Friday, September 26, 2008

The real costs of the banking crisis will be high!

I am sorry that I did not post until now, but while fighting a slight fever, I have been catching up a bit on my knowledge of banking crises by reading an IMF working paper, Systemic Banking Crises: A New Database. This paper reports simple descriptive statistics for 42 systematic banking crises across 37 countries, including the current crises in the U.S. and U.K. It details information on the macroeconomic conditions at the start of the crises, the containment of the crises, and the resolution of the crises. After reading this paper, I see that the U.S. and U.K. will pay a high price, via high fiscal deficits or low output. Either way, we are in for a ride.

Across the 42 banking crises, a wide range of policies were used to contain and resolve the crises, including Troubled Asset Relief Program (TARP) – style reallocation of wealth. But a reallocation away from tax payers and toward debtors (banks) comes at a cost: The moral hazard associated with banks abusing government shelters can result in further mismanagement of risk and capital after the crisis is resolved. Point: Government intervention really doesn’t fix the problems at hand – the gross mismanagement of risk – but it alleviates the short-term economic pain of mass bank failure. And the Troubled Asset Relief Program (TARP) will be no different.

According to the paper, banking crisis can be broken down into its three phases, which I have summarized, and then comment on below:

(1) Initial conditions – macroeconomic conditions are usually weak before a banking crisis.
Fiscal balances are usually negative (-2.1% of GDP on average); current accounts are usually negative (-3.9% on average); inflation is high (137% on average); GDP growth is average (2.4% on average); non-performing loans – bank loans that are not earning interest and the borrower is likely to default - tend to be high (25% of total loans on average).

RW: In 2007, the annual fiscal balances as a % of GDP were negative in the U.K. (-0.29%) and the U.S. (-1.36%); the current account as a % of GDP was negative in the U.K. (-4.32%) and in the U.S. (-5.30%); GDP growth was 3.06% in the U.K. and 2.03% in the U.S. The macroeconomic statistics satisfied some of the average initial conditions for a banking crisis, with the exceptions of high inflation and a non-performing loans (4.8% in the U.S.).

(2) Crisis Containment – emergency liquidity support and blanket guarantees are commonly used. In the 42 banking crises, 71% were complimented by new liquidity measures, while 29% included blanket guarantees on deposits.

RW: The U.S. Federal Reserve Bank (Fed) has extended its liquidity facilities since December 2007 when the first Treasury Auction Facility (TAF) was announced. In addition, the Fed has opened additional funding measures, the Term Securities Lending Facilities (TSLF) and the Primary Dealer Credit Facility (PDCF); both facilities accept a wide range of collateral from Depository Institutions (regulated by the Fed) and Primary Dealers in exchange for Treasury bills or direct funding.

The Bank of England (BoE), the U.K. central bank, also extended its lending facilities in April 2008. Like the Fed, and under the Special Liquidity Scheme, the BoE now accepts a wide range of collateral, including mortgage-backed securities in exchange for government bills and bonds for a one year term. Further, the government offered a guarantee on deposits at Northern Rock (mortgage lender in the U.K.) during its collapse.

(3) Crisis resolution – reduced regulation is often a theme in the resolution phase, but strict regulatory standards follow the resolution. This does not usually solve the problem, and often, a restructuring of the banking system occurs.
In 86% of the 42 crises, despite regulatory forbearance, governments were forced to intervene directly by closing banks, facilitating mergers, or nationalizations.

RW: Sound familiar? In an effort to avoid marking illiquid assets at their current market values, regulators have turned a blind eye to potentially insolvent balance sheets. A quote from Naked Capitalism:
“So rather than follow the course of action that has been shown to work in Sweden and to a lesser degree in the US S&L crisis, namely, let asset prices fall, strip out bad assets and sell them, combine and recapitalize the good pieces, and sell those to the public too, we have clearly decided to go down the Japan path, of maintaining phony asset prices to keep institutions that would otherwise fail alive.”
RW: I agree, why not force the assets to be marked down to current market values (which is nothing), and let the banking system work it out; history has shown that regulatory forbearance doesn’t work! Eventaully, banks will fail. WaMu?

My final thoughts

After reading this paper, it is obvious to me that the current banking crises that are plaguing the U.S. and U.K. are not unusual in the world of banking crises. The difference is: The banking crisis is in developed, rather than developing economies. And in a developed world, a significant amount of capital is at stake. According to the McKinsey Institute, the value of global capital markets in 2006 was $US 167 trillion, where the U.S. held $56.1 trillion and the U.K. held $10 trillion. The current banking crises in the U.S. and U.K. puts $66.1 trillion, 40% of the world’s stock of capital, at stake.

Overall, the fiscal costs and real effects of banking crises are high.
  • On average, fiscal costs (RW: net of recoveries, meaning net of the potential profits earned from TARP) average 13.3% of GDP.
  • Using an asset management company to manage the portfolio of acquired assets by the government (again, TARP) may lower only slightly the fiscal cost by increasing the recovery rates.
  • Output losses (loss in aggregate production) average 20% of GDP during the first 4 years of the crisis.
  • RW: In the case of the U.S., there will likely be less output loss and higher fiscal costs, as the two are negatively correlated - higher fiscal costs lower output loss - across the sample of 42 banking crises. The TARP program illustrates a strong desire to go down the fiscal road.

The U.S. banking sector has hit the containment phase of this crisis and moved on toward the resolution phase. However, the banking crisis cannot be fully resolved until the housing market bottoms. I still see that U.S. home sales will bottom this year, followed by a trough in home prices next year, and the start of a healthy recovery in 2010. Once that happens, the mortgage-backed securities will likely assume some positive value, and the U.S. government will finally realize the costs of its interventions.

Overall, the outlook for the U.S. is not good. This paper indicates that ex post (after all is said and done), the costs – fiscal or reduced output – will be high.

Rebecca Wilder

1 comment:

  1. They still have not agreed on anything in DC. Just maybe someone will be able to get a Swedish style plan going. Read somehwere else today that it would be a viable option but not totally the answer. Maybe there is no totally right answer. I pray for us.....