Project Report On Banking Crisis

Table of Contents

Abstract .......................................................................................................................................................1 Introduction ................................................................................................................................................2 The Repressed Financial System .................................................................................................................2 List Of Banking Crisis ...................................................................................................................................3 Causes Of Banking Crisis .............................................................................................................................3 Great Depression ........................................................................................................................................4 Asian Financial Crisis ...................................................................................................................................5 Sub Prime Crisis...........................................................................................................................................5 Anatomy Of The Crisis.................................................................................................................................6 Prediction Of Banking Crisis ........................................................................................................................7 Imminent Crisis Reasons .............................................................................................................................8 Major Areas Of Reforms .............................................................................................................................8 Conclusion ...................................................................................................................................................9

ABSTRACT
One hand the world is concerned for the stability of the banking sector and on the other world seems to be continually beset of banking crisis. The structural evolution of the banking sector may have a significant bearing on questions of solvency and stability. Banking systems have developed in different ways in different countries, for a variety of reasons, but the trend has been towards an increasingly liberal stance by the authorities as regards allowing banks to diversify their activities. This should be welcomed, but only on two conditions: first, that the management of individual banks is sufficiently capable; and secondly that every bank can be effectively supervised by the central bank (or other responsible regulatory body). Access by foreign banks to a particular country is usually beneficial in terms of competition and efficiency. The causes of banking crises can be categorized under several headings:

1. 2. 3. 4. 5. 6. 7.

Macroeconomic instability Deficient supervision Poor strategies Weak management Inadequate control systems Operational failures Fraud

INTRODUCTION
Any financial Crisis is caused at two levels: by global macro policies affecting liquidity and by a poor regulatory framework that, far from acting as a second line of defense, actually contributed to the crisis in important ways. The financial crisis affects banking activity depending upon the scale of its spread. Bank Run: It is a situation in which a large number of bank or other financial institutions customer withdraws their deposits simultaneously due to concerns about the bank's solvency. As more people withdraw their funds, the probability of default increases, thereby prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals. Banking Panics: It is the higher level of financial Crisis that occurs when many bank suffers run at the same time , as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether. Systemic banking Crisis: It is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down.

The Repressed Financial System: This also leads to the banking crisis. This is the major

feature in the developing countries where government controls all the banking system. In this system government implements policies to channel themselves funds that in a deregulated market environment would go elsewhere. Policies include directe lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy moral suasion. This intervention keeps the interest rates that domestic bank can offer to a lower level and this leads to creation of excess demand for credit. It then requires the banking system to set a fixed fraction of the credit available to priority sector. Beyond the pain of low real returns imposed on savers and investors, there are other costs and risks associated with financial repression It can inhibit growth over the medium to longer term because it tends to promote very inefficient capital allocation and to crowd out more productive investment. In addition, repression can potentially lead the economy toward significant (unintended) market distortions: asset booms/busts, uncontrollable bouts of

inflation, and sudden stops in economic activity from loss of confidence, or capital flight leading to crisis situation and loss of confidence of investors in the financial market. Process of Banking Crisis can be explained in following steps: 1. 2. 3. 4. 5. 6. 7. 8. 9. Trigger any exogenous event like new technology, financial market innovation Boom New Opportunities for investing let profits rise Credit Expansion - Banks are transforming short term deposits into long term credit Destabilizing speculation - Price bubbles, herding, overinvestment Crash - Profits do not live up to previous expectations, banks write off part of the outstanding debt Reversal of Capital Flow - Depositors try to withdraw Panic - It cause rapid decline in asset prices Liquidity squeeze Banks compete for scarce liquidity, Banks in need of refinancing& eventual illiquidity Liquidity spirals - Banks sell long-term assets. In which asset prices may fall below fundamental value and more banks go bust.

LIST OF BANKING CRISIS

There are many banking crisis which can be started from 18th century to 21st century. Few of the main banking crises affecting the world economy in major way are listed as under: 1. Great Depression 2. Japanese Asset Price Bubble (1986-2003) 3. Savings and Loan Crisis of 1980s and 1990s US 4. Asian Financial Crisis -1997 5. Russian Financial Crisis-1998 6. Banking Crisis specific to different countries Finnish, Swedish, Venezuelan, Ecuador 7. Subprime mortgage Crisis US -2007 8. United Kingdom Bank rescue Package -2008-09 9. Banks of European Union 10. Russian Banking Crisis

CAUSES OF BANKING CRISIS

1. Speculative Causes (Liquidity Crisis) This can be for single bank or widespread for many banks together. The depositors taking away their funds in excess of reserve requirement which may be result of mob psychology or mass panic. In case of systemic banking crisis there is widespread speculation with contagion effects. There is imperfect information about health of banks and results in aggregate liquidity shocks throughout the country. 2. Fundamental Causes (Solvency Crisis) Insolvency occurs due to high level of non performing loans associated to lending booms followed by liquidity crisis. It occurs for single bank or systemic in which there is

country wide economic recession leading to high level of NPL. Poor macro policies leading to internal and external instability. International effects related to this are current account deficits, unstable international capital flows and foreign exchange rate crisis. 3. Mismanagement Causes For single bank the Fraud/looting/corruption by bank managers, employees and bad lending are due to inappropriate regulations and supervision. Poor banking regulations in the face of inappropriate financial liberalization can lead to widespread banking crisis. BANKING CRISIS

GREAT DEPRESSION
US enjoyed nearly a decade of optimism and prosperity when in October 1929 the stock market crashed. The stock market which had appeared to be surest way to become rich; quickly became the path to bankruptcy. Many banks had also invested large portions of their clients' savings in the stock market; these banks were forced to close when the stock market crashed. Seeing a few banks close caused another panic across the country. Afraid they would lose their own savings, people rushed to banks that were still open to withdraw their money. This massive withdrawal of cash caused additional banks to close. Since there was no way for a bank's clients to recover any of their savings once the bank had closed, those who didn't reach the bank in time also became bankrupt.

Great Depression Causes There were multiple causes for the first downturn in 1929: 1. 2. 3. 4. 5. 6. 7. 8. Unequal distribution of wealth High tariffs & War debts Overproduction in Industry & Agriculture: Mismatch of production and consumption Farm crisis & Dust bowl: Drought conditions in Mississippi Valley which destroyed many farmers crop Federal Reserve Monetary Policy: Raising the Federal Reserve fund rate and Fed raised interest rate again to try and preserve the value of dollar. This further restricted the availability of money for business causing more bankruptcies Smoot Hawley Act: Increase of US tariff on over 20,000 imported goods to record level which lead to breakdown of international trade Stock Market Crash (16400000 shares of stock, worth 40 billion USD sold off) About 32000 businesses went bankrupt: Greater fall in net worth of business, profits, reduction in output

9. 10.

More than 5000 Banks failed leading to Bank Run: Investor withdrew all their dollars from the bank causing more panic Financial Panic

Great Depression Effects In a short period of time, world output and standards of living dropped precipitously. As much as one-fourth of the labor force in industrialized countries was unable to find work in the early 1930s.

ASIAN FINANCIAL CRISIS

After years of economic stability, the currencies of various South East Asian countries came under pressure in 1997, as the dollar appreciated against the Yen. A number of South East Asian countries had maintained a currency peg against the US$ and experienced a deteriorating current account position as well as an increasing foreign debt burden in the process. One central element in the causation of the South East Asian currency crisis has been seen in the dynamics of international investment flows. The IMF (IMF 1997) maintains that foreign speculators and hedge funds had some impact in producing the crisis in so far as they were important in the speculative attack on the Thai baht. An outflow of funds from the region was likely to be destabilizing, considering the fragile local banking systems and the asset price distortions produced by the previous strong capital inflow. Certain standard symptoms of external vulnerability a large current account deficit and predominantly short term external debt- were clearly present. One pervasive problem in a number of South East Asian countries was insufficient prudential banking regulation and supervision, often in the wake of inadequately administered domestic financial liberalization. A number of Korean firms had excessive short term debts and it was a series of bankruptcies that triggered the withdrawal of funds from Korea in 1997.

SUB PRIME CRISIS

The world economy suffered a global financial and economic crisis that has become severe since the second half of 2008. This global financial situation was triggered by the advent of the subprime mortgage crisis in the United States that became apparent in mid-2007. Europe was the first area affected, thereafter its contagion spread to the rest of the world. East Asia did not escape. The nature of the current global financial crisis is unprecedented in terms of: 1. The scale of the problems in the financial sector (particularly in the United States and Europe) 2. The depth and speed of contagion worldwide (through financial sector and trade linkages) 3. The severity of the recession (particularly in emerging market economics, small countries, and East Asia).

Over the decade prior to the crisis, the United States and several other advanced economies experienced an uninterrupted upward trend in real estate prices, which was particularly pronounced in residential property markets. The boom in real estate prices was exacerbated by financial institutions ability to exploit loopholes in capital regulation, allowing banks to significantly increase leverage while maintaining capital requirements. They did so by moving assets off-balance sheet into special purpose vehicles that were subject to weaker capital standards and by funding themselves increasingly short-term and in wholesale markets rather than traditional deposits. These special purpose vehicles were used to invest in risky and illiquid assets (such as mortgages and mortgage derivatives) and were funded in wholesale markets (for example, through asset backed commercial paper), without the backing of adequate capital. The growing importance of this shadow banking system highly dependent on short term funding, combined with lax regulatory oversight, was a key contributor to the asset price bubble. Higher asset prices led to a leverage cycle by which increases in home values led to increases in debt. The first signs of distress came in early 2007 from losses at U.S. subprime loan originators and institutions holding derivatives of securitized subprime mortgages. However, these first signs were limited to problems in the subprime mortgage market. Later in 2007, these localized signs of distress turned into a global event, with losses spreading to banks in Europe (such as U.K. mortgage lender Northern Rock), and distress was no longer limited to financial institutions with exposure to the U.S. subprime mortgage market. Problems intensified in the United States with the bailout of Bear Stearns, and later in the year with the collapse of investment bank Lehman Brothers, and the government bailouts of insurer AIG and mortgage lenders Freddie Mac and Fannie Mae. By the end of 2007, many economies around the world suffered from a collapse in international trade, reversals in capital flows, and sizable contractions in real output. But as the crisis mounted, so did the policy responses, with many countries announcing bank recapitalization packages and other support for the financial sector in late 2008 and early 2009.

ANATOMY OF THE CRISIS

Root Causes of the crisis There are both macroeconomic roots and the microeconomic roots of the crisis. The complacency of policy makers , abundant global liquidity diverted to real estate (global imbalance), rapid credit growth leading to high leveraging are the macro factors; whereas the rating agencies, financial products , maturity mismatches, weakness in supervision and regulation are the micro factors. Economic consequences of the crisis 1. The impact on the potential output: critical challenge in the world is to prevent reduction in growth from lower or unproductive investment due to risk aversion, credit constraint or government intervention and labor market hysteresis 2. Impact on Labor market and employment: A typical labor bears the brunt of the crisis 3. Impact on Budgetary position 4. Impact on global imbalance 5. Impact on internal imbalances and competitiveness

Policy Response Change in Financial policy, Monetary policy, Fiscal policy, Structured policy for better recovery of the economy. Crisis Management Measures 1. Speculative-type Crises should be dealt with liquidity support provided by the Central Bank. There should be introduction deposit insurance - but only for small depositors. The information and its availability to the general investor should be readily available. This better disclosure of information and transparency will decrease the speculative panic created in the investor due to lack of information. 2. Fundamental-type Crises should be dealt with significant financial assistance in foreign exchange. With this the Macroeconomic Measures to deal with Economic Instability and revive economic growth should be taken .Government Intervention in Troubled Banks, including Restructuring Programs for Affected Borrowers should be initiated in the preliminary stage. 3. Mismanagement-type Crises (fraud/looting and poor financial Banking regulation) should be dealt with improved Legal Structure and Corruption Prevention act which are stringent and effective .Improvement of banking regulations and supervision and quick intervention in troubled Banks should be taken to avoid the panic. Cost of banking Crisis 1. Impact on the real sector is great: output growth is affected 2. Impact on monetary policy can be large: exchange rates, inflation 3. Impact on fiscal policy and governments budgets is often high

Prediction of Banking Crisis

1. Current Account Indicators: The few indicators are adverse movements in exports/imports, large deterioration in the ratio of current account to GDP (beyond 3%), terms-of-trade deterioration and large movements in real exchange rates. 2. Capital Account Indicators: Large increase in the ratio of external debt to GDP (beyond 60%),Large short-term capital inflows/outflows, High ratio of short-term debt to international reserves (beyond 1.0) and Quick drop in international reserves (below 3 months of imports) are few capital account indicators. 3. Financial Sector Indicators: Excessive rate of growth of bank credit/GDP, deterioration in the level of non-performing assets to total assets (beyond 10%),Other erosion in the banks capital base ,Increase in the level of connected lending, Increased cases of bank fraud and looting ,Inadequate bank supervision, High ratio of fiscal deficits to GDP (beyond 3%),Large money supply increases relative to international reserves are few financial sector indicators which shows prediction of banking crisis. 4. Real Sector Indicators: Large declines in asset prices, particularly real estate prices and stock prices, large increase in the number of corporate losses or bankruptcies 5. Other Triggers: Non Economic Factors, Runs by domestic or foreign depositors, collapse of large bank, financial crisis in neighboring country, large increase in import prices, major case of Banking Fraud

Imminent Crisis Reasons

1. Too Big to fail: Some banks got steadily bigger while the overall number shrank. The limitations to bank to either act as commercial or investment banking functions helped not to spread problems in one area of financial activity to spread in the other area. But after the 1999 the Financial Services Modernization Act of 1999 this was removed and banks started growing big leading to big bank blow up. 2. See no evil, hear no evil: Creation of shadow banking system which is unregulated system such as alternative investment vehicles which have largely unregulated funds and when it failed it took the investors money with them. 3. Calling in the cavalry, but giving them the wrong direction: The Feds role in the rescue of some shadow banks sent the wrong message: that the government would be there to fix problems, and that banks and shadow banks alike didnt have to work too hard to manage risk and to protect themselves from contagion. The government further erred by nudging sound banks to take over failing ones. This policy led to further consolidation of the banking system, making surviving banks even bigger! Finally, the government failed to take action to address the problems that let big financial institutions get into trouble in the first place. 4. Creating financial weapons of mass destruction: As derivatives became more popular, transactions were restricted to two parties, trading only with each other. These overthe-counter derivatives (OTC) transactions werent regulated. Congress has taken some steps to increase regulation of OTC derivatives, and to push for more trading on organized exchanges. But these provisions have been riddled with exceptions, and delayed. 5. Companies consolidate, while regulations remains fragmented: Regulation continues to be very fragmented, with many different agencies responsible for bits and pieces of banking regulation. The Commodity Futures Trading Corporation, the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corporation, the Federal Reserve, the National Credit Union Association, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the Treasury Department each regulates some significant aspect of bank activities. 6. Perps get off scot free: The current failure to prosecute means that banks will continue to pursue risky policies. Bankers continue to get paid based on results, and theres so much to gain from a successful risky bet, and so little to lose from a bet gone bad, particularly if the taxpayer is there to pick up the tab.

Major Areas of Reforms

1. Improve Mobilization of Resources: This is the liability side of the system. A major purpose of the reform of a financial system should be to increase its size by mobilizing increasing amounts of private resources through the financial system. To increase the flow of private savings to the formal financial system, the following measures are needed: (a) Liberalize Deposit interest rates

(b) Expand Competition & Banking Coverage (c) Diversify Savings Instruments 2. Improve Resource Allocation (the asset side of the system): Another major objective of financial sector reform is to encourage the allocation of resources to the most economically viable investment opportunities. This will improve economic efficiency and accelerate economic growth. For this purpose the following measures are normally included in financial sector reforms: (a) Liberalize Interest Rates on Lending (b) Eliminate Preferential and Directed Credits (c) Reduce Intermediation Cost 3. Improve Prudential Supervision of Financial Institution: The core The Core Principles for Effective Banking Supervision and Regulation of the Basel Committee on Banking Supervision (composed of G-10 Senior Bank Supervisors), provides a good assessment of the components of an effective system. Its five elements include organization of the banking supervisory authority, Bank licensing, prudential norms, Accounting and information requirements, Exit procedures for bank failure. 4. Strengthen Financial Competition: A degree of competition in the financial sector is needed to bring competition to financial services and improve service quality. 5. International Financial Liberalization: Competition can be brought by opening of the financial sector to foreign banks and liberalizing the flow of international capital. However, liberalization of International Capital should be preceded by the development of strong prudential regulations and supervision, as well as a stable foreign exchange rate system. Otherwise, it would lead to Moral Hazard problems. 6. Domestic Capital Markets Development: A second way to bring competition in the financial sector is by developing alternative mechanisms for firms to get financing. For this, the development of domestic capital markets is essential.

Conclusion
The crisis situation clearly demonstrated that when problem hit one bank they can spread to the whole financial sector and well beyond the border of any country. It also showed that systems are not in place to manage financial institutions facing difficulties. Very few rules exist which determine what action should be taken by the authorities in the bank crisis. The financial crisis ultimately leading to banking crisis provided clear evidence of the need of robust crisis management arrangement at national level as well as the need to put in place arrangements better able to cater cross border banking failures.