Banking and Currency Crises and Systemic Risk: Lessons from Recent Events

Abstract

Introduction and summary Many countries worldwide have experienced serious banking and/or currency (exchange rate or balance of payments) problems in recent years with high costs in terms of reduced income and increased unemployment to their own countries as well as others. A study by the International Monetary Fund (IMF) reported that more than 130 of the IMF's 180-plus member countries had experienced serious banking problems between 1980 and 1995, and this was even before the recent banking crises in East Asia--Korea, Thailand, Malaysia, and Indonesia--as well as in Russia (Lindgren, Garcia, and Saal, 1996). A map of countries experiencing banking crises is shown in figure 1. Lindgren et al. define serious problems to include banking crises that involve bank runs, collapses of financial firms, or massive government intervention, as well as less damaging but extensive unsoundness of institutions. With the primary exception of the U.K., the Benelux countries, [1] and Switzerland, most of the countries that avoided bank problems had no or nearly no modern banking systems. Currency crises were even more frequent than banking crises. They are typically defined as historically large depreciations in exchange rates and/or large declines in foreign reserves. Another IMF study of 53 industrial and developing countries identified 158 currency crises and only 54 banking crises in approximately the same time period (IMF, 1998a). Many countries suffered more than one such crisis during this period. A third study by Kaminsky and Reinhart (1996 and 1999) of 20 countries from 1970 to 1995 identified 71 currency crises and 25 ba nking crises. This article examines these twin banking and currency crises to attempt to identify their causes, particularly any similarities and interconnections, and their implications both for the country in which they occur and for other countries through possible contagion. Lastly, the article evaluates the effectiveness of alternative public policy initiatives introduced to mitigate if not prevent these crises and their accompanying potentially severe damage to the economy. Not only have banking and currency crises been frequent in number worldwide, but they have often been extremely costly in terms of both declines in real output and increases in transfer payments (wealth transfers) from taxpayers to bank depositors and other financial claimants whose funds were explicitly or implicitly insured or guaranteed at par value by the government. Thus, these crises are a major public policy concern. The IMF estimated that cumulative losses in gross domestic product (GDP) from potential (trend) growth in the 158 recent currency crises in 53 countries averaged 4.3 percent of the trend GDP values in each country and 7.1 percent in the 96 crises in which any output losses were suffered (IMF, 1998a). This is shown in table 1. The average time to return to trend value was about one and a half years. The output loss was greater in emerging economies than in developed economies, although the crises lasted somewhat longer in industrial than emerging economies. The estimated cumulative output loss from potential output in the 54 banking crises was significantly greater than in the currency crises, averaging 11.6 percent in all crises and 14.2 percent in the 44 crises that experienced an output loss. The loss was again greater for emerging than industrial economies. Moreover, banking crises last 3.1 years on average, twice as long as currency crises. In countries that experienced both a banking and a currency crisis simultaneously, the estimated output loss was greater than when each crisis was experienced separately. The average cumulative output loss was 14.4 percent in the 32 such crises observed and this time was greater for industrial than emerging economies. [2] The average time for recovery averaged about the same as for a banking crisis alone, but increased sharply for industrial countries to nearly six years. …

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