adherence to this principle should be to the extent of defensibility. As argued by Ogun and Makinde (2018, 2021)26, the widespread intervention of governments and their agencies during financial crises since the period of the Great Depression has denied the related data series of natural long-run dynamics; hence, an exclusively short-run focus might be considered logical and more appropriate.

 

References

1 The World Bank: “Understanding Financial Crisis: A Developing Country Perspective,” Frederic S. Mishkin, 1996, in Annual World Bank Conference on Development Economics 1996, Michael Bruno and Boris Pleskovic, Editors, January 1997, Washington, D.C.

2 Journal of International Economics: “Collapsing exchange-rate regimes: Some linear examples,” Robert P. Flood and Peter M. Garber, August 1984, Volume 17, Issues 1-2, Pages 1-13.

3 Global Journal of Business Research: “Modeling of Financial Crises: A Critical Analysis of Models Leading to the Global Financial Crisis,” Gurudeo Anand Tularam and Bhuvaneswari Subramanian, 2013, Volume 7, Issue 3, Pages 101–124.

4 Economics Letters: “Speculative attacks on the currency with uncertain monetary policy reactions,” Alpo Willman, January 1987, Volume 25, Issue 1, Pages 75-78.

5 National Bureau of Economic Research (NBER): “Looting: The Economic Underworld of Bankruptcy for Profit,” George A. Akerlof and Paul M. Romer, April 1994, NBER Working Paper 1869.

6 International Monetary Fund (IMF): “Financial Crises: Explanations, Types, and Implications,” Stijn Claessens and M. Ayhan Kose, January 30, 2013, IMF Working Paper WP/13/28.

7 Brookings Papers on Economic Activity: “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,” Steven Radelet and Jeffrey D. Sachs, 1998, Volume 28, Issue 1, Pages 1-74.

8 The World Bank: “Understanding Financial Crisis: A Developing Country Perspective,” Frederic S. Mishkin, 1996, in Annual World Bank Conference on Development Economics 1996, Michael Bruno and Boris Pleskovic, Editors, January 1997, Washington, D.C.

9 Bank for International Settlements (BIS): “Phoenix miracles in emerging markets: recovering without credit from systemic financial crises,” Guillermo A. Calvo, Alejandro Izquierdo and Ernesto Talv, December 2006, BIS Working Paper No. 221.

10 International Monetary Fund (IMF): “Financial Crises: Explanations, Types, and Implications,” Stijn Claessens and M. Ayhan Kose, January 30, 2013, IMF Working Paper WP/13/28.

11 International Monetary Fund (IMF) (Munich Personal RePEc Archive): “When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options,” Carmen Reinhart and Guillermo A. Calvo, 2000, Reforming the International Monetary and Financial System, Peter B. Kenen and Alexandre K. Swoboda, Editors, Washington, D.C., Pages 175-201.

12 Journal of International Economics: “Betting against the state socially costly financial engineering,” Guillermo A. Calvo, June 2000, Volume 51, Issue 1, Pages 5-19.

13 International Monetary Fund (IMF): “Financial Crises: Explanations, Types, and Implications,” Stijn Claessens and M. Ayhan Kose, January 30, 2013, IMF Working Paper WP/13/28.

14 This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff, 2009, Princeton University Press.

15 De Nederlandsche Bank (DNB): “Identifying and dating systemic banking crises using incidence and size of bank failures,” Raymond Chaudron and Jakob de Haan, January 8, 2014, DNB Working Paper 406.

16 The World Bank: “Understanding Financial Crisis: A Developing Country Perspective,” Frederic S. Mishkin, 1996, in Annual World Bank Conference on Development Economics 1996, Michael Bruno and Boris Pleskovic, Editors, January 1997, Washington, D.C.

17 The World Bank: “Bank Insolvency: Bad Luck, Bad Policy, or Bad Banking?” Gerard Caprio Jr. and Daniela Klingebiel, 1996, in Annual World Bank Conference on Development Economics 1996, Michael Bruno and Boris Pleskovic, Editors, January 1997, Washington, D.C.

18 International Monetary Fund (IMF): “Systemic Banking Crises: A New Database,” Luc Laeven and Fabián Valencia, November 2008, IMF Working Paper WP/08/224.

19 International Monetary Fund (IMF): “Systemic Banking Crises Database: An Update,” Luc Laeven and Fabián Valencia, June 2012, IMF Working Paper WP/12/163.

20 American Economic Review: “International Financial Crises: Causes, Prevention, and Cures,” Lawrence H. Summers, May 2000, American Economic Association, Richard T. Ely Lecture, Papers and Proceedings, Volume 90, Issue No. 2, Pages 1-16.

21 This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff, 2009, Princeton University Press.

22 Central Bank of Nigeria (CBN): “Banking Crisis: Its Causes, Early Warning Signal and Resolution in Central Bank of Nigeria,” S.O. Alashi, 2002, “Conference proceedings: Enhancing financial sector soundness in Nigeria, 25-26th November, 2002,” Abuja, Pages 126–153.

23 National Bureau of Economic Research (NBER): “Banking Crises and the Rules of the Game,” Charles W. Calomiris, October 2009, NBER Working Paper 15403.

24 Financial Markets and Financial Crises: “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” Charles W. Calomiris and Gary Gorton, January 1991, R. Glenn Hubbard Edition, Chicago: University of Chicago Press, Pages 109-173.

25 African Economic Research Consortium (AERC): “Recent developments in econometric methods: An application to the demand for money in Kenya,” Christopher S. Adam, September 1992, Special Paper 15.

26 Ethiopian Journal of Economics: “Explaining Financial Crises in an African Open Economy,” Oluremi Ogun and Olutomilola Makinde, April 2018, Volume 27, Issue 1, Pages 91-111.

Also published as:

Modern Perspectives in Economics, Business and Management: “Study on Financial Crises in an African Open Economy,” Oluremi Ogun and Olutomilola Makinde, July 12, 2021, Volume 2, Pages 74-87.

 

 

ABOUT THE AUTHOR

Prof. Oluremi Ogun is a Professor of Economics at the University of Ibadan-Nigeria, where he has taught modern monetary theories and practices to many generations of undergraduate and postgraduate students. He is an Associate Editor of the American Journal of Archaeology and Anthropology and Co-editor of Global Economics Science. He is a member of the Econometric Society and an associate member of the Chartered Institute of Bankers (CIB), London.

 

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