Randall S Kroszner: Analyzing and assessing banking crises
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of San Francisco, Conference on the Asian
Financial Crisis Revisited, San Francisco, 6 September 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Good morning. I am delighted to be speaking to you today at the second of a pair of excellent
conferences that the Federal Reserve Bank of San Francisco has organized on the tenth
anniversary of the Asian financial crisis. Janet Yellen and her staff deserve kudos for
focusing our attention on this important topic and I feel honored for the invitation to speak
today.1
Introduction
Before moving to the main topic, I would like to reinforce remarks made last week by
Chairman Bernanke on the recent turbulence in financial markets. In the United States we
have seen a fairly sharp downturn in housing markets, and in recent weeks there have been
growing investor concerns about mortgage credit performance, particularly with subprime
mortgages. If current conditions persist in mortgage markets, the demand for homes could
weaken further, with possible implications for the broader economy. And financial stress has
not been limited just to mortgage markets, but has spread to other markets. In general, a
shift in risk attitudes has interacted with heightened concerns about credit risks and
uncertainty about how to evaluate those risks. Fortunately, this recent period of turbulence in
financial markets has occurred at a time when U.S. commercial banks are strongly
capitalized, reflecting years of robust profits.
As the nation's central bank, the Federal Reserve seeks to promote general financial stability
and to help to ensure that financial markets operate in an orderly manner. Accordingly, the
Federal Reserve has taken some steps in recent weeks to provide liquidity and to promote
the orderly functioning of markets. We continue to follow these developments in financial
markets closely, particularly those that may have a broad impact on real economic activity.
Today I plan to offer some thoughts about ways to analyze and assess the impact of banking
crises on real economic activity. Others at this conference will be addressing some of the
specifics of the Asian financial crisis in 1997-98 and the status of economies and financial
systems of Asian countries today, so I believe I can best contribute by setting up a
conceptual and empirical framework that can be applied to various types of financial crises,
including Asia in 1997-98.
Much of what I plan to discuss is based on a paper I published earlier this year with
colleagues at the International Monetary Fund and World Bank, Luc Laeven and Daniela
Klingbiel, titled "Banking Crises, Financial Dependence, and Growth".2 In particular, this
research focuses on a key question for policy, namely, through what channels can financial
turmoil have an impact on real economic activity? We study the effect of different types of
crises on the performance of various sectors and firms in economies with differing levels of
development of their banking and financial systems. Surprisingly, little systematic empirical
work had been done detailing the mechanisms by which financial crises can generate
problems in the real economy.3 I will provide a brief overview of these results and then draw
some lessons that policymakers might keep in mind when considering ways to help prevent
and mitigate future crises.
As a final introductory thought, I want to note that my remarks today on banking crises relate
to research conducted on a range of countries, many of them emerging-market countries,
and are not a commentary on current financial conditions or on the health of the U.S. banking
system, which, as I noted above, is quite good.
Framework for assessing and analyzing banking crises
Financial crises can assume various forms. I am going to focus primarily on financial crises
involving the banking sector and do so for several reasons. First, banks play a prominent role
in the credit intermediation process in most countries, providing funding to firms beyond the
cash flow provided by their normal operations. Banks also typically serve as custodian of a
significant portion of household saving. In many Asian countries, for example, banks play a
key role in channeling credit to firms - particularly those firms not able to acquire funding
from capital markets or other sources - and also hold substantial consumer deposits.
In addition, much of the literature on financial crises indicates that crises involving the
banking sector can lead to disruptions in the real economy. The definition of banking crisis I
will use today, consistent with the definition in our recent paper, is an episode during which
the capital of the banking sector has been depleted due to loan losses, resulting in a
negative net worth of the banking sector.4 Therefore, the use of the term "banking crisis" in
our research refers to major disruptions in a country's banking system, not just minor
downturns or disturbances. By focusing on banking crises in our research paper, we were
able to isolate the impact of banks on the provision of credit and liquidity to firms during times
of distress. I believe that combining this type of empirical research on banking crises with
practical experience from bank supervisors and market participants, such as those attending
this conference, helps us all to understand and address the problems associated with
banking crises - and perhaps even to help to prevent them.
Much work has been done on how financial intermediaries and financial markets facilitate
investment by firms and, hence, promote economic growth.5 Financial intermediaries and
financial markets are generally thought to reduce information asymmetry problems that can
make raising external funds difficult and expensive for firms. Well-functioning and
welldeveloped financial intermediaries and markets thus should particularly benefit firms that rely
most heavily on external funding to finance their growth.6 Conversely - and this is the novel
aspect of our research - crises in the financial sector thus should have a disproportionately
negative impact on firms that rely heavily on external sources of finance.
In particular, we investigate whether the impact of a banking crisis on sectors dependent on
external sources of financing varies with the level of development of the financial system. If
the banking system is the key element allowing firms that depend heavily upon external
funding sources to finance their growth, then an impairment of these intermediaries - in a
system where such intermediaries are important - should have a disproportionate
contractionary impact on precisely those sectors that flourished in "normal" times, due to their
reliance on banks. Thus, an important element of our analysis is the level of development of
a country's financial system, that is, whether it is "deep" (more developed) or "shallow" (less
developed).7
To address these issues, we gathered data from thirty-eight developed and developing
countries that have experienced a banking crisis during the last quarter century.8 We
documented clear linkages between the state of the banking system and the performance of
the real economy. More specifically, we find that in well-developed and deep financial
systems, sectors highly dependent on external sources of funding tend to experience a
greater contraction during a banking crisis than do externally dependent sectors in countries
with shallower financial systems. In other words, sectors of the real economy that rely heavily
on external finance (that is, do not fund capital expenditures through cash flow) tend to
experience a substantially slower growth of value added during a banking crisis than those
sectors that do not rely so heavily on external funding. This effect is more pronounced in
countries with more developed financial systems. Our results hold for a wide group of
countries and over a long time span, but as I note below, have particular relevance to
emerging market countries.
While these results are consistent with a so-called credit channel impact of banking crises on
real economic activity, there are further implications of the "credit channel" view that we
explore in more detail. Among firms that depend heavily on outside financing, young firms
with short histories and firms with a large fraction of hard-to-measure intangible assets, for
example, may have particular difficulties raising funds from the market due to information
problems. Instead, such firms would tend to depend heavily on banks and other
intermediaries for funding. Consistent with this, we find a greater negative impact of banking
crises on growth for industries dominated by young firms that are highly dependent on
external finance and for industries with high levels of intangible assets.
While all of these results are consistent with a "credit channel" view of the impact of banking
crises on real economic activity, we certainly need to explore some alternative explanations
before drawing final conclusions. In particular, many factors may be correlated with the level
of financial development of a country, so we want to make sure that the level of financial
development is not simply standing in for something else. The differences in financial
development, for example, can arise from historical, political, cultural, and legal reasons.
There is a well-developed literature emphasizing, for instance, that the nature of a country's
legal system and the manner in which laws are enforced can have an effect on the
development of its financial system.9 Similarly, other country-specific factors also might have
an influence on how financial institutions and markets behave. If one of these factors, rather
than financial development, is driving the results, we might have to interpret those results
differently.
As a way to try to address such questions of interpretation, we controlled for the quality of the
political and legal institutions in the countries included in our data analysis. We found that our
results still hold, namely that a banking crisis has a more pronounced effect on a country's
economy when its financial system is more developed and when its firms rely more on
external finance, even after taking into account a variety of proxies for the differences in the
quality of institutions and legal structures across countries.
Furthermore, we explored differences in the effect of banking crises on countries based on
their overall levels of development. In other words, we wanted to assess separately the
impact of banking crises in less-developed countries versus more-developed countries since,
of course, overall economic development and financial sector development tend to be
correlated. Interestingly, when we remove Organization for Economic Co-operation and
Development (OECD) countries from our sample, the effects of banking crises were more
pronounced, indicating that banking crises in emerging market countries likely do more harm
to the overall economy than in developed countries.
Interestingly, our research also provides evidence that crises affecting the banking sector
can have a more serious impact on the real economy than alternative economic disruptions
such as economic contractions or shocks such as currency crises.10 That is, banking crises
have represented a unique shock to a country's financial system. These results suggest that
the "credit channel" effects on real economic activity we document are operating through the
banking system.
In short, the results highlight that a healthy banking system generally contributes to strong
economic growth, and banking crises can present a substantial drag on the real economy.
This underscores why we consider it important to analyze the economic impact of financial
crises involving the banking sector, and to mitigate potential drivers of such crises. Indeed, in
the case of Asia a decade ago, the trouble experienced by the region's banks, given their
dominant role in Asian financial systems, created disruptions that spread across Asia.
Problems in the real economies of Asian countries would likely not have been so great had
the banking systems been stronger.
So far I have been discussing results that focus on the real growth impact on sectors or
industries. We were able to obtain data on the impact on individual firms but for a smaller
sample than for the sectors or industries. We use a variety of measures for individual firm
performance, such as real growth in sales, real growth in earnings before interest and taxes,
and real stock market returns. The results are the same as in the sectoral level data I
described above: The performance of firms heavily dependent upon external sources of
funding is disproportionately negatively affected in deep financial systems during periods of
banking crisis.
In addition to providing microeconomic support for the credit channel view, individual firm
data also allow us to examine important hypotheses about the impact that transparency and
public disclosure by individual firms can have to mitigate the effects of banking crises on
those firms. One author, using data from the Asian crisis, has investigated the relationship
between stock market performance and quality of public disclosure.11 Our recent paper also
delved into this issue by using certain proxies for individual firm disclosure practices, such as
having a listing in the United States (hence disclosing by U.S. standards) or by being audited
by one of the major international accounting firms. Our results suggested that greater public
disclosure had a favorable impact on stock market performance, both during the crisis period
as well as afterward. Indeed, there is a large literature supporting the idea that a country can
benefit by promoting transparency and disclosure. But I know that there is still ongoing
debate about the effects of globalization on financial markets and economies and I believe
that further research and discussion about the benefits of openness and transparency are
worthwhile. Perhaps a discussion on this topic will ensue at this conference over the next two
days.
I will pose one final topic before moving on to some policy suggestions. I believe it is
important to try to understand the long-term impact of a crisis on the financial system and the
real economy. In particular, it is useful to examine whether a particularly deep crisis or a
recent one may have effects on participants in that country during the next crisis.
Interestingly, our recent work provided some evidence that past crises do not necessarily
create a stoppage of bank credit to firms once "normal" times returned, but when the next
crisis occurred, its impact on growth was usually deeper in magnitude.
Thoughts on preventing and managing banking crises
Having raised some issues for consideration about banking crises - and having tried to
provide some answers, where possible - I would now like to offer some thoughts that
policymakers may consider as they try to prevent and manage banking crises. I note that
market participants should also consider these ideas, since it is not just policymakers who
can learn lessons from past crises.
First, one of the major lessons to be learned from past banking crises is the importance of a
healthy banking system. Maintaining a safe and sound banking system, given the key role
that banks play in most financial systems, contributes to the health of a country's overall
economy. Most countries do this by some form of banking supervision, generally accepting
that the added protection to the banking system in the form of supervision is worth the costs
of the regulatory burden. Effective banking supervision has helped foster a banking system in
the United States that today is safe, sound, and well-capitalized.
One of the ways that bank supervisors can help promote a healthy banking system is to
focus banks on the development of improved risk-management techniques. Indeed,
identifying, assessing, and promoting sound risk-management practices have become
central elements of good supervisory practice. Bankers should ensure that their
riskmanagement practices include a focus on less likely outcomes, not just the most common
ones, and that the bank is being adequately compensated for the risk it is bearing. The use
of exercises such as stress tests and scenario analyses can help bankers identify certain
points of vulnerability that may arise during potential downturns.
In some countries, bank supervisors have an explicit responsibility to ensure that banks
adhere to existing laws and maintain and implement appropriate consumer protection
policies. For example, in the United States the federal banking agencies play an important
role in fostering not just a safe and sound banking system, but also one that is diverse and
fair in meeting the needs of consumers.
Good banking supervision is vital to the health of banks, particularly when the banking
system has some type of government support - for example, either explicit or implicit deposit
insurance. But ensuring a safe and sound banking system that is also competitive and
profitable has its challenges. Clearly, banking supervision on its own can create some
distortions or burden, so it is also very important to let market forces work as much as
possible, with reliance on market participants - in their role as depositors, counterparties,
creditors, and shareholders - to exercise discipline on banks. Policymakers have to find the
right balance between the more visible hand of government supervision and the invisible
hand of market forces.
Second, pursuing sound macroeconomic policies is another way for policymakers to help
prevent banking and financial crises. For instance, it is beneficial to have sound and
sustainable monetary and fiscal policy to provide a stable operating environment for
entrepreneurs and financial institutions and markets. Many past crises were precipitated
either by an external shock affecting an already vulnerable financial system or by market
participants targeting vulnerabilities in certain markets or in certain institutions or
governments. History has taught us that if a condition or policy looks unsustainable, it most
likely is and market forces will eventually bring it to an end. To paraphrase Herb Stein, if a
policy cannot go on forever, it won't!
Third, I referred earlier to research on the benefits of disclosure and transparency. Our
analysis contributes to the evidence that having an open and transparent financial system
and economy, accompanied by reliable and accurate accounting standards, generally
benefits a country and its market participants. A core principle of economics is that markets
are more competitive, and therefore more efficient, when accurate information is available to
both consumers and suppliers. Information is thus critical to the effective functioning of
financial markets: timely and accurate financial information about markets, market
participants, and governments is important for all actors to be able to make informed
decisions. This is of course true during normal times, but perhaps more so during a crisis
when market participants and governments are sometimes trying to determine where
problems lie and how severe they might be. Lack of information can present additional
problems during a crisis, and incorrect or incomplete information provided by firms,
governments, and other institutions can severely undermine their credibility, worsening the
problem.
Conclusion
These conferences on the Asian crisis serve as excellent forums to analyze the events of ten
years ago and share views on ways to prevent and mitigate future crises. They also allow
market participants to offer feedback on past policy steps, including which past policies
helped and which ones hindered. Policymakers and market participants must remember that
preventing and mitigating financial crises requires a blend of sharp analysis, keen judgment,
practical experience, and rigorous understanding of how markets work - in both normal times
and times of stress.
I have tried to provide a framework for analyzing the impact of banking crises on real
economic activity, described some results analyzing crises from around the world during the
last quarter century, and offered three policy lessons: the importance of a healthy banking
system, of sound macroeconomic policy, and of high levels of transparency and disclosure.
This is by no means an exhaustive list but I hope it can provide a useful starting point for the
discussions that will take place during the rest of the day.
As a final thought, I counsel policymakers and market participants alike to remember that no
two crises are the same. Recall that the Asian crisis of 1997-98 actually manifested itself
differently across Asian countries, with each country having its own set of problems and
needing to find its own solutions. In other words, there is never a single remedy to each crisis
and each brings its own surprises and risks. Clearly, we can all learn a lot from past crises -
which is the value in holding conferences like this one. But we should not assume that past
remedies will fully solve the next set of problems or address all future risks. The key is to
take lessons from the past and tailor them appropriately to future situations of potential
distress.
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