Crises are not new and they don’t just happen in emerging markets. A recent study by Reinhart & Rogoff (Banking Crises: An Equal Opportunity Menace, 2008) documented more than 260 separate crises across 66 developed and emerging market countries since 1800. It starts with the Bank of France crisis in 1802 and continues right through to the current global financial crisis. They found banking crises to be an “equal opportunity menace” for both developed and emerging economies, no matter which way history is cut and diced.
Not only are banking crises not a new phenomenon, they tend to come in waves. During the Great Depression simultaneous banking crises occurred. But there were also other waves of global financial stress, including around 1907 and the start of World War I.
More recently, and possibly as a consequence of inadequate regulation, the occurrence of banking crises increased simultaneously with worldwide financial liberalisation through the 80s and 90s and increased levels of international capital mobility. Examples include the US savings and loan crisis, the bursting of Japan’s asset bubble, the Mexican crisis, the Asian crisis, as well as the recent credit bust.
This current crisis isn’t a traditional banking crisis in the sense that for the most part, panic and runs on banks have generally been averted. However, by mid-September 2008 no one wanted to lend due to the fear that counterparties weren’t safe, global interbank lending seized up, the liquidity crisis became a credit crunch and stock markets crashed.
Credit cycles have long been linked to economic cycles. They occur after booms and are subsequently associated with economic downturns. Irving Fisher famously documented this in his The Debt Deflation Theory of Great Depressions as long ago as 1933. He noted then the role of financial innovation in luring investors to increase leverage…not much has changed!
This time, with investors having leveraged via financial and non-financial institutions, systemic risk was lower because it was distributed across many players. But as noted by Michael Bordo (An Historical Perspective on the Crisis of 2007-2008, 2008), rather than reducing risk, this increases risks by raising the probability of a much more widespread meltdown in the event that a crisis occurs. When institutions with low capital ratios are hit by a crisis, they commence major deleveraging and the fire sale of assets into a falling market. As we saw recently not only was the US full of overleveraged consumers with overpriced houses, but many countries in Europe and elsewhere had their own real estate bubbles, and shared in the consequences of a rapid deleveraging process.
If crises aren’t new, then the consequences of crises aren’t new either.
Domestic crises can have international consequences. Reinhart & Rogoff found that historically a high incidence of global banking crises has been linked to a high incidence of sovereign defaults on external debt. Ecuador has already defaulted on part of its external debt. Argentina looks to be reducing its risk of default by treading a path that has involved nationalising the local pension fund. The IMF has been called on to rescue countries from Iceland to Latvia and the Ukraine, just to name a few. And while advanced economies are less prone to default on sovereign debt than emerging economies, they are no less prone to banking crises in the first place.
Investors are rediscovering their true risk tolerance – and its asymmetry. In boom times, players are more than happy to take ‘risk’ and leverage up their investments to achieve higher returns. In contrast, once things go bust, there is almost no reward great enough to entice shocked and scared investors back into risky markets.
Governments around the world are now, with some success, stabilising their economies through policies which push up public sector indebtedness. Reinhard & Rogoff estimate that government debt rises an average of 86 per cent in the three years following a banking crisis. This is due to a combination of bailout costs and fiscal costs, which are dependent on both economic and political factors. The recovery of the real economy can be protracted, adversely affecting government revenues beyond the timeframe of increased fiscal stimulatory spend
The adjustment process should not be expected to be smooth but already the riskiness of risk assets has diminished; and the risks embedded in ‘safe haven’ assets (treasuries) are rising. This is not a time for looking backwards and extrapolating past returns – we can be more confident that the reward from most risk assets will eventually be delivered to investors brave enough to seek it.
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