The Evolving Role of Central Banks
Chapter

13 Role of the Central Bank in Banking Crisis: An Overview

Editor(s):
Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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Author(s)
ANDREW SHENG

In recent years, bank failure has become a growth industry. Banking crisis around the world has become so pervasive that many central bankers are likely to have some personal experience of one financial crisis or other in the last five years. As banks around the world begin to feel the onset of recession, with rising loan losses arising from property and share price falls in Japan, the United States, and the United Kingdom, and as banks in highly indebted countries still suffer the effects of major structural adjustment programs, an unprecedented global shake-up in the financial sector is likely to occur in the early 1990s. If so, central bankers must be prepared to deal with banking crises as they arise, or better still prevent crises from happening. This paper looks specifically at the role of the central bank in domestic banking crises.1

The decade of the 1980s has taught central bankers around the world quite a lot about banking crises, although controversy still exists about the exact causes and cures. The landmark bank failures of the 1970s, Herstatt and Franklin National, appear today small-fry compared with the losses of the savings and loan debacle in the United States, and the banking crises in Spain, Latin America, Africa, and Asia in the 1980s, A number of these cases have become fairly well documented in the International Monetary Fund and the World Bank. This paper attempts to synthesize broadly the practical lessons drawn from these cases, based upon a research project in the Bank on bank restructuring in developing countries. It begins with the definitions of banking crises, then looks at the contractual nature of banking and the macroeconomic and microeconomic origins of crises. Various country cases are then grouped into various types of crises and the methodology of crisis resolution is then examined. Finally, a case study is presented on the management of banking crisis from the vantage point of the central bank, based upon the experience of the Malaysian banking crisis of 1985–87.

Definitions

In this paper, the terms banking crisis and financial crisis are interchangeable. Most definitions of a financial crisis would be close to that offered by Goldsmith (1982):

a sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators—short-term interest rates, asset prices (stock, real estate, land prices), commercial insolvencies and failures of financial institutions.

In the narrow sense, the actual crisis (such as a large bank failure that sparks off a large run that spreads to a number of banks) is a decisive event that marks the turning point in the business cycle. However, real and financial conditions deteriorate—managements behave speculatively, structures become fragile, supervision becomes lax, depositors become nervous—over a fairly long time horizon. Moreover, the resolution of a banking crisis, particularly where the root causes are structural, takes not less than three to five years. The U.S. thrift crisis took about a decade to unfold: from the first technical insolvencies caused by high interest rates in the beginning of the 1980s to government action in 1989 to restructure the regulatory, supervisory, and liquidation agencies to handle the large number of thrift failures.

Banking crises typically occur when financial distress prevails. Distress is defined as the condition when the banking system as a whole has negative capital and current profits are insufficient to cover losses to such an extent that the banking system is unable to generate internally positive capital (Hinds (1988)). There are, however, different degrees of severity of crises. Mr. Corrigan (1989/90), of the Federal Reserve Bank of New York, has recently differentiated between “financial disruptions” and “financial crises,” the latter being episodes that cause clear and significant damage to the real economy. Under this definition, major bank failures or market crashes in the postwar period would certainly count only as “disruptions.” For example, stock and land prices fell sharply in Taiwan Province of China and Japan in 1990, but these factors do not appear to have caused significant changes in real economic growth, changes in the balance of payments, or foreign exchange reserves—factors common in a number of financial crises. In strong economies, some banks may be hurt and peripheral financial institutions may fail, but real economic activity need not be severely affected.

This definition of financial disruption is similar to what Anna Schwartz (1985) calls pseudofinancial crises, that is, declines in asset prices of equity stock, real estate, commodities; depreciation of the exchange rate; financial distress of large firms, financial industry or sovereign debtors. In her view, real financial crises occur when the stability of the banking system is threatened.

Nature and Origins of Banking Crises

There are a number of schools of thought on the causes of banking crises. Schwartz and others in the monetarist school consider that financial crises are not triggered by financial distress but by the failure of authorities to respond correctly to financial distress and that they are aggravated by the private sector’s uncertainty about the correct policy responses. On the other hand, the Minsky and Kindleberger school has evolved a theory of financial fragility, which is defined broadly as a long period of economic growth that leads to euphoric behavior by economic entities. The financial fragility of players (governments, enterprises, banks, and households) increases over the growth cycle as capital cushions deteriorate, leverage increases, and the economy becomes more vulnerable to economic shocks. Political events, external shocks, local or sectoral problems all create doubts over the sustainability of such euphoria, and the speculative bubble bursts when asset prices fall. The forced debt liquidation accentuates declining asset values, tightening liquidity, and precipitating insolvencies of debtors, thus triggering bank failures.2

Controversy also exists over whether banking crises have macroeconomic or microeconomic origins. The macroeconomic school blames structural imbalances, inappropriate economic policies and external shocks, or a combination of such factors. Typical factors include large fiscal and balance of payments deficits, overvalued exchange rates, negative real interest rates, high external debt, inflation, and fundamentally inefficient domestic industries. These factors, plus flaws in the financial structure, make the economy (and hence the banking system) highly vulnerable to external shocks, sudden relative price changes, or major policy shifts.

Changes in the macroeconomic environment are not the only factors accounting for ailing banks. Many financial systems have not been designed to withstand shocks. The monetary sector of the financial system is usually highly regulated and protected by the central bank, but other components, such as rural savings institutions, deposit-taking cooperatives, stock markets, and informal curb markets are usually self-regulated or very loosely regulated. These secondary or fringe financial institutions do not have lender of last resort facilities, nor effective supervision to ensure that public savings with them are adequately protected from fraud and management abuses. Failure in these unregulated subsectors often spill over to the monetary sector. In addition, the duplication of supervision or gaps in supervision (particularly where there are lacunae in the law) do not allow the authorities to act flexibly and quickly in response to problems in any particular sector.

Macroeconomic and structural issues aside, experienced bank supervisors invariably have no hesitation in pinpointing microeconomic roots in bank failures—bad bank management, supervisory inadequacies, poor accounting standards, and weak legal framework (U.S. Treasury (1988) and Sinkey (1979)). Aristobulo de Juan’s dictum (1987) on how good bankers become bad bankers through the stages of technical mismanagement, cosmetic mismanagement, desperate management, and, finally, fraudulent management is now well-known. Temptations to steal in banking are so large that elements of fraud or conflict of interests are found in almost all cases of bank failure. In Malaysia, there is a saying that “you don’t let monkeys look after bananas.” Strong and effective bank supervision can play a major role to detect bank problems, but as can be seen later, cannot wholly prevent bank failure.

In practice, there is often a macro-micro negative feedback mechanism. Macroeconomic maladjustments, such as an overvalued exchange rate, large fiscal deficits, heavily protected industries, corruption, and excessive domestic speculation lead ultimately to losses incurred by borrowers. These losses show up as nonperforming loans in the banking system. Banks initially may be able to absorb such losses, so long as nonperforming loans remain a small proportion of their total loan portfolio. The costs of loan-loss provisions are usually absorbed through higher spreads, such costs being borne by depositors and performing borrowers. If loan-losses persist, however, and erode the banks’ solvency, the management may seek to hide their losses through cosmetic accounting, or through “evergreening” loans to keep large borrowers alive, bidding up deposit rates to maintain their liquidity. Perverse incentives occur. Distressed borrowers have no hesitation in paying excessive real interest rates to have access to new credit in order to maintain the illusion of solvency. On the other hand, distressed asset sales drive down asset prices and erode further the collateral base of the banks. Faced with uncertainty and large losses, banks contract credit and raise real interest rates, thus dampening investment and growth.

At this point, doubts over the soundness of a particular financial institution, whether true or unfounded, could lead to a bank run, inducing flight to quality, or in more serious cases of contagion, a flight to currency. If the contagion is not stopped quickly, nervousness about the soundness of the banking system would create capital flight. As experience shows, central bank lending to banks during capital flight only adds fuel to the fire and is self-defeating, as it entails immediate loss in foreign exchange reserves. The resultant depreciation of the exchange rate could cause more panic. Raising interest rates to stem capital flight would contract economic activity further, sending the economy into a deflationary spiral. Consequently, few central banks dare to treat potential problems of banks lightly. Because of the constant threat of contagion, it is impossible to tell ex ante whether a bank problem is a financial disruption, or what ex post turns out to be a full blown financial crisis. It is the fear of systemic risks (discussed later) that drives central bank intervention in problem banking situations.

The role of the central bank at this stage is crucial. The central bank is required fundamentally to maintain financial stability. This involves not only maintaining the internal and external value of the currency, but also the stability of the banking system. But, what does “maintenance of the stability of the banking system” mean in practical terms? Providing liquidity to a solvent banking system to ease sporadic shortage of funds and maintaining integrity of the payments mechanism is generally accepted doctrine. The provision of central bank funds to an insolvent financial system to maintain stability, however, has quasifiscal implications and is much more controversial and less well understood.

Is a central bank obliged as guardian of the system to provide not only liquidity but also to safeguard system solvency? Indeed, under conditions of crisis and uncertainty, it is extremely difficult to distinguish between a liquidity need and a solvency need. My personal experience is that when bankers come to the central bank for liquidity help (after they are not able to obtain help from other institutions), it is no longer liquidity assistance, but a question of solvency. This dilemma was considered by Bagehot (1978), whose view of the proper role of the lender of last resort was succinctly restated by Summers (1989) as central banks should adopt, announce, and follow a policy of lending freely and aggressively but at a penalty rate to all sound but no unsound borrowers in time of crisis.

There are three good reasons behind this advice. First, provision of liquidity to good borrowers would assure the smooth and stable functioning of the payments system, thus heading off problems of confidence in the ability of even good borrowers to meet their commitments. Second, by lending only at penalty rates against good security, the central bank deters moral hazard behavior of distressed borrowers and protects its own solvency at the same time. Third, in a crisis, the central bank may be the only available buyer of good securities. Its presence in the market could check the free fall of the price of bonds or quality commercial paper, the forced debt liquidation of which may make even normally sound borrowers insolvent.

Central bank intervention in banking crisis has wide monetary and fiscal implications. Central bank lending to problem banks is expansionary on money supply. Central bank’s losses through measures to subsidize ailing banks, assumption of foreign exchange losses of banks or enterprises, or takeover of bad assets of insolvent banks are all quasi-fiscal deficits in nature. If these losses are monetized, the result could be higher inflation. In an open economy, there is always the danger that if the public perceives that the central bank is itself “insolvent” by absorbing too much loss, then capital flight would ensue. At the worst stage, a central bank with net foreign exchange liabilities would be caught in a downward spiral in which it tries to buy foreign exchange to service its debt only at higher and higher rates, thus losing monetary control and depreciating at the same time. The devaluation worsens the foreign exchange losses of the central bank, and the central bank itself becomes the source of monetary inflation.

There are tempting reasons for governments to use central banks not only as the lender of last resort but also as equity provider of last resort to help rescue banks. Central banks are, after all, institutionally created to act quickly to deal with financial crises. It may not be possible for the government to appropriate funds from the budget quickly enough to help stem a crisis. In times of crises, when there is a shortage of risk capital in both the private and public sectors, there may be no alternative to the central bank putting its funds at risk; however, the central bank can do this if, and only if, the losses on the assets it acquires are less than its income from other assets, otherwise the central bank’s own solvency is affected. As the case studies described later will show, experience suggests that it would be perilous for governments to tinker with a central bank’s solvency, since that damages the public’s confidence in the stability of the domestic currency. The capacity of a central bank to absorb losses of the banking system is a theme to which I shall return.

The Contractual Nature of Banking

The periodic instability of financial systems has its roots in the contractual nature of banking. As financial intermediaries, banks essentially straddle two sets of contracts in the economy, a bundle of deposit contracts with savers and various loan contracts with borrowers. Bank failure is fundamentally the breakdown of contractual obligations between banks and their borrowers to the point that banks have to break their contracts with depositors. All markets, other than barter markets, are markets in contracts. Economic entities (principals and agents) trade products, or rather contractual obligations, under a written or unwritten set of regulations that protect and enforce the property rights of the market participants. All markets operate under conditions of uncertainty and risk. Implicitly, the Basle Committee on Banking Supervision (1990) in its recent work on credit concentrations has conceptually acknowledged the contractual nature of banking by categorizing banking risks into two broad categories: counterparty risks (credit risks, sectoral concentration exposures) and market risks (foreign exchange, interest rate, equity, and asset price fluctuation risks).

All financial products are by definition different forms of contracts that allocate risks and obligations between the various parties involved. Holders of obligations can only eliminate counterparty risks (such as credit risk) by final settlement in cash. In the meantime, both parties are subject to market risks, such as changes in interest rates, exchange rates, prices, or general market conditions that may affect the liquidity or solvency of the counterparty to deliver on the due date. What is not normally understood is that while contracts protect rights and obligations when both parties are solvent, the minute one party becomes insolvent, the holders of the insolvent party’s obligations immediately assume losses. In other words, rational self-preservation behavior calls for an insolvent institution to borrow as much as possible, since contractually it passes losses to all holders of its obligations. Eventually, it reaches the stage of “too big to fail” and the creditors are obliged to bail out that institution in their own self-interest. Hence, the fundamental truth of the anecdote that if you owe the bank $1,000, you are in trouble; if you owe the bank $100 million, the bank is in trouble.

In a world of volatile prices, no transparency in accounting disclosure, and general uncertainty, holders of contracts are never sure when the counterparty becomes insolvent or engages in cheating behavior, such as reneging on the contract. Market participants deal with each other on the basis of past experience or reputation. Confidence is generated through repeated successful conclusion of contracts. When a contract fails, confidence is eroded. Thus, banks are able to generate public confidence through their ability to meet deposit withdrawals on demand. Banks are therefore also subject to reputational risks. Contagion occurs when the public perceives, rightly or wrongly, that banks (or their subsidiaries or affiliates) may not be able to meet their obligations. Reputational risks occur when creditors (including depositors) associate problems of one economic entity with another related entity. The withdrawal of credit from one entity to entities of the same group typically creates a liquidity crisis for the group as a whole. Hence, bank supervisors tend to supervise financial institutions on a group or consolidated basis. Experience suggests that reputational risks can quickly destroy large groups of companies, particularly where these have been weakened by connected lending and excessive reliance on funding from associated financial institutions.

Systemic risks are in a sense an extension of reputational risks from individual institutions or groups to the financial system as a whole. A closer examination of systemic risks suggests that such risks occur mainly at the payment system level. Failure of one participant in the payment system triggers a chain reaction in nonpayment by other participants, particularly when the affected parties are unable to raise liquidity themselves in time to fulfil their own contractual obligations. The inability of (reputationally) first-rate institutions to meet their obligations creates uncertainty and can lead to panic self-protective measures by depositors, such as a run. Consequently, the central bank as lender of last resort has to step in quickly before problems spread throughout the system.

One can extend this argument to the economy as a whole. All financial contracts are measured and based on the currency contract, money being the measure and store of value, as well as the means of final settlement. When the central bank, as the issuer of domestic currency, is unable to maintain the stability of the value of the currency internally and externally, depositor and borrower behavior changes, and the crisis is worsened by inflation and currency flight. The reputation of the central bank is destroyed, as its credibility to defend the currency or the stability of the financial system itself is questioned. At that point, perhaps the worst type of financial crisis, the central bank may itself be a party to the crisis of confidence.

In sum, financial crises arise when real losses in the economy occur. These real losses ultimately are reflected in the banking system, through the breakdown of borrower and depositor contracts. A crisis occurs when the existing financial system (the institutions as well as the legal and regulatory framework) is unable to withstand external shocks to the system through sudden relative price changes or through internal corrosion, such as fraud and mismanagement (or a combination of both). A liquidity crisis when solvency is not at stake is a financial disruption. A solvency crisis, in which large parts of the financial system are insolvent, is a genuine financial crisis. The central bank may be able to address short-run crises of confidence through the temporary provision of liquidity, but ultimately it must also address the questions of insolvency of financial institutions and loss allocation. If depositors are to be protected from losses, then the losses are borne ultimately by other sectors of the economy, through inflation, taxation, or levies on the banking system. All these are in the realm of political economy, as the following case studies show.

Types of Financial Crises

Before proceeding to a survey of the different types of banking crises encountered in recent years, it may be useful to make a general observation about banking developments in the 1980s. The catch-phrases globalization, securitization, innovation, and deregulation that arose from the “big bang” are an appropriate starting point.3 The world is becoming one big financial market through liberalization of exchange controls, freeing of exchange rates, and improvements in telecommunications and bank processing technology. In their search for profits and through competition, banks have introduced a number of innovations, particularly new financial products (contracts), such as swaps, options, securitized paper, and off-balance sheet obligations, for which the risks and regulatory framework are by no means clear. National governments have helped the process of innovation and competition through deregulation, although the process of deregulation varies considerably from country to country.

On the other hand, periodic financial disruptions, such as the problems of Continental Illinois or Johnson Matthey, have evolved an illusion of a banking safety net that the central banks will always step in to protect banks that are too big to fail, or whose failure would disrupt the payments or market-clearing mechanisms. This was justified on the basis that the direct costs of rescuing a bank would be lower than the social costs of disruptions to the payments system and the confidence in the banking system as a whole. Implicitly through central bank action or explicitly through deposit insurance schemes, governments around the world have de facto if not de jure guaranteed the nominal value of the liability side of the banking system’s balance sheet, while having relatively little control over the asset side.

Indeed, through innovation, deregulation, and greater volatility of prices, interest rates, and exchange rates, the asset side of banking systems around the world has become much more vulnerable to shocks, at a time when competition and the search for profits have tended to erode the banking system’s capital base. The Basle Committee’s work has helped considerably to stem this erosion, but in a world where share prices can rise and fall 15 percent in one day, and when banks are heavily exposed to property and highly indebted countries well in excess of their capital base, it is not surprising that the public is concerned over the safety and soundness of the banking system. The size of these asset losses are not always transparent to the public, due to the poor state of accounting standards in many countries, inadequate bank supervision, and general unwillingness in a number of countries to deal with such complex problems. These issues become more evident from the following brief survey of country experiences.4

Recent experience of financial crises can be grouped broadly into four country groups: the developed economies with advanced financial systems and reasonably strong supervision; the small, open-market-oriented developing economies that suffered shocks and bank fraud or mismanagement; the centrally planned economies with de facto nationalized banking systems; and finally, the hyperinflation economies that are still undergoing various stages of financial crises and structural adjustment.

The classification of these case studies remains fundamentally qualitative and judgmental, as the quantitative research and analysis is still going on.5 The basis for classification is intuitively simple: solvent authorities (including central banks under this category), defined as those with large reserves, low debt, or the capacity to borrow or tax without affecting significantly monetary and price stability, have generally been able to solve banking crises with relative ease. At the other extreme, governments with large fiscal deficits and heavy external debt may themselves be the fundamental cause of financial crises, and inappropriate measures to deal with crises without maintaining fiscal and monetary discipline only worsen the situation.

Developed Country Experience

Financial disruptions in the advanced economies have so far proved to be relatively easy to solve, because of their sophisticated financial structure—sound contracts, good legal systems, established laws and enforcement agencies, availability of bank management skills, relatively high standards of bank ethics, and reasonably adequate bank supervision that could respond fairly quickly to detect and solve problems. Problems in these economies came mainly from either macroeconomic policy mistakes or flaws in the banking structure that were not corrected in time.

For example, the problems of the U.S. thrifts originated in their flawed funding structure. Their portfolio of long-term fixed interest housing loans were funded from short-term deposits, and many thrifts became technically insolvent when tight monetary policy in 1980–81 raised domestic interest rates. Instead of addressing the capital shortfall directly, the authorities made a number of policy errors: they allowed the thrifts to try to outgrow their problems by liberalizing their asset portfolio (without corresponding improvement in supervision), and they allowed the thrifts to finance the asset expansion through a raised limit ($100,000) on the deposit insurance scheme. Over the last decade, inadequate supervision, plus the moral hazard raised by the high deposit insurance scheme, allowed thrift management to incur large losses in junk bonds, real estate, and other areas where they had traditionally no expertise (Silverberg (1989)). The U.S. savings and loans saga, plus the present problems in the banking industry, came partly from the structural flaws of highly segmented banking markets, regulatory constraints on nation-wide branch banking, and difficulties of coordinating supervision. The saga is still unfolding.

The English secondary banking crisis of 1973–75 was mainly the result of overborrowing on the part of real estate and securities firms that suffered from the collapse of property and share prices following tight monetary policy in the wake of the 1973 oil crisis. While the large clearing banks were not affected, the smaller secondary banks, which were highly exposed to real estate and securities sectors, became both illiquid and insolvent, creating a situation of instability at a time when the economy was adjusting from a balance of payments crisis. The decisive action by the Bank of England to organize a “lifeboat fund” amounting to £1.2 billion (equivalent to 40 percent of the capital base of the English and Scottish clearing banks) jointly with the strong clearing banks, contained the problem. Twenty-six deposit-taking institutions received help from the fund, and eight were eventually liquidated (Bank of England (1978)).

The Spanish banking crisis of 1978–83 was partly the result of structural adjustment in the economy following the oil crisis of 1973 and 1979 and too many new banks as a consequence of financial liberalization. Fifty-one banks out of 110 were affected, involving nearly 20 percent of total deposits. Nearly 90 percent of the problem banks were relatively new institutions (Larrain and Montes-Negret (1986)) and bank mismanagement and fraud was much to blame (de Juan (1985)). Again, decisive action by the Bank of Spain to establish the Spanish Guarantee Fund (jointly with the banks) helped to stem the crisis. The Spanish Guarantee Fund was a model for bank restructuring in a number of other countries.

An interesting case of bank crisis in a largely self-regulated and free market banking environment was the failure of a number of smaller banks in Hong Kong in 1985-86, caused mainly by fraud and mismanagement and lack of effective supervision. The failures were exposed in the wake of the decline in share and property prices following uncertainty over the political future of Hong Kong during negotiations between China and the United Kingdom in 1983–84. In the absence of a central bank, the Hong Kong Government used reserves from the Exchange Fund to finance the liquidity as well as share acquisition support for the affected banks. The Hong Kong case suggests that even in a much vaunted free market environment, financial markets are not very efficient in self-regulation and some effective government supervision is necessary to check fraud and mismanagement.

Developing Country Experience

The second group of small-to-middle-income developing countries that experienced financial crises or distress of relative degrees that are so far documented include Thailand, Malaysia, the Philippines, Colombia, Ghana, and Guinea. These economies with mixed (large public sector banks, operating with private, as well as foreign banks) banking systems suffered a variety of problems, ranging from the effects of structural adjustments in the economy; commingled with extensive fraud and mismanagement, brought about partly because of inadequate supervision, inadequate legal powers to deal with bank problems, and, in some cases, political interference.

The “purest” case of bank failure that could be attributed almost exclusively to fraud and mismanagement without any apparent macroeconomic origins is the case of Guinea-Conakry (Tenconi (1989)). The authorities closed down six state-owned banks, which accounted for 95 percent of the assets of the banking system, after it was found that fictitious assets and accounts accounted for 76 percent of total assets. The Government bore the brunt of its losses from the budget.

For the middle-income countries of Thailand, the Philippines, Malaysia, and Colombia, banking problems demonstrated partly the vulnerability of small economies dependent on a narrow range of export commodities. Overexuberant lending at the height of a commodity boom, followed by strong measures to tackle macroeconomic imbalances in the wake of a sharp decline in commodity prices, had the usual effects of deflation that affected overborrowed enterprises. In Colombia, problems also came from overseas branches of domestic banks, which were used to bypass domestic credit restrictions (Montes-Negret (1990)). In the Philippines, political interference in the government-owned banks’ credit process was a major cause of losses for the two largest banks (Lamberte (1989)). In all these countries, losses were evident in banks that had loan concentrations to large groups, or specific economic sectors, such as real estate. For Thailand and Malaysia, strong corrective measures on the macroeconomic front and tighter bank supervision helped to overcome the distress, and the banking systems recovered rapidly, as these economies enjoyed high growth rates in the last three years. In both cases, the central banks played critical roles in dealing with the crisis, with liquidity or financial support coming mainly from the central banks.

The Malaysian case had remarkable similarities with the Norwegian banking crisis (Solheim (1990)) and the U.S. Texas banking problems, all three economies being oil producers with a high degree of commodity concentration. The Malaysian economy suffered a classic case of Dutch disease in the second half of the 1970s, as high oil income on top of rising commodity prices generated an economic boom, and led to an overvaluation of the currency. This caused a large shift towards nontradables, particularly speculation in real estate. Large fiscal and external account imbalances emerged by 1981–82, with a fiscal deficit as high as 18 percent of gross domestic product (GDP) and a current account deficit of 14 percent of GDP in 1982. With a collapse of oil prices coming on top of the slide in commodity prices in the early 1980s, the authorities cut back on fiscal expenditure, and the resulting deflation brought about massive collapse of share and property prices. The central bank had to step in to resolve 35 deposit-taking cooperatives that failed, 4 badly affected banks, and a number of small finance companies.

Generally, the lessons from this group of case studies appear to be that those countries that successfully tackled their macroeconomic imbalances managed to resolve their banking crises, but not before major restructuring of their financial systems by changing laws, tightening supervision, and improving bank management.

State-Owned Financial Systems

Centrally planned economies with almost wholly nationalized or state-owned banking systems are perhaps the most interesting group of case studies. Theoretically, there should be no runs against state-owned banks, since the banking system carries a blanket state guarantee; however, crises in the financial systems of centrally planned economies emerge as currency flights and monetary overhangs that threaten to explode into hyperinflations. State-owned banking systems have a large capacity to hide losses, because of price distortions in the economy, directed and subsidized credit to loss-making and inefficient enterprises or borrowers, or weak and inefficient bank management. Soviet-style accounting used widely by enterprises and banks in those economies, from China to Eastern Europe, is designed to report compliance with central plan targets and not the viability and solvency of borrowers or banks. In other words, the real losses or inefficiency of borrowers are hidden largely in the books of the banking system, and since the system is a monopoly on public savings (with a state guarantee), such losses can be carried for a long time without erupting into periodic financial crises.

On the other hand, state-owned banks operating in environments with limited private sector enterprises also tend to suffer from fraud and corruption as lowly paid bureaucrats and bank managers can easily succumb to bribes to give loans to enterprises, since all loan losses are borne by the state. Central banks in these environments have great difficulty in supervising state-owned banks because their management are either bureaucrats of the same or equivalent rank or, in many cases, are politically appointed and not accountable to the central bank.

Banking crises in centrally planned economies have a special feature in that all losses of the banking system are effectively quasi-fiscal deficits.6 The typical monobank or recently divested two-tier stateowned banking system carries on its liability side a large deposit liability, partly denominated in foreign currency and the external debt, against which there is very little hard currency reserves. On the asset side, the banking system carries large loans to state-owned enterprises or public sector investments, many of which would not be viable under international prices. Where the currency has undergone devaluation in recent years, it is often not surprising to see large revaluation losses on the asset side of the balance sheet. Where the external debt is vested in the books of the central bank, the central bank suffers large revaluation losses when the domestic currency is devalued. Usually, the cost of financing these losses and servicing the external debt is so large that the central bank loses monetary control. In the Yugoslav case, 80 percent of the National Bank’s revenues at one stage was used to finance interest payments on foreign debt (Gaspari (1989)). The capital losses were as large as 11.8 percent of social product in 1986. When the central bank is called upon to refinance loss-making enterprises on top of monetization of its own revaluation losses, stabilization of the economy through monetary policy is almost impossible.

Given the shortage of convertible currency, some banking systems in these economies allowed banks to accept foreign currency deposits from residents, and the proceeds were surrendered to the central bank in exchange for domestic currency. This placed a large internal debt, denominated in foreign currency, on the central bank. The large net foreign currency liability to residents was a source of monetary instability in Yugoslavia and a number of other Eastern European countries, as residents could quickly shift in and out of domestic currency as a hedge against inflation or impending devaluation. This structural flaw, found in a number of centrally planned economies and other economies, threatens to break out periodically as capital flight whenever political crises occur, thus exacerbating the fragility of the economic system.

High-Inflation Economies

The last group of case studies comprises the economies that suffered extremely severe financial distress, and some are still going through various stages of crises. The most severe case recorded is that of Argentina, which had two bouts of hyperinflation in as many years and appears in the last decade or so to be in a prolonged state of financial crisis. The overhang of excessive external debt and large fiscal deficits were primary causes of financial instability. With external funding shut off as a result of the international debt crisis, attempts to correct the balance of payments deficit through devaluation caused large foreign exchange losses in enterprises, which were transferred to the central bank under an exchange rate guarantee scheme. Large fiscal deficits, caused partly by loans to loss-making state enterprises, were funded through central bank rediscounts, which were in turn financed through high reserve requirements and forced investments on the banking system. Central bank monetization of the large fiscal and quasi-fiscal deficits was a major cause of the hyperinflation. The system was subject to disintermediation from the banking system and periodic bouts of capital flight, held back only by excessively high real interest rates. Bouts of crises were arrested by drastic austerity measures and attempts to curb the fiscal deficit, which were eroded over time by public pressure to increase nominal wages and subsidies to loss-making public enterprises.

These types of crises demonstrate the complexity and extremity of distress when central bank financing of large fiscal (and quasi-fiscal) deficits are at the root of the crisis. The inequities caused by the breakage of the currency contract create complex political problems, which make the financial crises more difficult to solve. Rich savers have the knowledge and skill to benefit from speculative behavior during high inflation and to avoid direct taxation or even the inflation tax through capital flight. The small saver is forced to hold currency for basic transactionary purposes and therefore bears the brunt of the inflation tax.

Probably the most successful case of a turnaround in the banking crises in a high inflation economy was the Chilean banking crisis of 1981–83. Problem banks that were liquidated or intervened by the Government represented 60 percent of the banking system’s portfolio (Larrain and Montes-Negret (1986)). The immediate causes of bank failure were the macroeconomic adjustments to control inflation and correction of balance of payments and fiscal deficits, which sent the economy into a recession and caused extensive borrower defaults. This came, however, on top of a weakened banking structure after the extensive denationalization of the banks in the early 1970s, when the abolishment of legislation against concentration of ownership meant that banking became controlled by large private groups with interlocking interests in industry, commerce, and banking. The Chileans used two major techniques: an across-the-board debt rescheduling for borrowers and coverage against foreign exchange losses and a “carve-out” of bad loans from the banks by the central bank in exchange for central bank promissory notes, to be repurchased over time. Once the macroeconomic situation was stabilized and inflation brought under control, the banking system gradually returned to profitability.

Crisis Resolution

The exact techniques of crisis resolution are dealt with in Chapter 14, by Brian Quinn. This section will deal with the four key stages of resolution of banking crisis, namely, diagnostics, damage control, loss allocation, and rebuilding profitability.

The diagnostic stage in crisis resolution is critical to the identification of the problems and central bank understanding of the depth and scope of the crisis. De Juan calls this “getting out of the dark.” A timely, accurate, and reliable central bank off-site surveillance reporting system, plus other information sources, such as market talk, consumer feedback, research studies, industry surveys, and bank consultations all help to piece together a reliable composite picture of market performance. Having good bank-accounting standards, particularly loan classification and income accrual standards, are critical to an appreciation of the extent of nonperforming loans and to assess whether an ailing institution is only illiquid or in reality insolvent. The reporting system should be able to detect potential problem areas, such as loan concentrations, connected lending, high exposures to market risks, noncompliance with prudential regulations, and any unusual behavior. The off-site surveillance system should be complemented by a team of on-site bank inspectors or external auditors, which can move quickly to assess first-hand the extent of the damage, when a financial institution begins to display signs of failing. Moreover, an alert supervisor would be able to detect structural flaws in the system, which call for major legal and institutional reforms.

Two lessons from experience deserve mentioning in the diagnostic stage: the-sooner-the-better and the-problems-are-always-worse-than-expected. The first dictum requires prompt action—hesitation and procrastination in dealing with a crisis situation have inevitably proved costly. This advice is closely related to the second dictum: bankers have a tendency to sit on a problem until it becomes too big to handle. De Juan relates how the Spanish experience suggested that loan-loss provisions by external auditors tend to be double those made by bank management. Bank examiners would double the provisions made by the auditors, and in a liquidation situation, loan losses would turn out to be double those estimated by the bank examiners. Once a bank moves into negative capital, the losses are effectively passed either to the depositors or de facto to the central bank or deposit insurance fund. As lenders of last resort, central banks would bear the ultimate risks unless such loans are fully secured.

The next stage of damage control (sometimes conducted almost simultaneously with diagnostics) is to stop or minimize losses. This involves an immediate change in management of the problem institutions, if incompetence or fraud is suspected, or at least the placement of competent advisers who can institute effective internal controls and measures to prevent further losses from speculation, continued lending to bad borrowers, and wasteful expenditure. On the part of the central bank, an effective monitoring system has to be established quickly to ensure that the losses and financial condition of the ailing institutions are monitored and reported constantly. Where existing tax measures, regulations, and bad practices have been causes of bank losses, remedies should be taken as soon as possible. On the whole, bank supervision and examination staff should be strengthened, and power for the central bank to act promptly should be provided.

The loss-allocation process is in practice the most difficult stage of crisis resolution, as loss allocation is not always defined in the law, and may have to be done arbitrarily. There are numerous interest groups in the loss-allocation process: the borrowers, bank shareholders, employees, other creditors, depositors, the central bank, and the government. According to present Western convention, defined partly in company and banking law, the bank losses should be borne first by the borrowers, then the shareholders, then other creditors, including employees, and thereafter by the depositors or the government through the deposit insurance fund. In practice, the process of loss allocation depends on the power of individual interest groups. For example, in a number of Latin American cases, foreign exchange losses of the enterprises and borrowers were passed to the central bank. In one African case, the powerful shareholders of failed banks received some compensation from the government. Bank unions can also ask for large compensations. Part of the reason why governments favor deposit insurance funds as liquidators of banks is the sheer complicated process of unwinding thousands of deposit and loan contracts, on top of employment contracts of failed banks, which can easily be disrupted by legal suits.

Thus, more often than not, it becomes politically expedient to absorb bank losses directly into the budget or off-budget in the books of the central bank. The point to remember is that losses absorbed by either the government or the central bank is a fiscal or quasi-fiscal deficit that has to be financed by taxation, borrowing, sale of government assets, or through inflationary financing. Periods of financial crises and structural adjustments are not always the appropriate time to raise taxes. Hence, it is always tempting to political decision makers to request the central bank to absorb the losses. When the central bank has large reserves relative to the size of losses, the problems can be resolved; however, when the degree of losses exceeds even the capital and reserves of the central bank, then the net losses of the central bank tend to become monetized and the loss burden is distributed in the economy through the inflation tax.

Consequently, a critical issue of banking crisis is how the losses are ultimately distributed or borne in the economy. Since the central bank is part of the government, the government may initially take responsibility for the losses, but it is eventually passed on to the population in the form of higher taxes, borrowing, or through the inflation tax. Experience shows that measures that affect the solvency of the central bank is self-defeating and may prove highly costly in the long run. The government has to deal with the loss directly through the budget, and become the “equity provider of last resort.” How the bank losses are ultimately distributed to the system would depend on the combination of techniques adopted.

For example, the government need not bear the full brunt of the losses. In a number of cases, losses were borne partly by the depositors. In Malaysia, the depositors of the failed deposit-taking cooperatives received 50 percent of their deposits in the form of equity in a licensed finance company that took over the assets of the failed cooperatives, while the balance of 50 percent was repaid over a three-year period at a low rate of interest. In Thailand, depositors of failed finance companies received only the principal portion of their deposits in ten equal installments over ten years, interest free. This represented roughly a 50 percent loss in real terms when deposit rates were around 10 percent a year. This technique of cofinancing by depositors was also recently adopted in an Australian failed building society. Another way to recover costs is through ex post levies on the banking system, which would pass the costs back to the consumer through higher bank spreads.

Finally, the root cause of bank losses must be addressed. Often these can be found either in distortions in the enterprise sector, fiscal imbalances, or structural imbalances in the economy that require major policy changes. In addition to laying down a sound and competitive framework for banks to operate in, under which they can rebuild profitability, it is essential that a sound and stable macroeconomic environment is built for the real sector, with appropriate policies that encourage competition and efficiency. Dealing with bank crisis without tackling real sector distortions will invite a repeat crisis in the near future.

Crisis Management by Central Banks

Much has been written about banking crises, but relatively little about how one manages institutionally during the crisis. References on how to handle a financial crisis are few. The only helpful practical advice remains variations on Bagehot’s dictum for the central bank to lend liberally in a financial crisis against good security. The academic literature has been sparse on the practicalities of dealing with crises.

How one deals with crises depends on the circumstances of each case, such as the legal framework, institutional structure, and often the capabilities of the crisis management team. Since central banks are directly responsible for the stability of the financial system, it is often assumed that central bank management knows how to handle crises. The case study of Malaysia illustrates this point. The Central Bank of Malaysia’s capacity to deal with bank problems was shaped by its early history. Following runs on a large domestic bank in the mid-1960s, the Malaysian central bank, Bank Negara, began to build up its bank supervision and examination capacity. It developed, early on, teams of inspectors with the capacity to identify quickly bank problems, especially in the credit portfolio, and to assess the quality of bank management. At the same time, an off-site surveillance system was installed with a comprehensive bank data base. In the early 1980s, as banks began to “herd” into lending to finance the property sector, the Bank put into place close monitors on lending to property and shares.

The Bank also led the way in installing a sophisticated dealing room with good telecommunications to help develop the domestic money and foreign exchange markets. Under a flexible exchange rate regime since 1973, the Bank soon built up its own skills in managing the interbank money and foreign exchange markets and relied heavily on the dealing room to monitor market trends.

In 1983–84, the Bank was closely involved with the Ministry of Finance and the Economic Planning Unit of the Prime Minister’s Department to address the large twin deficits in the budget and the balance of payments. It realized that the self-imposed structural adjustment program, calling for very large budgetary cutbacks in the face of declining commodity prices, would have a massive deflationary impact on the economy, and hence on the banking system. Early signs of the impending recession came when the stock market crashed first in 1983, recovered for a short while, and then crashed again in December 1985, when the Kuala Lumpur stock exchange was closed for a few days.

In preparation for potential banking problems, the banking law was changed to allow the Bank to acquire shares in ailing banks. No deposit insurance scheme was envisaged as the stronger banks were not willing to finance the failure of weaker institutions. By coincidence, emergency legislation was drafted as a contingency plan to deal with illegal deposit-taking corporations that sprung up during the period of tight liquidity. This piece of legislation was a powerful tool for the Bank in dealing with the collapse of 24 cooperatives, involving more than half a million depositors in July and August 1986. The suspension of payments by the cooperatives (not supervised by the Bank) caused immediate runs against a number of the weaker licensed finance companies, which the Bank had to deal with.

A clear issue in dealing with financial crises was which agency should deal with the day-to-day problems, and how could the problems be managed from an issue and policy point of view. How could that agency, for example, be accountable for financial and other decisions that have budgetary and political implications? These issues fortunately were spelt out in the Malaysian emergency legislation. The central bank was vested with the responsibility and power to deal with the crisis. It could not, however, carry out its wide powers, such as investigate or “freeze” bank accounts of cooperatives or bank management suspected of fraud, without clearing it through an advisory panel, comprising the governor as chairman, the secretary-general of the treasury, the attorney general, the chairman of the Association of Banks and a private sector member. This panel de facto became the policy-making body that oversaw the handling of the crisis, summoning as and when needed advice from the Cooperative Department, police, or other government departments. The secretariat of the panel was vested in the Bank Regulation Department of the Bank, which prepared regular position and policy papers for decision by the panel. The panel met sometimes daily but at least once a week to decide on important issues. Administrative costs for managing the crisis were borne by the central bank.

To manage the 17 firms of auditors plus numerous teams of bank examiners that had to investigate the 600 odd branches of the cooperatives, the Bank established an Operations Room, continually manned to monitor, coordinate, and direct operations. This served as the center in which all information sources were concentrated and digested. For example, reports came in from newspaper articles, public tip-offs, calls from banks or finance companies, examiners returning from onsite inspections, and other sources about the occurrence of bank runs or any incidence affecting the banks, finance companies, or licensed finance companies. When a bank run occurred, the Operations Room would be able to register the incident, determine the cash requirements, obtain authority from the head office of the branch concerned to provide the Bank with collateral or funding, and promptly authorize the nearest central bank branch to issue cash against such collateral. The Bank used the opportunity to obtain from the bank or finance company management or shareholders maximum cooperation for assistance. In a number of instances, the Bank was able to effect required changes in management or commitments to increase capital, before additional funding was approved. The policy of the Bank in bank runs was to supply as much cash as required to meet the deposit withdrawal, until depositors realized that it was pointless to run against a bank or finance company behind which the central bank stood as lender of last resort. Prompt press releases were made to give assurances to the public that the central bank was providing liquidity support. Hesitation in meeting deposit withdrawals always worsened bank runs.

The Operations Room was critical as an information and decision center. It had current information on the financial conditions of each licensed institution and was able to refer quickly to senior staff for decisions. It coordinated information received from all sources, including the dealing room, which monitored behavior in the money and foreign exchange markets. Information gaps and monitoring deficiencies were quickly corrected. For example, the Bank’s information on bank exposure to shares prior to 1986 was subject to considerable lag. This was quickly corrected, since it became apparent that a number of smaller finance companies had been lending considerably to finance shares and were vulnerable to further declines in share prices. By the October 1987 stock-market crash, the Bank had current information on the exposure of each bank to each stockbroker. The Operations Room was a useful adaptation of a military innovation that helped to deal with immediate problems without losing sight of the overall strategic directions. It played a key role to keep the central bank management, other government departments, and the political decision makers constantly informed of developments, policy issues, implications, and options for decisions. Once decisions were made, the Operations Room implemented the decisions, issued necessary press releases to keep the public informed to allay problems of public uncertainty, and maintained the pace of reforms and measures necessary to deal with the crisis.

The lesson of the Malaysian banking crisis of 1986–88 in the management aspect is perhaps that it was critical to have political backing and intragovernmental consensus and cooperation to deal with the crisis. Once it was decided that the central bank should be the lead organization to handle the crisis, an administrative decision-making mechanism and structure was quickly built to cope with the crisis as it unfolded. Timely, reliable, and accurate information was critical, and the Bank used external auditors to supplement its own examination teams to verify the information. The information received was quickly digested and analyzed, and policy recommendations evolved from the advisory panel decision. Having the legal powers to act quickly and effectively under the emergency legislation was important. Keeping the public informed and winning the confidence of the public in the tough action taken against bank mismanagement and fraud was equally critical. It was quite clear, however, that without the correction of the macroimbalances, specifically cutting the fiscal deficit and turning around the balance of payments current account to a surplus, the banking crisis could not have been solved so quickly.

Conclusions

In sum, the nature of financial crisis is complex, with economic, political, institutional, and legal implications. There are immense difficulties and complex conditions under which different central banks work in dealing with financial crises. Each central bank has to work with different resource constraints, financial as well as manpower, under disparate cultural, national, political, and bureaucratic environments.

It is too easy to say that prevention is better than the cure. Certainly, the avoidance of macroeconomic imbalances, the existence of efficient and competitive banking systems under strictly enforced bank supervision to prevent fraud and mismanagement, and an underlying strong real sector all help to prevent crises, or at worst the minimization of financial disruptions.

Central bankers have to deal, however, with the real world, where such imbalances and crises exist. Central bankers have an institutional role to maintain the integrity of the currency contract—that is, the stability of the internal and external value of the currency. This implies above all financial discipline on banks, enterprises, and governments, particularly fiscal discipline. It is when the currency contract is broken, when the public loses confidence, when the banking system and ultimately the government will not protect their savings that crises break out. The solvency of the central bank, that is, its net capital and reserves, only helps to bolster that confidence. In the last analysis, it is the professional competence, integrity, and independent judgement of the central banks that can steer policy in the right way or the wrong way. Without financial discipline, banking crises are historical inevitabilities.

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*The author is a Senior Financial Specialist, Financial Policy and Systems Division, World Bank, on leave from his position as Advisor, Bank Regulation, Bank Negara Malaysia. All views and opinions expressed in this paper are entirely those of the author and do not represent those of the World Bank or Bank Negara Malaysia.
1The subject of dealing with international financial crises is outside the scope of this paper, although many international crises have national origins. For a survey of the issues involved in international banking crisis, see Krugman (1989).
2Excellent surveys of the literature on financial crises are found in Bordo (1985) and Sundararajan(1988).
3The “big bang” is the term usually applied to the liberalization of the U.K. securities markets in 1986 and is generally extended to the financial liberalization efforts of the 1980s.
4This brief survey cannot do full justice to the complex origins and factors involved in each case. For detailed discussions of cases mentioned, please refer to references cited.
5An excellent analysis of seven cases—Argentina, Chile, Uruguay, Thailand, the Philippines, Spain and Malaysia—was presented in Sundararajan (1988). For short summaries of individual cases, see Sheng (1990).
6By definition, when there is an implicit or explicit government guarantee on bank deposits of a banking system, and the government would not allow any bank to fail, all losses of the banking system (after deducting capital and reserves) are quasi-fiscal deficits.

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