Hindsight on banking crises

While I would not claim to have been able to foresee the global financial meltdown, triggered by the unprecedented crisis of structured finance, a few of the national systemic crises in Europe, including our own, occurred more or less independently and had a more traditional character.

Could early warning packages, designed to alert regulators in developing countries to the possible emergence of a boom-bust systemic banking crisis, been of use in Europe? In particular could they have provided ammunition for those who were warning about property bubble excesses in Ireland? To explore this, I revisited some old work of my own.

In a 1997 paper, published before the East Asia crisis broke and based on a statistical analysis of worldwide banking crises before 1995, I suggested two simple and readily available systemic indicators as warning flags of a possibly unsustainable banking boom. These are: the loan aggregate-to-deposit ratio and the real growth in private credit. Reluctant to claim too much, I cautioned that these flags should only be thought of as crude preliminary indicators that might generate many false positives.

In a 2000 paper, I showed that these two indicators had both indeed been flashing simultaneously during 1994-96 for all five of the countries most affected by the East Asia crisis of 1997-98. Furthermore, on that occasion there were few false positives: the flags were both raised for only five other (non-crisis) countries out of 139 countries for which data was available.

Now, revisiting this simple two-flag approach using 2004-2006 data on thirty European and selected other high income countries, I find a striking confirmation of its apparent usefulness.

Indeed, of these 30 countries the banking systems of only three countries, namely Iceland, Ireland and Latvia, registered above average values for both flags. Of course these are the three countries which have subsequently experienced the most severe bank-related collapses in Europe.

The two indicators are plotted in the Figure — the straight lines are the mean of each variable. Note how only the three countries referred to are in the top right quadrant.

Iceland, whose banking system collapsed in spectacular manner in October 2008, is the clear outlier, followed by Latvia which is also struggling — with IMF assistance — since last December, to emerge from a bank-led collapse.

Ireland was firmly in the danger zone too on this 2004-2006 data. Maybe I should have taken my crude early-warning system more seriously!

The countries included are: Austria, Belgium, Bulgaria, Canada, Chile, Croatia, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Latvia, Lithuania, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Romania, Slovak Republic, Spain, Sweden, Switzerland and the United Kingdom. These represent all of the smaller EEA countries for which full data is available in IFS (Cyprus, Estonia, Malta, Poland and Slovenia missing), plus Canada, Israel and New Zealand.

4 replies on “Hindsight on banking crises”

Given that you are obviously modest, you are to be forgiven for not alerting the rest of us. We knew from the likes of Faber and Roubini anyway, but since we were not in a position to make any difference, we just watched to see if what we understood from the Austrians would come to pass. It did. And the resolution of all that mal investment has only just started.
But you probably knew that? The problem is not in knowing what is going to happen. Many participants who could have stopped it knew also. But they could still make more money from working as hard as ever to milk the system. And some even knew to hedge against the risks. So where did they put their money? In a deflationary world where do you put your wealth? I know and so do others. It isn’t in stocks. And that is why all these stimuli will fail, except to pay off some folks!
Eliot Spitzer fixed some responsibility on GWB. And then he was outed. Whatever you say on the economy will be ignored as we already know, but welcome to the club. Those in charge are not pleasant people.

Aedin: The US is at 6, 126, so well away from the danger zone.

This is not, I think, not related to being an SOE or not. Instead, it’s because this particular indicator system was designed for boom-and-bust type crises, whereas the US failure was an example of one of the other two canonical syndromes, namely crises attributable to correlated micro/management failures. (The third syndrome related to government induced failures).

I did have other proposals for early warning of the other types, but not so easy to operationalize.

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