Bank runs in emerging-market economies: evidence from Turkey's Special Finance Houses.

• Author: Starr, Martha A.
• Position: Author abstract

1. Introduction

   Recent decades have seen an increase in the incidence of banking crises in emerging-market countries, reflecting combined effects of financial liberalization, mobile global capital, and under-regulation (Kaminsky and Reinhart 1999). Banking and financial crises are a particular problem in countries in intermediate stages of development, perhaps because partially developed credit markets magnify effects of exogenous shocks (Aghion, Bacchetta, and Banerjee 2003). Banking crises also tend to be more severe in emerging-market countries than in the developed world, both in terms of budgetary costs of resolving them and in terms of reductions in real economic activity (Caprio and Klingebiel 1996; Rojas-Suarez and Weisbrod 1996).

   The role of deposit insurance in banking crises is a subject of debate. Diamond and Dybvig (1983) demonstrated theoretically that, when first-come-first-served rules are used to accommodate withdrawals, any shift in expectations that makes depositors anticipate a run, whether or not it conveys anything fundamental about a bank's condition, can in fact lead to one. In this case, deposit insurance is beneficial for banking stability since bad news will no longer cause depositors to rush to withdraw, just because they fear that other depositors will. However, deposit insurance also reduces banks' incentives to manage risk prudently. Especially in systems where banks are under-regulated, deposit insurance may lead banks to take on too much risk, knowing that the government would absorb depositors' losses should they become insolvent. Thus, it is unclear a priori whether deposit insurance increases or decreases banking stability. (1)

   At issue in this debate has been the characterization of depositor behavior during bank runs. In contrast to the Diamond-Dybvig view of runs as self-fulfilling, Chari and Jagannathan (1988) argue that runs are brought on by problems of uncertainty and asymmetric information about banks' financial conditions. In their portrayal, runs reflect a signal extraction problem in which some individuals receive a noisy signal about the bank's return, which may lead them to withdraw funds early; other depositors must infer from observed withdrawals whether a negative signal was received by informed depositors, or whether liquidity needs happen to be high. Here bank runs occur because uninformed depositors misinterpret liquidity shocks as bad news about the condition of bank assets. But in this perspective bank runs are not inefficient and should be allowed to happen. (2)

   Some previous research has attempted to distinguish between informational and self-fulfilling views of bank runs. In studies of bank runs in the United States before the introduction of deposit insurance in 1933, it is a consistent finding that runs tended to occur in periods of deteriorating economic fundamentals (Gorton 1988; Calomiris and Gorton 1991). A number of studies also find that banks with weaker pre-run balance sheets tended to face the heaviest withdrawals during them. (3) Similarly, Schumacher (2000) shows that, in the bank runs in Argentina in 1994, deteriorating fundamentals contributed to the onset of the runs, and the banks most likely to lose deposits and fail during the crisis were those that had been weakest before it. (4) While these studies are consistent with an informational view of runs, they do not rule out the possibility that runs have self-fulfilling aspects; they only establish that runs are not 'sunspots' unrelated to fundamental factors. As such, it remains possible that, as Chen (1999) argues, there are both first-come-first-served and informational elements at work in bank runs.

   To investigate the importance of self-fulfilling and informational dimensions of bank runs, this paper analyzes the dynamics of depositor behavior during a set of runs that occurred in Turkey in the first part of 2001. Turkey's large and troubled commercial-bank sector had been covered by deposit insurance since 1984; combined with problems of insider lending and under-regulation, implicit and explicit promises of government bail-out had caused widespread problems with failure, insolvency, and illiquidity in the commercial-banking sector. However, this paper examines a sub-sector of the Turkish banking industry that was not covered by deposit insurance and had not been subject to the same moral-hazard problems: the Special Finance Houses (SFHs). The SFHs are Shariah-compliant bank-like financial institutions in which costs of borrowing and returns to lending are based on risk participation, rather than interest payments. Part of a broad-based international movement to promote principles of Islamic finance, in Turkey Islamic banks are a sub-sector of the banking industry and compete with banks that charge and offer interest; for the most part, they operate much like conservatively managed banks. To our knowledge, the international scholarly literature has not yet included a detailed study of Islamic banking in Turkey, nor has it explored how Islamic banks contend with periods of macro/financial crisis that include bank runs. More generally, there is very little contemporary empirical evidence on the dynamics of depositor behavior during bank runs, for either the developing or the developed world. (5)

   In February 2001, the largest finance house in Turkey became insolvent due to irregular use of funds and was abruptly closed. Occurring at the same time as a macro/financial crisis, runs on the other SFHs erupted, resulting in a sizable loss of deposits in the sector. We argue that, while there were valid reasons for depositors to be concerned about the safety of their funds, their sense of urgency about getting their money out of the SFHs was out of proportion with the risk, and is best interpreted as prompt reaction to noisy bad news that escalated into a panic. Because we have detailed withdrawal information from one SFH, we are also able to investigate how depositors of different sizes reacted to each other's withdrawals, using a vector autoregressive (VAR) framework. This is, to our knowledge, the first time VAR analysis has been used to analyze depositor behavior during a bank run. We find that increased withdrawals by moderate-size accountholders tended to boost withdrawals by smaller counterparts, suggesting that the latter viewed the behavior of the former as informative with respect to the SFH's financial condition. Yet we also find that increased withdrawals by smaller accountholders tended to boost withdrawals by moderate-size accountholders, and that increased withdrawals by moderate-size accountholders tended to boost withdrawals by large accountholders--effects that are more consistent with concerns about self-fulfilling elements of runs. We interpret our findings as consistent with the argument of Chen (1999)--that there are both first-come-first-served and informational elements involved in bank runs. This suggests a role of deposit insurance, judiciously used, to rule out inefficient aspects of runs.

2. The Special Finance Houses in the Context of Turkish Banking

   Turkey's SFHs are bank-like institutions that offer Shariah-compliant financial services. As such, they make loans and take deposits in ways that respect the Qur'an's prohibition against interest, based on the idea that it is inequitable and unfair for a lender to earn a fixed return while the borrower bears all the risk and exerts all the effort. (6) Instead, costs of funds to borrowers and returns to lenders are based on mechanisms for sharing profit and loss. (7) In most countries, Islamic banks constitute sub-sectors of national banking industries and compete with interest-oriented banks; only Iran, Pakistan, and Sudan have banking systems that are primarily or exclusively Islamic. (8) While Islamic banks have grown to have 10-20% shares of total deposits in countries such as Egypt and Kuwait, in Turkey their share has remained in a 1-3% range, in part reflecting ambivalence in Turkey towards mixing religious principles with public life. Note, however, that the SFHs frame themselves not as institutions advancing religious principles, but rather as profit-oriented businesses catering to consumer tastes. (9)

   First authorized to operate in Turkey in 1983, three foreign-owned finance houses began operations in the 1980s, and another three domestic houses entered the market in the 1990s (see Table 1). The SFHs can engage in all the activities of a commercial bank, as well as leasing and commodity trading. However, they take deposits and make loans in ways that do not involve payment or receipt of interest, but rather are based on risk participation. Their main source of funds is profit-and-loss participation accounts. (10) Depositors invest funds for a given term (one month, three months, six months, one year, and longer terms up to five years), and receive returns based on the investment projects financed with their funds; for each maturity, returns are calculated weekly and reported in newspapers. There is no guarantee of a positive return or return of principal. As such, profit-and-loss accounts are to some extent more like mutual funds with set maturities than they are like traditional bank deposits. The main use of funds by SFHs is short-term loans (typically four to five months in duration) provided to small and medium-size companies needing capital. This sort of financing, known as murabaha, represents 90% of the SFHs' total use of funds; as discussed in Kuran (1995, p. 162), the concentration of lending in this low-risk form implies that returns, if not guaranteed, are highly predictable. (11) SFHs also offer financial leasing and full or partial funding for longterm business projects, known as mudharabah and musharakah participations, respectively. The SFH keeps 20% of income from lending activities and 80% is distributed to accountholders. While the SFH sector had been growing consistently...