The number of financial crises around the world has risen over the last twenty years, and even more sharply over the last ten years. During the 1980s, the World Bank counted forty-five major systemic banking crises.
These are crises in which most or all of the banking system capital is wiped out.2In the 1990s, there were sixty-three major banking crises—an increase
Second, panic strikes—a sudden and dramatic loss of depositor and investor confidence is often the precipitating event. In Ecuador in 1998, depositor confidence quickly reached crisis proportions when banks could not meet their customers’ demands for currency and the central bank reserves were depleted; customers’ deposits were frozen and effec- tively confiscated; a week-long bank holiday ensued when people could not get their funds out of their banks. Argentina faced a similar melt- down in confidence in 2001 and 2002, with ugly street riots and public demonstrations by angry depositors swept up in that country’s fiscal and currency problems that finally impaired its financial sector.
When both the financial and panic dimensions collide, they set off a chain reaction and a country begins to spiral downward, as panic and the loss of confidence increases problems in the banking system as well as the real economy at the microeconomic level. Contagion between countries occurs as well.
of more than 60 percent. Moreover, this trend has been fueled by dramatic increases in the number of crises in emerging market economies, especially in Latin America, in Asia, and in the transitional socialist countries in East- ern Europe and former Soviet bloc countries that have been moving from state-run economies to more market-oriented financial regimes.
Back in the 1980s, major financial crises were relatively rare. Latin Amer- ica was hit with a string of crises stemming mostly from macroeconomic mis- management and weak financial systems. In the United States, thousands of undercapitalized, poorly regulated savings and loans associations (S&Ls) went belly up as a result of imprudent real estate and other commercial lend- ing problems, and ultimately had to be bailed out by taxpayers.
In the 1990s, there were major crises in every corner of the world, from Thailand and Korea, to Russia and the transition economies of Eastern Europe, to Mexico and Brazil. These banking crises, which included banking system meltdowns and major currency devaluations in industrialized countries such as Norway and Sweden, resulted in a tremendous loss of economic growth.
Conventional wisdom has it that financial crises subside in a few years;
the government steps in to bail out the solvent banks and liquidate the failed ones, depositors are offered guarantees, and the IMF and World Bank may give new loans to repay creditors. Conventional wisdom also defines the direct costs of a crisis as the new costs that are being assumed, but this is not often the case. A more correct interpretation would be to think of the losses as “sunk” costs and the so-called direct costs as a transfer payment from taxpayers to depositors in a banking crisis. Using this optic, it is the political process of allocating pain between citizens in an economy that is being observed. Nonetheless, to the external observer, normalcy appears just around the corner. Eventually, the crisis headlines in the press die down, or at least move from the front page to the business section of the local news- paper. Indeed, about one-third of crises fit this description.
Yet, many more financial crises have a very long tail: More than one- half of all financial crises of the last two decades have lasted four years or more. Jamaica in 2002, for instance, is in its eighth year of financial crisis, while Indonesia is in its fifth year, both with lingering problems left unman- aged. After the 1998 financial crisis and currency devaluation, it took four years before Russian banks could again issue international bonds.3In coun- tries like Japan and Indonesia, the lack of political will to resolve crises has allowed them to drag on and on. In other countries like Turkey, the same lack of political will results in recurring crises that materialize every few years. This raises other types of costs that need to be considered: costs that relate to the forgone growth of the countries afflicted by financial crisis.
Since these will be new costs and can still be avoided, it is important to do everything possible to resolve the crisis expeditiously to avoid these addi- tional costs.
Financial Storms’ Costs Are Escalating
Financial crises are a staggering drain on economies because of the direct costs of bailing out the financial system and the even more important cost of lost growth, both of which need to be managed and avoided. The direct costs of a financial crisis alone—or the costs to taxpayers of guaranteeing deposits and recapitalizing the banking system—are enormous (Figure 2.2).
Even the lowest costs to taxpayers are estimated at roughly 4 to 5 percent of the national GDP in Sweden and the United States. In Korea, for instance, the government has already spent $125 billion in direct costs to stabilize the financial system, equal to roughly 35 percent of GDP, according to a Bank of England study. In Mexico, the equivalent cost was approximately $75 billion or about 20 percent of GDP.
In the developing world, taxpayers’ costs can rise to a range of as much as 30 to 40 percent of GDP or more in countries like Chile in 1981 or Thailand in 1997 (42 percent), and up to as much as 50 to 55 percent in Argentina in
10 17
25
14 18
26
15 14
23 Average
Costs of crisis1
% of GDP
Duration of crisis2 Years before positive GPD growth is observed
Forgone income growth opportunity3
% of GDP
Indonesia
Turkey
3
1 2
7 3 2 1
3 2 50
27 33
37
30 20 20
18 2
38 34
30 44
10 25
55
42
gure 2 2
RISIS COSTS ARE STAGGERING
Korea Thailand
Jamaica Colombia Mexico
Average Asian countries
Other countries
1Ranges represent differing estimates from two reports cited
2For those crises that have not yet subsided (Indonesia, Korea, Jamaica, Colombia, and Turkey) duration is calculated through 2002.
3Difference between average GDP’s growth rate during crisis period and steady-state growth rate; economic literature suggests that in steady-state economic growth should be equivalent to population growth
Sources: Caprio, Gerard and Daniela Klingebiel, “Episodes of Systemic and Borderline Finan- cial Crises,” World Bank, October 1999. Hogarth, Glenn, Ricardo Reis, and Victoria Saporta,
“Costs of Banking System Instability: Some Empirical Evidence,” Bank of England, 2001;
McKinsey analysis
FIGURE 2.2 Crisis costs are staggering.
1980 or Indonesia by 1999, when the bank recapitalization began. Bank of England research finds that over the last twenty-five years, banking crises have cost an average of 15 to 20 percent of GDP.4
In Asia, where many financial storm clouds are still gathering, the potential cost is staggering. A 2001 estimate by Ernst & Young puts the value of nonperforming loans in the region at about $2 trillion, an increase of about one-third in just two years.5The situation in individual nations is equally threatening. In China, nonperforming loans represent an estimated 44 percent of GDP; in Malaysia, 50 percent; in Indonesia and Korea, 15 per- cent. Japan is estimated by Ernst & Young to have at least $1 trillion in NPLs. We believe the size of the NPL problem is growing in Asia at an esti- mated rate of about 6 to 10 percent annually. Assuming an average recovery rate of 38 percent, which is average for the world, this will cost Asia roughly
$1.2 trillion to resolve. If taxpayers bear this burden as they have in other countries, the pain of what must still be allocated is enormous.
These direct costs are bad enough, but the more important costs in our view, and the ones rarely discussed, are the costs of lost opportunities and economic growth. These are the costs that come when liquidity dries up, lending stops and deposit transactions freeze, and real assets abruptly re- price. Businesses and banks—both good and bad—fail, and both consumer demand and investment can remain depressed for years. In Korea, for ex- ample, we peg the lost growth opportunity at about 17 percent of GDP. In Mexico, it was about 10 percent, while in Sweden, we estimate it was about 5 percent.6
The last few years have brought us problems that continue to multiply.
Now, in a globally linked economy, the crisis of one nation often becomes the crisis of another. After the Russian default in August 1998, for instance, bond yields skyrocketed in virtually every bond market in the world. As a result, Brazilian companies faced interest rates that were 1,300 basis points higher than previously. In the United States, meanwhile, start-up firms found that they could not issue bonds at any interest rate. In an interconnected global capital market, events in one market ripple inexorably out to others.
More Financial Storms Are Brewing
The increasing frequency and costs of financial crises are troubling enough.
Yet, we also believe that more potentially big financial crises are now smol- dering underground and may someday ignite.
This type of precrisis situation can burn slowly for years, with equally devastating effects on the economy. An overt crisis has not broken out—
that is, bank runs are not visible, the payments system continues to function, and bank losses are contained just as inefficiencies are perpetuated—but there are signs nevertheless of financial duress that are of crisis proportions.
These signs include many insolvent banks, too rapid loan growth, and non- performing loans as a significant percentage of GDP—and subsequently constrained credit as a result. All it will take is a crisis of confidence to erupt and tip the situation into a full-fledged crisis.
Japan is an example. It has not yet had a sudden financial panic as we write this book, but that is in large part because the government has contin- ued to prop up many large banks that would otherwise have gone under. In effect, taxpayers have continued to bail out failing banks.
The problem began in 1986 and peaked in 1989, when Japanese banks were badly hit by the collapse of the stock market and the real estate mar- ket. They were holding large portions of stock and had made numerous real estate loans that went bad. Yet, the banks and government did little to resolve the problem, refusing to restructure the financial sector and continu- ing to pour in new money to prop it up. With few investment alternatives, Japanese savers have not demanded their deposits. Given the lifting of blan- ket protection on time deposits in April 2002, however, observers should keep an eye on gold purchases. By now, there are at least an estimated $500 billion to $600 billion in nonperforming loans, and it will cost taxpayers at least 15 to 20 percent of GDP to recapitalize the banks.7
In 1999, the Japanese government began to take some of the steps nec- essary to resolve the crisis: Hokkaido Takushodu Bank failed and Long- Term Credit Bank was nationalized and then sold to a foreign private equity group—Ripplewood Partners. Several other major banks merged, but they have yet to address the bulk of NPLs.
Why don’t these pre-crisis situations flare into the open like so many others? Most of these countries, like China and India, have tight control over their financial systems and depositors have no real choice about where to put their money in the current environment. Foreign competition for deposits is limited or nonexistent. Governments also implicitly guarantee the system, and many banks are considered “too big to fail.” As a result, nearly insolvent banks are allowed to muddle on, ignoring their nonper- forming assets. In China’s case, however, this situation will begin to change as its WTO commitments phase in over the next five years starting in 2002 and new competitors are allowed in the financial system.
Crises Can Be Recurring
Other financial crises flare up periodically. Turkey has seen a repetition of currency and banking crises since 1994. A combination of uneven liberaliza- tion, large fiscal deficits, and a reliance on short-term, unhedged foreign cur- rency loans sparked the initial 1994 crisis. The Turkish lira lost half its value in the first three months of that year, and the central bank lost more than half of its currency reserves futilely trying to defend it. The economy was
plunged into recession, with GDP falling by 6 percent and inflation reaching three-digit levels. International banks withdrew more than $7 billion, adding to the liquidity crunch. The Turkish central bank and finance ministry calmed the waters with halfhearted measures, closing a few small banks and starting to bring its fiscal deficit under control. Yet, Turkey failed to address the underlying problems with both its economy and its banking system, so by 2000 it was once again faced with the ugly specter of a full-blown crisis.
It is only as of this writing, in early 2002, that Turkey is starting to manage the lingering structural problems of its banking system as it moves to meet the requirements for membership in the European Union.
Like the smoldering pre-crisis situations described before, recurring crises result mainly from a lack of political resolve—and perhaps under- standing—of how to manage the situation aggressively. In nearly all cases, these countries refused to admit there was a fundamental underlying prob- lem in their banking systems. Turkey, for instance, largely papered over its problems after its 1994 crisis. As a result, all it took to spark it again in 2001 was the collapse of a single, mid-sized bank—Demirbank. Once one bank went down, investors began to worry about the health of other banks as well. Savvy observers can feel the heat and smell the smoke, even when they cannot see the flames raging out of control.
Executives in many countries consequently will be forced to manage their way through financial crises for a long time to come. Financial crises in far-flung nations can affect a company’s financing, supply chain, growth plans, and overall strategy. In such a world, managers everywhere must understand clearly what causes financial crises to erupt, how to see the warning signs and then take the necessary precautions, and finally how to respond quickly and decisively once a crisis hits.