Can We Prevent Financial Crises?

The emerging markets are in turmoil. Stocks and currencies are falling. Global investors are pulling money out of stocks and bonds. Is another crisis looming?

To answer that question, the World Bank in February held a panel discussion led by authors of three books examining lessons learned from financial crises. Mahmoud Mohieldin, World Bank Group president’s special envoy, said the three books can help policy makers examine the current turmoil affecting emerging markets, along with the hypothetical diagnoses proposed by some commentators: distorted asset prices, questionable growth foundations, human behavior, and overborrowing by households and the private sector.

“The underlying cause is the structural problem in the financial system, which distorts incentives to rational human behavior, generates excessive credit growth, distorts prices, and results in overstretched balance sheets,” said Asli Demirguc-Kunt, the World Bank’s research director and co-author of a report, the Global Financial Development Report 2013: Rethinking the Role of the State in Finance.

The report, drawing on several new global surveys and unique country-level data covering 205 economies since 1960s, calls for a reexamination of the state’s role in the financial sector. The report’s overall message is cautionary. Government involvement in the financial sector helps maintain economic stability, support economic growth and create jobs in the short run, especially in times of crisis. But in the long run, governments may need to get less involved in some areas, while strengthening their hand in ensuring good supervision, healthy competition and better access to financial services.

State banks in Brazil, for example, aren’t efficient in allocating credits. Although their ability to absorb failed banks lessened the stress on the system during the current market turmoil, that came at a significant long-term cost in terms of inefficient and politicized lending, said Charles W. Calomiris, the Henry Kaufman professor of financial institutions at Columbia University and co-author of a new book, Fragile by Design: The Political Origins of the Banking Crises and Scarce Credit.

Looking at why banking systems are unstable in some countries but not in others, his book shows that the pattern of chronic banking crises and scarce credit results from complex political bargains made between politicians, bankers, bank shareholders, depositors, debtors, and taxpayers. Several countries, such as Singapore and Canada, have stable banking systems that provide abundant credit. He said that may be because they are either politically homogeneous or democracies with a history of anti-populist constitutions. Other countries, such as the U.S., have a history of recurrent financial crises, which reflects historical circumstances and a constitution that permits greater populist control of the banking system.

As a result, Calomiris said, models that analyze banking crisis propensity as a function of the economics of banking per se leads to “over-theorizing crises.”  "The propensity for crises is a political problem,” he said. “It’s not a math problem.” Non-democracies are systematically less likely to have stable and efficient banking systems, though being a democracy per se isn’t a solution to endemic banking crises.

Financial crises, affecting both emerging markets and advanced countries over the centuries, have severe economic consequences, but they can be hard to prevent and predict, said Stijn Claessens, assistant director of the International Monetary Fund and one of the editors of a new book, Financial Crises: Causes, Consequences, and Policy Responses. “Identifying financial crises’ causes remains both science and art,” he said. While it would be better to mitigate risks, financial crises will recur, often in waves, Claessens said, and better crisis management is therefore important.

Analyses of recurrent causes suggest that to prevent crises, governments should consider reforms in many underlying areas. That includes developing prudent fiscal and monetary policies, better regulating the financial sector, including reducing the problem of too-big-to-fail banks, and developing effective macro-prudential policies. Despite new regulations and better supervision, crises are likely to recur, in part because they can reflect deeper problems related to income inequality, the political economy and common human behavior. As such, improvements in crisis management are also needed

The Global Financial Development Report 2013 reviews recent successes and failures of the state as a regulator and supervisor. During the 2008 financial crisis, many developing economies had limited exposure to the risky behaviors that precipitated the meltdown, and most averted outright distress, including Malaysia and Peru, both of which were praised for their prudent policies. Nonetheless, some countries suffered direct hits, especially in Europe and Central Asia, where reliance on parent banks and a build-up of funding imbalances in the run-up to the crisis left many countries vulnerable.

The report analyzes common traits among countries that were hit hard by the crisis versus those that fared better. Non-crisis countries tended to have less complex but better enforced regulations. Crisis countries allowed for less stringent definitions of capital, were not as rigorous in calculating their capital requirements for credit risks, and only 25 percent of them required general provisions on loans and advances (vs. close to 70 percent in non-crisis countries).

The report refutes the view that there was too much competition in the financial sector of the crisis countries. “Research presented in the report suggests that with good supervision, more competition can actually help improve efficiency and enhance access to financial services, without undermining stability,” Demirgüç-Kunt said.