Banking Crises Regulation & Performance Economics 102 Winter 2002
Early Regulation • Scams, Bank failures ==> bank licensing from early 1800 s • 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
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
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
Safe Banking • Sound practice – Glass-Steagall (1933): segment services • Insurance - banking - securities - underwriting • NOW DEFUNCT cf. Enron issues – Bank supervision (gradual from 1800 s, state & federal) • Inspection • Case study: Bank of Tokyo NY, 1979 – Regulation Q (1933) • Prevent competition for deposits • Help guarantee margins
Banking Crises • Structural change is the enemy of sound banking – Managing risk is undermined – Mix of products / operations undermined
1970 s shifts • 1970 s – 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
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”
Demise of S&Ls • 30 year mortgages – Collecting 4% • Short-term deposits – Paying 10% • Entire sector rendered insolvent
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
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
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
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)
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.
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 B 20, 000 you owe B 40, 000 – And interest payable doubles too • Widespread defaults / bankruptcies
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
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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