Preventing banking crises in the future: lessons from past mistakes.

• Author: Kaufman, George G.

Almost every country -- large or small, developed or developing, free market or planned, free enterprise or socialistic, democratic or authoritarian, western or eastern, northern or southern -- has experienced serious banking (depository institution) problems in recent years.(1) Few countries have escaped unscathed. The cost of resolving these problems has been, or will be in most instances, borne primarily by the taxpayers. The cost of resolution to the public is equivalent to the part of the aggregate negative net worth of the banking institutions that is not paid by the financially healthy banks or other private sources. To date, the public's contribution has ranged from a small percentage of the respective nation's GDP, about 2 1/2 percent for the United States, to more than 20 percent in some countries. Not surprisingly, taxpayers have not been overly enthusiastic about paying this amount and have blamed the political party in power, as well as the regulators and the bankers, for their misfortune.

How did so many countries get themselves into such a mess? My analysis of the causes of the banking debacles suggests that a number of causes are common to all countries regardless of their type of banking system or economic structure. Moreover, the commonality spills over to the strategies initially employed by the governments to solve the problem, albeit with little if any success. Thus, we can learn much from the mistakes of the past.

The most important common mistakes made is believing that banking differs significantly from other industries and treating it as special purposes of public policy. This has resulted in the almost universal adoption of government safety nets under banking, which unfortunately have been so poorly designed for the most part that over time, by contributing to the problem they were intended to solve, they have done more damage than good. Avoidance of similar banking problems in the future requires a better understanding of banking as a business and of the implications of bank failures, as a better design of the safety net.

Is Banking Special?

I, along with my frequent coauthor George Benston and others, have recently reexamined whether banks are "special" and, if so, in what ways (Benston and Kaufman 1995). Many observers have long considered banks special both because they are "fragile" and thus likely to break and because they are an integral part of the payments system through providing deposits, which constitute a large part of a country's money supply, and, in some countries, operating the clearing system for checks and electronic funds. The latter functions make them the primary channel through which the central bank transmits monetary policy. Thus, some people fear that large-scale and even individual large institution failures could have major adverse effects on the financial system and possibly beyond to the domestic and even international macroeconomy that would be greater than those created by the failure of other business firms. Bank failures might start a domino or snowball effect, knocking down other banks and nonbanking firms in their path. Some have used this fear to justify special public policies toward banks to reduce both the probability and cost of failures. Indeed, arguments for considering banks special date back to Adam Smith (Short and Robinson 1997).

Analysts view banks as fragile because they have (1) low cash-to-asset ratios, (2) low capital-to-asset ratios, and (3) high demand-to-total-deposit ratios. Under these conditions, sudden large-scale withdrawals of deposits could force them to have to sell opaque and less-liquid earning assets, at fire-sale losses that would exceed their capital and drive them into insolvency. Thus, their greater fragility might lead to greater breakage. But many items are fragile -- fine glass, fine china, and even economists' egos, for example. Yet they do not necessarily break more often than less fragile items, but they receive more careful handling. Evidently, banks did too, at least in the United States and most developed countries before the introduction of special public policies to counteract the fragility. The market -- shareholders, depositors, loan customers -- appreciated the fragility and handled banks with greater care than other, less fragile firms. In the United States, for instance, the annual bank failure rate from 1870 to 1913, before the introduction of the initial bank safety net in the form of the lender-of-last-resort facilities of the Federal Reserve in 1914, was lower than either the failure rate for nonbanks in the same period or for banks from 1914 to 1994 (Kaufman 1996b). This low rate occurred despite legal and regulatory restrictions that prohibited banks from reducing risk as much as they may have wished through geographic and product-line diversification. Indeed, the U.S. banking structure appears to have been designed almost to maximize failures.

But the annual variance of the failure rate was substantially higher for banks than for nonbanks. Thus, in the few years when bank failures were numerous, they were very numerous. Moreover, the large-scale failures were consistent with the best known symptom of systemic risk: individual bank failures igniting an exploding series of further bank failures.

This pattern served to reinforce the public perception of bank failures as serious economic disasters. This perception rested at least partially on fear of the unknown. The public knows far less about the operation of banks and other firms that deal in intangibles than about the operation of firms that deal in tangibles such as steel, automobiles, or computers. For most, mystery shrouds the operation of banks and most other financial institutions; many cannot distinguish between factual and fictional descriptions. The failure of banks and financial institutions remains a favorite topic for both writers of fiction and scriptwriters for movies, particularly those who seek to portray scenes of widespread fear and suffering.

Although the lumpiness of bank failures suggests systemic risk, it does not by itself constitute proof. The evidence from many countries strongly suggests that bank failures follow problems in the overall or regional macroeconomy rather than either igniting them or resulting from a shock wave set in motion by the failure of a single bank or a small number of banks, although wide-scale bank failures do exacerbate problems in the real sector. (The evidence is reviewed in Benston and Kaufman 1995, and a number of important essays are published in Hubbard 1991; see also Selgin 1992.) When many banks fail concurrently, the empirical evidence suggests that the failures occur among banks whose balance sheets are all exposed to the same credit and interest-rate risks (Kaufman 1994; Flannery 1995); that is, bank runs tend to be firm-specific or informational, rather than industry-wide.

Bank fragility reveals itself and bank failures occur most frequently when the macroeconomy experiences rapid inflation and, in particular, bubbles in asset prices and interest rates (Goodhart 1995; Schwartz 1987; Caprio and Klingebiel 1996; Nakajima and Taguchi 1995).(2) Because activities on both sides of the bank balance sheet effectively involve forward contracts priced on the basis of predictions of prices, income, employment, and interest rates, unexpected adverse changes in these variables have caused banks to suffer large losses from loan defaults and high costs of deposits. However, at least in the United States before the safety net, such losses were too small to drive more than a small percentage of banks into insolvency and even more rarely any even reasonably large and diversified bank into insolvency. When the appropriate economic incentives exist, at least large marginal depositors can differentiate financially healthy from financially sick banks and exert discipline on the latter. At the same time, banks can signal the state of their financial health to depositors and other customers by rearranging their asset and liability portfolios and changing their capital ratios. Unlike actual runs, the threat of runs exerts powerful market discipline (Kaufman 1988).

Nevertheless, even though U.S. banks before 1914 on average failed no more frequently than firms in other industries and depositors at failed banks lost less on average than creditors at failed nonbanks, the combination of periodic large-scale bank failures and the widespread fear of bank failures and systemic risk caused policymakers to impose special regulations on banks. In banking, the perfect became the enemy of the good. Almost every country has thrust some sort of safety net under banks through the central bank's lender-of-last-resort facilities, deposit insurance, or both. Deposit insurance is often implicit rather than explicit, especially in countries where the government owns or operates one or more large banks. Depositors at these banks assume that the government views the deposits as its own debt obligations and would not permit a default. So far, these depositors have been proven right in every case I know: depositors at no state-owned bank appear ever to have lost a penny of their principal. Hence, the depositors have exerted little discipline on the banks, and, although some of the banks have had prolonged periods of economic insolvency, they have been able to continue operations because the depositors have not withdrawn their funds. Where private banks have competed with the state-owned banks, the implicit insurance has spilled over to them. Otherwise, dramatic shifts of funds would have occurred from the possibly not fully insured private banks to the fully insured state-owned banks. Implicit deposit insurance dominates any coexisting explicit insurance that does not cover all deposits or depositors.

Thanks to the implicit insurance that allows economically insolvent banks to avoid closure, governments can use...