Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: International Experience
Theories of Financial Crisis

Several strands of thinking have emerged towards the understanding of financial crises. Most of these explanations are, at best, partial; taken in totality, these explanations offer some clues of the causes of financial crises. The basic theories include:

• Debt and financial fragility: Financial crises follow a credit cycle with an initial positive shock provoking rising debt, mispricing of risk by lenders and an asset bubble, which is punctured by a negative shock, leading to a crisis.

• Monetarist: Bank failures impact on the economy via a reduction in the supply of money. Crises tend to be frequently the consequence of policy errors by monetary authorities generating 'regime shifts' that, unlike the business cycle, are impossible to allow for in advance in risk-pricing.

• Uncertainty: One cannot apply probability analysis to rare and uncertain events such as financial crises and policy regime shift and accordingly, price them correctly. Financial innovations are subject to similar problems when their behaviour in a downturn is not yet experienced. Uncertainty is closely linked to confidence, and helps to explain the frequently disproportionate responses of financial markets in times of stress.

• Disaster myopia: Competitive, incentive-based and psychological mechanisms in the presence of uncertainty lead financial institutions and regulators to underestimate the risk of financial instability, accepting concentrated risk at low capital ratios. This pattern leads to sharp increases in credit rationing when a shock occurs.

• Asymmetric information and agency costs: Aspects of the debt contract, which generate market failure due to moral hazard and adverse selection, help to explain the nature of financial instability, e.g., credit tightening as interest rates rise and asset prices fall or the tendency of lenders to make high risk loans owing to the shifting of risk linked to agency problems. Complementing these explanations, it is also possible to include:

• Bank runs: The basic ingredient of crises is panic runs on leveraged institutions such as banks which undertake maturity transformation, generating liquidity. :

• Herding: Institutions imitate each other in strategies, regardless of the underlying fundamentals; among banks, there may be herding to lend at excessively low interest rates due to inadequate incentives to loan officers to assess credit risk; among institutional investors, herding is a potential cause for price volatility in asset markets driven, for instance, by peer-group performance. :

• Industrial: Effects of changes in entry conditions in financial markets can both encompass and provide a supplementary set of underlying factors and transmission mechanism. For example, entry of new intermediaries leads to deterioration of information for existing players and heightened uncertainty about market dynamics. :

• Inadequacies in regulation: Such inadequacies may exacerbate the tendency to assume disproportionate risk. Mispriced 'safety nets' assistance generates moral hazard, which if not offset by enhanced prudential regulation may lead to heightened risk taking. :

A list of recent episodes of systemic risk is illustrated in Table 8.1. Although these events seem to be disparate in genesis and manifestation, on a closer look, however, it is possible to discern certain common threads running through such crises. This would suggest that financial instability can be broadly categorised into three major categories.

One generic type of instability is centred on bank failures, typically following loan losses or trading losses. Examples include the US thrifts crisis as well as the banking crises in Japan, the Nordic countries and the Asian countries. Most developing/emerging countries have suffered such crises in recent decades (Caprio and Klingebiel, 2003). A second type of financial disorder involves extreme price volatility after a shift in expectations (Davis, 1995). Such crises are distinctive in that they often tend to involve institutional investors as principals and are focused mainly on the consequences for other financial institutions of sharp price changes which result from institutional 'herding' as groups of institutions imitate one another's strategies. Examples include the stock market crash of 1987, the ERM crisis and the Mexican crisis. A third type of turbulence, which is linked to the second, involves collapses of market liquidity and issuance. Again, often involving institutional lending, the distinction with the second type is often largely one whether markets are sufficiently resilient and that these tend to characterise debt and derivatives markets, rather than equity or foreign exchange. Examples include the Long Term Capital Management (LTCM) affair in 1998.

Whatsoever be the cause of the financial crises, financial instability can pose a severe threat to important macroeconomic objectives such as sustainable output growth and price stability. According to Caprio and Klingebiel (2003), there have been 117 episodes of systemic crises and 51 cases of borderline or non-systemic crises in developed and emerging markets since the late 1970s. Output losses during banking crises have been, on average, over 10 per cent of annual GDP and bank lending is often subdued for years after the crisis. Given such large costs, central banks have long had a keen interest in financial stability. Central banks' interest in financial stability also stems from their role in the operation or oversight of payment systems that, in turn, act as the critical 'plumbing' supporting activity in financial markets. Widespread financial instability undermines the role of the financial system in performing the primary functions such as intermediation between savers and borrowers with an efficient pricing of risks and the smooth operation of the payments system. When financial instability rises to a crisis proportion, it often brings in its wake a macroeconomic crisis or a currency crisis or both. Recognising the interdependence of macroeconomic performance and financial stability, several central bank charters reflect a concern for both macro objectives - price stability and satisfactory economic performance - and financial stability (Table 8.2). While some central banks have at least some implicit reference to financial stability, many have quite explicit references to financial stability.