Systematic Banking Crises: Learning from the Past

I’ve had some more questions recently about the banking situation so I’m going to try cover some of it here.   People are worried that the TARP and bailout plans really won’t work and will cost a lot of money.

I covered some of this in October when the IMF came out with a working paper by Laeven and Valencia (2008 ) that looked at systemic banking crises and policy responses to them from the period 1970-2007.   This was at the time the TARP was pretty new and the financial crisis was not at the center of many people’s lives.

This study is 80 pages and it uses lots of  multiple regression analysis between country characteristics, banking system characteristics, and emergency measures taken by policy makers to solve these kinds of crises so be prepared to enter my world if you want to read it.  It’s not as bad as it could be, but be prepared.   It is beyond wonky.  It’s your basic research by economists meant at shaping policy worldwide.

They even separate the ’emergency measures’ from the long-run challenge of crisis resolution. The goal in the long run is to get the credit system and legal system back to functionality as well as rebuilding balance sheets of both banks and borrowers.  The short run emergency measures tend to be more focused on containing the crisis itself and stopping the contagion.  That means there are two phases to the response.

The first phase, crisis resolution typically involves coordinating problems that exist between debtors and creditors and frequently resembles a bankruptcy process.  A lot of this has to do with loans going bad. Two banks, for example, went into receivership this weekend.  There have been a total of 13 for this year already.  The FDIC and the Federal Reserve bank have procedures to handle this and are currently working on what to do for bondholders and equity owners of the bank while making sure the depositors know their deposits are safe.  Restructuring will happen over the weekend so the banks can resume some kind of business over the weekend.  A lot of times hasty marriages or mergers of convenience have previously been arranged with more healthy banks.

This is the typical process that goes on day in and day out.  As some one who has been an active part of the Fed’s monitoring process, I can tell you, that some one looks at all banks balance sheets every day.  Also, annually, Fed auditors will examine banks as well as state auditors, board of director’s auditors and even the FDIC.  This process only works when there is not a systematic problem though.  While the Fed usually sees a handful of these a year, 13 in about the first six weeks of the year, suggests a systemic problem.

Financial Crises, especially those that turn out to be contagious, will rapidly spread to many parts of the economy even when we don’t necessarily see vulnerabilities in banks themselves.   Things that cause these kinds of problems include unsustainable macroeconomic policies (interest rates that are too low, huge government fiscal outlays, huge current account deficits, or unsustainable public debt).  Emerging market countries and developing countries tend to be more vulnerable to these types of crises because they do not have very deep and wide financial institutions and frequently their laws and policy response mechanisms are quite poor.  There are also some other things that can cause these types of crises like currency and maturity mismatches that tend to happen in countries with questionable currencies and exchange rate policies.  Once the crisis occurs, the government must coordinate a response.  The paper I’ve referenced above looks for ‘best practices’ or responses that have worked during recent crises and this includes both the emergency response as well as long-term policy changes.

So, let’s talk first about the types of responses that can be employed by Governments that face a financial crisis.    Basically, the major response has to reallocate wealth towards bank and debtors and away from taxpayers.  Yes, that’s what  I said,  it’s a reallocation of wealth.  You can see right now that that sets up a very unpleasant trade-off  choice.  While this reallocation usually leads to a restart of ‘productive investment’  it has HUGE costs.  First, taxpayer’s wealth is spent on helping banks and bankers.  It is basically to help them out of what was a set of really bad decisions resulting from misallocation of capital.  The economy experienced distorted incentives, the money followed it, and everything hit the fan.  In our case, right here, right now, too much capital flowed into the housing market.  The Fed enabled a bubble by providing extremely low interest rates.  Banks, Freddie and Fannie loosened underwriting standards and came up with weird loans.  They lent to every thing and every one thinking they could pass the trash on with securitization.  Once demand for houses and real estate starting going up from the availability of weird loans that were backed by even weirder risk management arrangements (think swaps), all of which were poorly regulated and given very little oversight,  boom!  In economics and finance, we call these distortions.  Distortions or bubbles don’t last because capital usually will disappear then head off in another direction.   In this and many cases government actually encourages banks and firms to do stupid things through subsidies, government protections, and  poor regulation.  All of these things were present in the housing bubble.

If, in the case of many emerging  market countries and developing countries, you have institutional weaknesses  (i.e. poor legal system, currency issues, bad central banks, corruption), these can exacerbate the problem.  Fortunately, for the US, we really don’t have weak institutions.  But, we had huge investment distortions brought on by low interest rates, unregulated derivative markets, and lending gone wild.

So, what does history teach us?  What does the current research say about policy response?

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Americans Tighten their Belts

The Wall Street Journal is reporting that the American Consumer is drastically reducing their spending on food.   They’re reporting that restaurant patronage is way down and that households are opting for generic products and home brewed coffee. They’ve also begun bargain shopping.

In 2008’s fourth quarter, consumer spending on food fell at an inflation-adjusted 3.7% from the third quarter, according to data from the Commerce Department’s Bureau of Economic Analysis. That is the steepest decline in the 62 years the government has compiled the figure. The report is based on receipts from a sampling of food-oriented businesses across the country.

The big drop likely comes from two things, said Joseph Carson, an economist at AllianceBernstein who worked at the Commerce Department in the 1970s. First, consumers have been trading down to lower-priced items. Second, he thinks many households dug into their pantries for staples rather than going to the store, a trend that can’t continue indefinitely. “You can’t contract at this rate for long,” he said. “It’s just shocking.”

Restaurants usually are hard hit during recessions as they are  seen more as luxury goods than necessities.  The first indication of a recession frequently comes from this sector.  You’ll see a lot of folks eating at the upscale bistros less while places like McDonald’s with their dollar value meals will get more business.  The Journal is reporting that trend.

Declining sales at established locations have forced Starbucks Corp., Ruby Tuesday Inc. and other chains to shut hundreds of outlets and put many independent restaurants out of business.

On Wednesday, P.F. Chang’s China Bistro Inc. said same-store sales fell 7.1% at its bistro locations in the fourth quarter, and the deterioration intensified as the quarter progressed. “The lights went out in December,” Robert Vivian, the company’s co-chief executive, told investors.

The shift has a silver lining for some companies. While supermarkets passed along last year’s high ingredient costs to customers, McDonald’s Corp. and other fast-food chains absorbed some of the expense and kept many items priced at $1. Now, some consumers consider a fast-food meal a bargain. On Monday, McDonald’s said same-store sales rose 7.1% in January, including a 5.4% increase in the U.S.

People will also switch to staying home and cooking their own meals.  They also adjust the types of things they will buy.  Right now sales on pet food, meat and poultry, sweets, cereals and alcoholic beverages are down.  Sales of  dairy products and vegetables are up.  You’ll also see an increase in the use of coupons and consumers will focus on planning their meals around the weekly sales items.

This news also comes as Consumer Sentiment continues to fall.  Market Watch reports :

Amid persistent economic turmoil, a key index of consumer sentiment fell in early February to 56.2 from 61.2 in January, according to reported results Friday of the University of Michigan and Reuters survey.
Analysts polled by MarketWatch had been looking for a February reading of 61.

Additionally, we have hit a record high for ongoing jobless claims.  This is also reported by Market watch today.

For the week ending Jan. 31, the number of Americans receiving state jobless benefits rose 11,000 to a record 4.81 million. The four-week moving average of these continuing claims also reached a record, rising 73,750 to 4.75 million.
The continuing claims result is “incredibly worrisome,” wrote Dan Greenhaus of the equity strategy group at Miller Tabak.
While the pace of layoffs will eventually decline, the larger concern for the economy is how long it takes us to get the people not working back to a fulltime job,” Greenhaus wrote. “Those 4.8 million people are not spending money, not going out to eat, not traveling to other states on vacation and not buying gifts for friends’ birthdays.”

There is even a lot of worry among the candy companies that sales of chocolates for valentine’s day will be off the usual mark.  I’ve been doing a lot of belt -tightening myself, but I have to tell the Godiva folks not to worry about my chocolate demand.  It continues forward at its usual high level.  I’m also doing my part for the California wine makers.  At least until my new little grape vineyard in my “Obama Victory Garden” starts doing its thing.  I’m wondering if  there will be chocolate lines for me instead of bread lines since I stay on a low carb diet?  So, how are you tightening your belt these days?