What are leading indicators of banking crises, their negative effects on the real economy, and way governments resolve them. All the basics presented clearly on a few slides on banking crises.
2. What is a banking crisis
Banking crises are periods when many banks in the
economy are on the brink of collapse. Depositors rush to
get their money out and, often, the government intervenes
to save the banks. It might nationalize, close, or merge
banks to contain the problem.
It takes about 5 years for the banking system to get back to
normal.
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3. Notice on the chart the rapid increase of bank credit to the private sector
before the 2008 banking crisis in Ireland. Notice also the collapse of the
Irish GDP and the growth of government debt when the crisis began.
These dynamics are typical during banking crises.
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4. Leading indicators of banking crises
Rapid credit growth: Banking crises are preceded by a rapid
expansion of bank credit to firms and households for
several years. The credit expansion is usually fueled by
optimism about the economy that motivates households to
buy assets (real estate) and firms to invest in plant and
equipment.
Real estate bubbles: Typically, much of the new credit goes
into real estate and pushes prices up. The rising prices
contribute even more to the optimism.
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5. Leading indicators continued …
Capital inflows: Often, the expansion of credit is funded by
the inflow of international capital. In essence, foreign
banks lend to domestic banks which then lend to
households and firms.
Eventually, asset (real estate) prices reach very high levels
and stop rising. Demand for real estate drops, prices start
falling, borrowers cannot pay back the bank debts, and
banks start losing money. The government intervenes to
support them.
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6. The negative effects of banking crises
Recession: When banks go into trouble they reduce
drastically their lending to households and firms.
Respectively, households and firms reduce their
consumption of goods and services and the economy goes
into recession.
Steep rise in government debt: The government assistance
to banks requires a lot of money during a recession when
government revenues are down. Therefore, the government
borrows and keeps borrowing for several years.
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7. Resolving banking crises
It takes 4-6 years for the effect of a banking crisis to fade
away. In comparison, the average recession without a
banking crisis is about 1-2 years long.
Gradually, banks are restored to health and start lending
again. Households and firms start spending and the
economy picks up.
However, the large government debt that accumulates
during the crisis is a long-term legacy. It has to be paid off
for significantly longer than 4-6 years.
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8. The frequency of banking crises
Two well known economists, Carmen Reinhart and
Kenneth Rogoff identify 156 banking crises in 110 countries
from 1963 to 2007.
The frequency of banking crises has varied over time but it
seems to have trended upwards. For instance, only 3
banking crisis in their dataset occurred between 1960 and
1975, whereas about 35% of all crises occurred in the 1980s
and 45% in the first half of the 1990s.
This trend declined in the latter years as only 16% of the
crises happened after 1995, including the recent crises.
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9. More information
Financial structure explained - banks vs. stock markets
Finance and the real economy
Compare economic indicators across over 200 countries
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