Banking Crises

Editor and literary critic as well as banker and economist, Bagehot was described in retrospect by Lord Bryce as ‘the most original mind of his generation’ (Buchan, 1959, p. 260). It is a difficult claim to sustain, certainly as far as his scattered economic writings are concerned. There was no doubt, however, about his intellectual versatility: there was an immediacy, a clarity and an irony — what he said of his friend Arthur Hugh Clough’s poems, ‘a sort of truthful scepticism’ — about Bagehot’s essays in different fields which make them still pre-eminently readable. Bagehot saw connections, too, between economics, politics, psychology, anthropology and the natural sciences -‘mind and character’ — refusing to draw rigid boundaries between most of these subjects and ‘literary studies’, while recognizing in his later years that the frontiers of political economy needed to be more carefully marked. ‘Most original’ or not, he was, as the historian G.M. Young (1948) has observed, Victoranum maxime, if not Victoranum maximus: ‘he was in and of his age, and could have been of no other.’ He pre-dated academic specialization and professionalization, and he was never didactic in his approach.

The primary motivation for the establishment of the Bank of England was the need to raise funds to help the government finance the then current war against France, although the view had also developed that a bank could help to ‘stabilize’ financial activity in London given periodic fluctuations in the availability of currency and credit. An original proposal by William Paterson in 1693 for a government ‘fund of perpetual interest’ was turned down in favour of another proposal by Paterson in 1694 to establish a company known as the Governor and Company of the Bank of England, whose capital, once raised, would be lent in its entirety to the government.

There are two distinct phenomena associated with banking system distress: exogenous shocks that produce insolvency, and depositor withdrawals during ‘panics’. These two contributors to distress often do not coincide. For example, in the rural United States during the 1920s many banks failed, often with high losses to depositors, but those failures were not associated with systemic panics. In 1907, the United States experienced a systemic panic, originating in New York. Although some banks failed in 1907, failures and depositor losses were not much higher than in normal times. As the crisis worsened, banks suspended convertibility until uncertainty about the incidence of the shock had been resolved.

The distinctive function of banks is the transformation of short-term deposits into longer-term, less liquid and riskier loans (Fama, 1980; 1985; Diamond and Rajan, 2001; Gorton and Winton, 2003). By raising funds from depositors and providing credit, banks avoid the duplication of monitoring, which reduces the overall cost of transferring funds from capital suppliers to its users (Leland and Pyle, 1977; Diamond, 1984). At the same time, however, the greater liquidity of liabilities than of assets, which are typically longer-term and riskier, makes bank balance sheets vulnerable. Not only may banks fail if they are unable to obtain repayment of their loans, but depositors might even decide to withdraw their assets simply anticipating that others will do so. Such a ‘bank run’ can drive an otherwise sound bank to insolvency (Diamond and Dybvig, 1983). The need to protect depositors and so guarantee a stable monetary transaction system explains why the banking industry is so heavily regulated. It is harder for a depositor to protect his interests than for an average investor, because judging the financial condition of a bank is difficult and costly, even for specialists. For this reason, the typical instruments adopted by bank regulators include restrictions on the amount of risk that a bank can take, and compulsory deposit insurance schemes that prevent runs.

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price than some other investor even though the asset’s price exceeds its fundamental value. Famous historical examples are the Dutch tulip mania (1634–7), the Mississippi Bubble (1719–20), the South Sea Bubble (1720), and the ‘Roaring ‘20s’ that preceded the 1929 crash. More recently, up to March 2000 Internet share prices (CBOE Internet Index) surged to astronomical heights before plummeting by more than 75 per cent by the end of 2000.

A bubble may be defined loosely as a sharp rise in price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers — generally speculators interested in profits from trading in the asset rather than its use or earning capacity. The rise is usually followed by a reversal of expectations and a sharp decline in price often resulting in financial crisis. A boom is a more extended and gentler rise in prices, production and profits than a bubble, and may be followed by crisis, sometimes taking the form of a crash (or panic) or alternatively by a gentle subsidence of the boom without crisis.

Capital controls are any restrictions on the movement of capital into or out of a country. Capital controls can take a wide variety of forms. For example, capital controls can be quantity-based or price-based, or apply to only capital inflows, only capital outflows, or all types of capital flows. Capital controls can also be directed at different types of capital flows (such as at bank loans, foreign direct investment or portfolio investment) or at different types of actors (such as at companies, banks, governments or individuals).

2nd—New Century Financial, based in California and second only to HSBC in the US sub-prime mortgage market, filed for Chapter 11 bankruptcy protection, making over 3,200 employees redundant.

Bond rating and the establishment of formal CRAs began in 1909 when John Moody began rating US railroad bonds, soon expanding to utility and industrial bonds. Poor’s Publishing Company followed in 1916 and Fitch Publishing Company in 1924. The business was characterised by the investor-pays model, where investors bought reports from the CRAs containing their ratings. This changed in 1970, for two reasons. First, with the advent of the photocopier free-riding became commonplace and CRAs found it difficult to sustain their business (White, 2002). Second, in 1970 Penn Central defaulted on its commercial paper obligations, creating vast mistrust among investors and a large demand by issuers for certification. The business thus changed to an issuers-pay model (Cantor and Packer, 1995). In 1975, the Securities and Exchange Commission (SEC) created the Nationally Recognized Statistical Rating Organization (NRSRO) category to designate credit ratings agencies whose ratings were recognised as being valuable for investment decisions. Standard & Poor’s, Moody’s and Fitch were given this designation immediately, and four other firms attained it in the following 17 years. By 2000, however, mergers returned the number of NRSROs to the big three. The SEC gave out a fourth NRSRO designation in 2003 (Dominion), a fifth in 2005 (A.M. Best), and in response to congressional legislation promoting transparency and entry in 2006 gave out three more designations (White, 2010). All of these new NRSROs, however, remain very small players in the bond and structured finance businesses.

A currency crisis occurs when investors flee from a currency en masse out of fear that it might be devalued. Currency crises are episodes characterized by sudden depreciations of the domestic currency, large losses of foreign exchange reserves of the central bank, and (or) sharp hikes in domestic interest rates.

There have been many currency crises during the post-war era (see Kaminsky and Reinhart, 1999). A currency crisis is an episode in which the exchange rate depreciates substantially during a short period of time. There is an extensive literature on the causes and consequences of a currency crisis in a country with a fixed or heavily managed exchange rate. The models in this literature are often categorized as first-, second- or third-generation.

The euro zone crisis started in early 2010 when it emerged that the Greek government had for years doctored the official data on its deficits and debt. The figures for the deficit and debt level presented by the new government were so much higher than the previous ones that rating agencies and many market participants downgraded their assessment of Greece’s ability to service its debt fully. As a result, the cost of refinancing the Greek debt increased sharply and the government could not secure the resources needed to fund its current deficit and roll over the portion of the debt coming due. By the end of April 2010 it had to be bailed out with a ϵ110 billion programme.

The Federal Reserve System of the United States was established on 23 December 1913, when President Woodrow Wilson signed the Federal Reserve Act. The need for a new federal banking institution became clear when a severe crisis occurred in 1907. In May 1908 the Aldrich-Vreeland Act established a bipartisan National Monetary Commission that proposed establishing a National Reserve Association with 15 locally controlled branches that would ‘provide an elastic note issue based on gold and commercial paper’ (Warburg, 1930, p. 59). The proposal was not enacted, nor was a subsequent proposal for a central bank with about 20 branches that would be controlled by a centralized Federal Reserve Board, consisting largely of commercial bankers. In the debate preceding the Federal Reserve Act, banking industry domination was rejected in favour of a board that had five members appointed by the President and two ex officio members, the Secretary of the Treasury and the Comptroller of the Currency. The appointed members had staggered terms and were to represent different commercial, industrial, and geographic constituencies. A sixth appointed member representing agriculture was added in 1923. The composition of the Board and its relation to Federal Reserve banks were drastically changed in 1935. Partly because of continuing disagreements about public versus commercial bank control, the new Board’s powers were left ambiguous in the act.

The classical gold standard (which ended in 1914) and the interwar gold standard are examined within the same framework, but their experiences are vastly different.

In the aftermath of the global financial crisis of 2008, a number of Eurozone countries were engulfed in a spiral of rising public deficits and explosive borrowing costs that eventually drove them out of markets and into bail-out agreements jointly undertaken by the International Monetary Fund (IMF), the European Union (EU) and the European Central Bank (ECB). Greece was by far the most perilous case with a double-digit fiscal deficit, an accelerating public debt which in GDP terms was twice as much the Eurozone average and an external deficit near 5,000 US Dollars per capita in 2008, one of the largest worldwide. No wonder that Greece was the first to seek the bail-out assistance and the last expected to exit its ever-changing conditionality terms.

Figure 1 shows the fall in industrial production during the Great Depression in the four largest national economies at that date. Industrial production declined by almost half in the United States and Germany. It fell more slowly and continuously in France, and paused rather than fell in Great Britain. National incomes did not fall as far as industrial production since services did not contract as much, but they decreased sharply; real per-capita GNP in the United States fell by one-third. National experiences in the depression varied greatly, but very few countries in the world escaped the economic hardship of the 1930s. One task for any account of the Great Depression is to explain its worldwide impact.

What caused the worldwide collapse in output from 1929 to 1933? Why was the recovery from the trough of 1933 so protracted for the United States? How costly was the decline in terms of welfare? Was the decline preventable? These are some of the questions that have motivated economists to study the Great Depression.

The International Monetary Fund (henceforth ‘the IMF’ or ’the Fund’) was conceived at a conference at the Mount Washington Hotel in Bretton Woods, New Hampshire, in July 1944 and its Articles of Agreement entered into force in December 1945. The World Bank (henceforth ‘the Bank’) was set up at the same time. The IMF was established to promote international monetary cooperation and the elimination of exchange restrictions on current account transactions; to facilitate trade, economic growth and high levels of employment; to foster exchange rate stability; and to provide temporary financial assistance to countries so as to ease balance of payments adjustment. More specifically, it was given the role of supervising a system of pegged but adjustable exchange rates, which became known as the Bretton Woods system. In the first two sections of this entry we explain how the Bretton Woods system worked, and why it broke down in 1971. In the following sections we consider the roles which the Fund now plays, which differ from its original activities. They are: surveillance, ensuring stability for the international financial system and for individual economies within this system, and assisting the world’s poorest economies. As part of each of these three activities, the Fund also provides policy advice and technical assistance. This is a much less clear collection of responsibilities, and, as a result, the future direction of the Fund is somewhat uncertain. The aim of this article is to review the achievements of the Fund, and also the challenges that lie ahead. A related overview of some of the issues discussed here can be found in Gilbert and Vines (2004).

Domestic money is conceived of by society as a device to facilitate transactions in the marketplace, as a temporary store of value, and as a unit of account for contracts. Given the possibilities of fraud and counterfeiting, domestic monetary authorities have been established to regulate the quality of the domestic monetary unit in most countries. Such regulations attempt to guarantee the interchangeability of the different media, such as currency and the deposits of different banks, as well as stability in the value of the monetary unit, under conditions of prosperity.

Charles P. Kindleberger was born in New York City. He received his B.A. at the University of Pennsylvania in 1932 and his Ph.D. at Columbia University in 1937. He had a distinguished career in public service (including the Federal Reserve and the Office of Strategic Services during the Second World War) before going to teach international trade at MIT. His wartime experiences directed his interests towards the interaction of countries and gave him a keen sense of how academic ideas play out among real people and governments. His scholarship was characterized by its realism and willingness to consider actual—as opposed to idealized—behaviour.

Laboratory financial markets allow human subjects to trade assets under conditions controlled by the researcher. By varying the conditions — such as the trading format, or the timing and content of private information — the researcher can make direct and sharp inferences.

John Law of Lauriston has been regarded by some observers as a monetary crank, by others as a precursor of modern schemes of managed money and Keynesian full-employment policies. He was the originator of the Mississippi Bubble, perhaps the greatest speculative bubble of all time.

What is in a name? In the case of Lehman Brothers the name has two different and distinct meanings. Prior to the autumn of 2008, Lehman Brothers referred to one of the oldest investment banks in the USA, with roots in the cotton exchange of the mid- 19th century. At the time it filed for protection under Chapter 11 of the US Bankruptcy Code, Lehman Brothers Holdings International was the fourth largest US investment bank and the largest bankruptcy on record. Today Lehman Brothers, used synonymously with the Lehman Brothers bankruptcy filing, is commonly used to refer to an important episode during the 2007–2009 financial crisis. To borrow a line from Winston Churchill, the Lehman Brothers bankruptcy filing on 15 September 2008 did not represent the beginning of the end of the financial crisis, but rather marked the end of the beginning.

A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. In this case, many argue, increasing money in circulation has no effect on either output or prices. The liquidity trap is originally a Keynesian idea and was contrasted with the quantity theory of money, which maintains that prices and output are, roughly speaking, proportional to the money supply.

Stability is destabilizing. Those three words capture in a concise manner the insight that underlies Minsky’s analysis of the transformation of the economy over the entire post-war period. The basic thesis is that the dynamic forces of the capitalist economy are explosive so that they must be contained by institutional ceilings and floors—part of the ‘safety net’. However, to the extent that the constraints successfully achieve some semblance of stability, that will change behaviour in such a manner that the ceiling will be breached in an unsustainable speculative euphoria. If the inevitable crash is cushioned by the institutional floors, the risky behaviour that caused the boom will be rewarded. Another boom will build, and its crash will again test the safety net. Over time, the crises become increasingly frequent and severe until finally ‘it’ (a great depression with a debt deflation) becomes possible.

Franklin Roosevelt’s New Deal created the most dramatic peacetime expansion of government in American economic history.

Since the end of the post-Second World War Bretton Woods System of quasi-fixed exchange rates in the early 1970s and the advent of floating exchange rates across the developed world, the primary policy tool of the major central banks for managing aggregate demand and controlling inflation has been short-term interest rates. In the USA the main policy rate is called the Federal Funds Rate (FFR), whilst in the UK, Eurozone and Japan it is the Bank Rate, Main Refinancing Rate (MRR) and the Uncollateralised Overnight Call Rate (UOCR) respectively. Changes in short-term interest rates impact the economy via their influence on other types of interest rates (e.g. mortgage rates, auto loan rates and business loan rates), which affect the spending/saving decisions of private sector agents, and through influencing expectations about the future path for the economy.

On the morning of Friday 14 September 2007, queues of depositors began to form inside, and then outside, the (relatively) few branches of Northern Rock (only nine in the London area, for example). This was the first substantial run in the UK by retail depositors since the 19th century. Northern Rock had been a building society until 1997, with a large local presence in the north-east (headquartered in Gosforth, Newcastle upon Tyne), but otherwise then not widely known and subject to relatively strict Building Society requirements. In that year it demutualized, became a bank and later embarked on a massive program of expansion, under its incoming Chief Executive, Adam Applegarth.

The shadow banking system is a web of specialised financial institutions that channel funding from savers to investors through a range of securitisation and secured funding techniques. Although shadow banks—the institutions that constitute the shadow banking system—conduct credit and maturity transformation similar to that of traditional banks, they do so without the direct and explicit public sources of liquidity and tail risk insurance available through the Federal Reserve’s discount window and the Federal Deposit Insurance Corporation. Shadow banks are therefore inherently fragile, not unlike the commercial banking system prior to the creation of the public safety net. This definition closely follows that of Pozsar et al., (2010).

We maintain that a speculative bubble exists if the market price of an asset differs from its fundamental value—the expected present value of the stream of future dividends attached to the asset. In an economy with a finite sequence of trading dates, the fundamental theorem of asset pricing (see Dybvig and Ross, 1987) guarantees that the equilibrium market price of any asset equals its fundamental value. But in some economies with an infinite sequence of trading dates, this result does not hold, and speculative bubbles may arise. An investor might buy an asset at a price higher than its fundamental value if she expects to sell it later on at a higher price—Harrison and Kreps (1978) call this process ‘speculative behaviour’. In general equilibrium models, however, agents take prices as given and trade assets to transfer income across time and states. These models do not contemplate ‘speculative behaviour’ as it is usually understood. Therefore, the term ‘speculative bubble’ may seem inappropriate in some theoretical frameworks. Santos and Woodford (1997) talk broadly about ‘asset pricing bubbles’.

The South Sea Company was founded in 1711, in the expectation that peace between Spain and England after the end of the War of the Spanish Succession would produce profitable trading opportunities with the ‘South Seas’ (that is, Spanish America). The company’s trading activity remained intermittent and unprofitable throughout the 1710s. In 1719, a new scheme was launched — the conversion of government debt into equity of the South Sea Company. Debt-holders of the 1710 lottery loan were offered the option to convert their holdings into company shares. The government agreed to make interest payments to the company instead of to debt-holders. As old (and illiquid) loans were swapped for liquid company shares, debt-holders gained. The government negotiated a lower rate of interest, and the South Sea Company made a modest profit. The 1719 equity-for-debt swap is generally seen as Pareto-improving.

A subprime mortgage loan is a residential mortgage loan that is particularly risky for some reason. The elevated risk may stem from the credit history of the borrower, the lack of a large down payment, or a monthly payment that is large relative to the borrower’s income (see Chapter 2 of Muolo and Padilla (2010) for a history of subprime residential lending). Subprime loans were unlikely to meet the credit-quality standards of the two government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, which package so-called prime mortgage loans into mortgage-backed securities for sale to outside investors, and which eliminate credit risk by guaranteeing principal and interest payments to investors if the borrower defaults. While the GSEs did not have hard-and-fast cutoffs regarding borrower credit quality, they were historically less likely to securi-tize loans made to borrowers with poor credit histories.

The Netherlands of 1634–7 was the scene of a curious speculation in tulip bulbs that has come to be known as the Dutch tulipmania. Single bulbs of rare and prized varieties such as Semper Augustus or Viceroy became worth a middle-sized fortune. In its most extreme final phase in January-February 1637, prices of even common varieties such as Switsers or Witte Kroone soared twentyfold within a month and then crashed back to their original values. That these were prices of easily reproducible horticultural products has added to the bemusement of generations of historians and economists.