KinD 2009 home page image

Financial Crises (2009)
What we know
Don't count on decoupling
Crises reflect systematic risk
Financial safety nets are common, but bring their own risks

Crises have been much studied, including at the World Bank. At the time of writing, if one enters the phrase “financial crisis” in the search engine of the Bank’s “Policy Research Working Papers” series one gets over 650 research papers, back to 1990.[1] Of course, not all of these are relevant to any given crisis and some relevant research does not mention a “crisis;” for example, the literature on famines and natural disasters contains insights for policy responses to a financial crisis. Nor does the Bank have a monopoly over crisis research; financial crises have also been much studied by our sister organization, the International Monetary Fund (IMF), and have been the subject of much academic research. Nonetheless, as the world in 2008 entered what is clearly a truly major financial crisis it is of interest to take stock of what lessons might be drawn from the Bank’s past research.

The existence of financial crises does not change our assessment that, on balance, financial development and globalization are good for poverty reduction in the longer term. However, this positive long-run relationship can coexist with a negative short-run relationship through financial fragility. This can reflect fundamental distortions—that build up for a long time, hidden from view, before macro shocks reveal the underlying vulnerabilities—but financial crises also strike economies with relatively sound institutions and generally good policies.

Globalization facilitates contagion, although some economies and people are more vulnerable than others. Some of the same factors that have kept a significant share of the developing world’s population in deep and persistent poverty—including a lack of connectivity to markets, and consequent lack of opportunity for economic advancement—will also protect them to some degree from the crisis. However, significant welfare impacts can be expected—notably in countries, and regions within countries, that have benefited from market-oriented development and associated with a likely breakdown of the types of support mechanisms that operate in normal times. A crisis can also have longer-term impacts for some of those affected, most notably through the nutrition and schooling of children in poor families. Crisis responses can also lay the seeds of longer-term vulnerability to crises. The extent to which these adverse outcomes materialize will depend in part on the policies adopted by developing country governments.

The process of globalization and financial development has been prone to crises. Over the long run, financial development is expected to support economic growth and poverty reduction. But, along the way, even relatively mature financial systems are vulnerable to systemic banking crises, cycles of booms and busts, and financial volatility.[2] This appears to be partly intrinsic and partly due to policy mistakes. It arises as banks expand and capital markets generate new financial products. This entails new, unfamiliar, risks for financial intermediaries and regulators. Furthermore, as countries become more open to capital flows, crises are more easily transmitted across borders. The positive long-run relationship between financial development and growth coexists with a negative short-run relationship through financial fragility.[3]

back-to-top gif

What we know

Don’t count on “decoupling”

Given the lessons from the crises of the last 15 years, developing countries have taken measures to become less vulnerable to domestic and foreign shocks. For example, many have accumulated large reserves, have tried to switch to long-term and domestic currency borrowing, and have tended to reduce fiscal and current account deficits, thus lowering their debt levels.[4] Some observers have argued that (after the crises of the 1990s) developing countries had learned to avoid risks and, by choosing the right policies, had “decoupled” from turbulence in other parts of the world—effectively insulating themselves from the fate of countries elsewhere. Contrary to this view, our research has shown that crises continue to be contagious, due to the real and financial channels that fundamentally connect countries.[5]

It is difficult to achieve the benefits of economic and financial integration without being susceptible to contagious effects. However, the terms of the trade-off between reaping the benefits of globalization and vulnerability to crises also depend on aspects of the financial integration process and related policy choices. An example is the extent of reliance on portfolio investment through open capital markets versus foreign direct investment (FDI). The former leaves the country more exposed to contagion than the latter; FDI is also expected to bring more lasting benefits in terms of technology transfer. Other relevant factors influencing the extent of contagion are reliance on short-term debt and being a large liquid market and part of the portfolio of international investors.

The most direct channel linking the developed world to the financial crisis emanating from the developed world in 2008 is through exposure to assets that are at the heart of the crisis, notably the subprime mortgages. However, the more important channels for most developing countries will probably be indirect, notably through trade (via declining demand for developing-country exports), investment (as external finance for developing countries starts to contract) and remittances (also stemming from the recession in the developed world). Many developing countries are now quite strongly connected to the world economy through these channels.[6] Their growth prospects will be adversely affected by a slowdown or a recession in industrial countries. Slower growth has immediate consequences for the pace of poverty reduction, and it also tends to raise debt burdens and debt servicing difficulties. Our research shows that, for a given debt burden (as a share of GDP), the risk of debt servicing difficulties is substantially higher in countries experiencing adverse growth shocks. However, the magnitude of this effect is smaller in countries with better institutions and policies. This research points to the importance of tailoring debt burdens and relief efforts to the debt carrying capacity of a country as measured by the quality of its institutions and policies.[7]

back-to-top gif

Crises reflect systemic risk

Although much of the academic and policy discussion focuses on how to deal with idiosyncratic risks, crises are typically linked to systemic risk.[8] This has important consequences because financial systems are reasonably well equipped to deal with idiosyncratic risk and financial policies have focused on how to make institutions sound for that purpose.[9] However, neither financial intermediaries nor policymakers are well prepared to deal with systemic risk, which is particularly high in emerging economies. This is related to the fact that developing countries typically suffer larger exogenous shocks than rich countries; their domestic policies often represent an additional source of volatility, and they possess weaker macroeconomic and financial shock absorbers than developed economies.[10]

An economy-wide crisis puts stress on standard ways of coping with variability and risk at firm, household and community levels. Indeed, the covariate nature of the shock limits the scope for co-insurance, and mutual insurance arrangements may well break down when faced with such a large external shock.[11] Research on the impact of the 1995 “Peso crisis” in Mexico (resulting in a 9% decline in GDP in that year) revealed that many of the normal coping strategies of poor households (such as seeking credit, extra work, or private transfers) failed during this large macro shock.[12] However, there is evidence that firms had a lower probability of filing for bankruptcy when they had ownership links to banks and families (controlling for firm and country characteristics).[13]

Formal credit also responds in ways that constrain the scope for households and firms to buffer themselves. Credit growth slows substantially, but less so than output growth which begins to recover in the second year after the crisis while credit still stagnates.[14] Banks, including healthier ones, reallocate their asset portfolio away from loans. Other sources of credit are also affected. We have studied the effect of financial crises on trade credit. The empirical findings indicate that, although provision of trade credit increases right after the crisis, it subsequently collapsed in the following months and years.[15] Firms with weak financial position—for example, those with a high pre-crisis level of short-term debt and low cash stocks and cash flows—are more likely to reduce trade credit provided to their customers. This suggests that the decline in aggregate credit provision is driven by the reduction in the supply of trade credit, which follows the bank credit crunch.

back-to-top gif

Financial safety nets are common, but bring their own risks

Policy makers typically erect financial safety nets to make systemic breakdowns less likely and limit disruption and fiscal costs. The safety nets include deposit insurance, lender-of-last-resort facilities at the central bank, procedures for investigating and resolving bank insolvencies, strategies for regulating and supervising banks and provisions for accessing emergency assistance from multinational institutions. The design and implementation of these schemes are important since mistaken policies also have the potential to erode market discipline, lead to excessive risk-taking and further undermine financial stability in the long run.[16]

Our research suggests that whether deposit insurance benefits or harms a country depends on how well it is designed and administered.[17] The design of deposit insurance systems plays a critical role in distorting risk-taking incentives and making systems more vulnerable to macro shocks. One mechanism through which the design of deposit insurance undermines market discipline is that poor design makes bank creditors less sensitive to bank risk-taking.[18] It has also been shown that financial liberalization is unlikely to add to the risk of systemic bank failures provided that the institutional underpinnings are strong and safety nets are well-designed.[19]

Another important component of the safety net which promotes systemic stability is the design of prudential regulation and supervision. Research on prudential regulation and supervision around the world suggests that effective systems empower and rely on market discipline, instead of undermining it.[20] Market participants such as shareholders and depositors of banks and other financial institutions and holders of their subordinated debt must have the incentive and ability to monitor those institutions. Improving compliance with disclosure and transparency regulations, which enables market participants to monitor, are among the features most robustly associated with bank soundness.[21]

This research is relevant in understanding the causes of the recent financial crisis.[22] It is crucial to evaluate different potential causes of the crisis, and identify the political and bureaucratic incentives that undermine the effectiveness of financial regulation and supervision. The Knowledge in Development Note, “Policy Responses to Crises,” goes further into the policy implications.

Contact: Martin Ravallion, mravallion@worldbank.org, 202-473-6859

back-to-top gif

Notes

Most World Bank research documents cited in this summary are available through the World Bank’s research archives at http://econ.worldbank.org/docsearch or the Bankwide archives at http://www-wds.worldbank.org/.

1. The working paper web site is http://econ.worldbank.org/docsearch. If one searches on the phrase “financial crisis” the site returns 657 papers (as of November 7, 2008); just searching on the word “crisis” gives 730 papers.

2. See S. Schmukler. 2004. “Financial Globalization: Gain and Pain for Developing Countries.” Economic Review, Federal Reserve Bank of Atlanta, pp. 39-66, Second Quarter.

S. Schmukler. 2008. “The Benefits and Risks of Globalization: Challenges for Developing Countries.” In Capital Markets Liberalization and Development, ed. Joseph Stiglitz and Jose Antonio Ocampo. New York: Oxford University Press.

3. N. Loayza and R. Romain. 2006. “Financial Development, Financial Fragility, and Growth.” Journal of Money, Credit, and Banking 38(4): 1051–76.

Also see G. Kaminsky and S. Schmukler. 2008. “Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization.” Review of Finance-Journal of the European Finance Association 12(2): 253–92.

4. F. Broner, G. Lorenzoni, and S. Schmukler. 2004. “Why Do Emerging Economies Borrow Short Term?” Policy Research Working Paper 3389, World Bank, Washington, DC.

5. T. Didier, P. Mauro, and S. Schmukler. 2008. “Vanishing Contagion?” Journal of Policy Modeling 30(5): 775–91.

G. Kaminsky and S. Schmukler.1999. “What Triggers Market Jitters? A Chronicle of the East Asian Crisis.” Journal of International Money and Finance 18: 537–60.

G. Kaminsky and S. Schmukler. 2002. “Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?” World Bank Economic Review 16(2): 171–95.

G. Kaminsky, R. Lyons, and S. Schmukler. 2004. “Managers, Investors, and Crises: Mutual Fund Strategies in Emerging Markets.” Journal of International Economics 64(1): 113–34.

H. Kawai, R. Newfarmer, and S. Schmukler. 2005. “Financial Crises: Nine Lessons from East Asia.” Eastern Economic Journal 31(2): 185–207.

6. S. Claessens and S. Schmukler. 2007. “International Financial Integration through Equity Markets: Which Firms from Which Countries Go Global?” Journal of International Money and Finance 26(5): 788–813.

J. C. Gozzi, R. Levine, and S. Schmukler. 2008. “Patterns of International Capital Raisings.” Policy Research Working Paper 4687, World Bank, Washington DC.

7. A. Kraay and N. Vikram. 2006. “When Is External Debt Sustainable?” World Bank Economic Review 20(3): 341–67.

8. E. Levy Yeyati, M.S. Martinez Peria, and S. Schmukler. 2004. “Market Discipline and Systemic Risk: Evidence from Bank Runs in Emerging Economies.” Policy Research Working Paper 3440, World Bank, Washington, DC.

A. de la Torre and S. Schmukler. 2004. “Coping with Risks Through Mismatches: Domestic and International Financial Contracts for Emerging Economies.” International Finance 7(3): 349–90.

9. M.S. Martinez Peria and S. Schmukler. 2001. “Do Depositors Punish Banks for Bad Behavior? Market Discipline, Deposit Insurance, and Banking Crises.” Journal of Finance 56(3): 1029–51.

10. For details, see N. Loayza, R. Romain, L. Serven, and J. Ventura. 2007. “Macroeconomic Volatility and Welfare in Developing Countries.” World Bank Economic Review 21(3): 343–57.

11. S. Coate and M. Ravallion. 1993. “Reciprocity without Commitment: Characterization and Performance of Informal Insurance Arrangements.” Journal of Development Economics 40: 1–25.

This has also been a theme of the literature on famines; for an overview see M. Ravallion. 1997. “Famines and Economics.” Journal of Economic Literature 35(3): 1205–42.

12. D. McKenzie. 2003. “How do Households Cope with Aggregate Shocks? Evidence from the Mexican Peso Crisis.” World Development 31(7): 1179–99.

13. S. Claessens, S. Djankov, and L. Klapper. 2003. “Resolution of Corporate Distress in East Asia.” Journal of Empirical Finance 10: 199–216.

14. A. Demirgüç-Kunt, E. Detragiache, and P. Gupta. 2006. “Inside the Crisis: An Empirical Analysis of Banking Systems in Distress.” Journal of International Money and Finance 25(5): 702–18.

15. I. Love, L. Preve, and V. Sarria Allende. 2007. “Trade Credit and Bank Credit: Evidence from Recent Financial Crises.” Journal of Financial Economics 83(2): 453–69.

16. Here we are referring to pre-crisis, steady state arrangements that shape incentives, rather than post-crisis actions such as blanket guarantees of deposits and bail-outs of financial institutions taken to protect the survival of a financial system when policy makers are left with few viable options.

17. A. Demirgüç-Kunt, E. Kane, and L. Laeven. 2008. “Determinants of Deposit Insurance: Adoption and Design.” Journal of Financial Intermediation 17 (3): 407–38.

A. Demirgüç-Kunt and E. Kane. 2002. “Deposit Insurance around the Globe: Where Does it Work?” Journal of Economic Perspectives 16(2).

18. A. Demirgüç-Kunt and H. Huizinga. 2004. “Market Discipline and Deposit Insurance.” Journal of Monetary Economics 51(2): 375–99.

19. A. Demirgüç-Kunt and E. Detragiache. 1999. “Financial Liberalization and Financial Fragility.” In Proceedings of the World Bank Annual Conference on Development Economics, ed. B. Pleskovic and J. Stiglitz. Washington, DC: World Bank.

20. J. R. Barth, G. Caprio, Jr., and R. Levine. 2006. Rethinking Bank Regulation: Till Angels Govern. New York: Cambridge University Press.

21. A. Demirgüç-Kunt, E. Detragiache, and T. Tressel. 2008. “Banking on the Principles: Compliance with Basel Core Principles and Bank Soundness.” Journal of Financial Intermediation 17(4): 511–42.

22. G. Caprio, A. Demirgüç-Kunt, and E. Kane. 2008. “The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats.” Policy Research Working Paper 4756, World Bank, Washington, DC.

back-to-top gif