FRBSF Economic Letter
99-28; September 17, 1999
 Economic
Letter Index
Early Warning Indicators of Banking Sector Distresss
The financial crises in Japan and East Asia have been costly; they disrupted
credit channels and curtailed economic activity not only in those countries
but in other parts of the world as well. Such high costs make it desirable
to have some form of early warning system of impending banking sector
distress. If policymakers could identify the factors that lead to a higher
likelihood of banking problems, they might be able to take steps to avert
them. Of course, each banking crisis usually has idiosyncratic features
that make it unique. But there may also be common features associated
with episodes of banking sector distress identifiable across a large number
of countries and cases. This Economic Letter discusses the common
features associated with banking crises and whether distress signals may
be identified before serious problems arise.
Frequent and costly banking sector distress
An episode of banking distress may be associated with depositor runs
on banks, the closure or merger of financial institutions, or the extension
of large-scale government assistance. Typical characteristics of a financial
system under stress include a significant portfolio of nonperforming assets
and a limited capital base. Using these measures, Glick and Hutchison
(1999) find more than 94 episodes of banking sector distress in industrial
and developing economies since the mid-1970s. And they find the frequency
is rising--nine crises were marked in 1975-80, 34 during 1991-95 and,
by 1997, there were seven new and 29 continuing episodes. Banking crises
are commonplace regardless of development status, but they occur with
somewhat greater frequency in developing or emerging market economies
than in industrialized economies.
Banking crises generally impose significant costs on the economy. One
cost is the loss of output. The great majority of countries have suffered
recessions following episodes of banking sector distress, with the cumulative
output loss associated with periods of banking sector distress averaging
about 10% of GDP (Hutchison and McDill 1999). These costs range widely
across countries, of course. Countries such as Chile and Thailand in the
early 1980s suffered severe output losses, amounting to over 25% of GDP
over several years. Recent experience indicates that the ultimate costs
of the East Asia financial crises also will likely be very large.
Another cost is the fiscal cost associated with government efforts to
solve the problems in the financial system. Direct government funds to
recapitalize banks, shore up deposit insurance funds, and so on, amounted
to a significant portion of output and a huge commitment of government
budget resources--usually somewhere between 6-10% of GDP. Again, the range
in fiscal costs is large. Estimates of the resolution costs of Argentina's
and Chile's banking crises in the 1980s were over 40% of GDP (Caprio and
Klingebiel 1996). This same study puts the cost of resolution cost of
the U.S. thrift industry bailout in the 1980s at just over 3% of GDP.
The commitment of additional funds by the Japanese Diet in 1998 to shore
up the deposit insurance fund and recapitalize problem banks brings the
cumulative fiscal cost to date (after seven years of banking problems)
to about 12% of Japan's GDP.
Why is the banking sector vulnerable?
Much of the theory on banks' vulnerability to adverse shocks focuses
on the special role of banks in asset maturity and currency transformation
in an uncertain world with asymmetric information. The literature emphasizes
that institutional features of economies, such as the existence of deposit
insurance and a market-determined interest rate structure, affect the
profitability of banks and the incentives of bank managers to take on
risk in lending operations. Adverse macroeconomic shocks, such as a fall
in asset prices (leading to a fall in bank capital or the collateral underlying
loans) or economic activity (leading to more delinquent loans), may push
an already vulnerable banking sector into a crisis situation. Adverse
economic shocks may originate domestically (for example, via recession,
inflation, budget deficits, or credit slowdowns) or externally (for example,
via trade or exchange rate depreciation).
Banking systems may be particularly vulnerable in times of rapid financial
liberalization and greater market competition, when banks are taking on
new and unfamiliar risks on both the asset and liability side of balance
sheets. Weak supervisory and regulatory policies under these circumstances
also may give financial institutions with low capital ratios incentives
to increase their risk positions in newly competitive environments and
allow them to avoid full responsibility for mistakes in monitoring and
evaluating risk. Further, deficiencies in accounting, disclosure, and
legal frameworks contribute to the problem because they allow financial
institutions (or financial regulators) to disguise the extent of their
stresses. Governments frequently have failed to identify problem institutions
quickly or to take prompt corrective action when a problem arises, resulting
in larger and more difficult crisis situations.
Early warning indicators
Hutchison and McDill (1999) consider a number of early warning indicators
of the onset of banking sector distress. Since focusing only on episodes
of banking distress would introduce an inherent bias, a broad sample of
developing, emerging-market, and industrial economies were considered.
Important information may be gleaned from an environment that may have
appeared ripe for the onset of banking sector distress but avoided it.
In this way, a control group of countries that did not experience banking
distress helps isolate those indicators that actually may predict banking
problems
The study identifies two groups of indicators likely to be candidates
signaling the onset of banking crises: macroeconomic and institutional.
The choice of variables for each group is limited, of course, by the availability
of data across a large number of countries and over a sustained period.
But enough data are available to draw out some of the main statistical
features common to most episodes of banking sector distress. Specifically,
starting with a sample of over 130 countries over the 1975-97 period,
with over 90 banking crises identified, the study examined 97 countries,
of which 53 had severe banking problems at some point. Since several countries
had multiple occurrences over the sample period, 65 episodes of banking
distress are identified for detailed statistical analysis (using the probit
model regression procedure on a panel data set).
On the macroeconomic side, a large number of variables were investigated
to see if they either provided an early warning signal or were contemporaneously
associated with the onset of banking problems. These variables include
real output growth, exchange rate changes, real credit growth, real interest
rates, inflation, changes in asset prices, and the ratio of international
reserves to the money stock. Each factor has been offered, in different
contexts, as an indicator of the likelihood of banking distress. Hutchison
and McDill, however, find that only two of the macro variables are systematically
correlated with the onset of banking sector distress: declines in real
output and declines in asset values (reflected by equity values). This
is not surprising. The likelihood of a serious banking problem would be
expected to rise when recessions occur (associated with more bankruptcies
and problem loans) and when asset prices fall (indicating a decline in
collateral values, which is frequently associated with a depressed real
estate sector).
What is surprising is that the other macroeconomic variables generally
were not associated with the onset of banking crises. Simple accounting,
for example, tells us that sharp exchange rate depreciation played an
important role in bringing on or exacerbating banking crises in Korea
and Indonesia in 1997 and many other countries. This was because bank
subsidiaries (Korea) or firms (Indonesia) had large short-term net foreign
liability positions at the time of the depreciation. But in many cases,
collapsing currencies did not lead to banking distress. Japan and the
United States, for example, had sharply appreciating exchange rates in
the early 1990s and 1980s, respectively, when their bank and thrift problems
were emerging to crisis proportions.
Another surprise is that macroeconomic variables are not very
reliable predictors of the onset of banking sector distress,
even though recessions and falling asset prices occur simultaneously with
the onset of banking sector distress. This finding contrasts with two
other studies that seem to find stronger evidence of a leading indicator
relationship. Various permutations of the Hutchison-McDill study--such
as data transformations, lead and lag checks, and so on--hold up the basic
result: it is very difficult to find any macro variable that is a reliable
predictor of the onset of future banking sector distress. The broader
data set used in their study--including developing, emerging-market, and
industrial countries as well as those countries not experiencing
severe banking problems as a control group--appears to give a less rosy
picture of our ability to pick out early warning signals of impending
problems.
Institutional features
Institutional features were important in identifying those countries
more likely to run into banking problems at some point. Because institutional
features, such as the regulatory and supervisory structures, deposit insurance,
financial liberalization, and so on, do not change much over time, including
these variables mainly serves to pick up cross-country differences in
institutional structures that may lead to a higher probability of banking
problems. In this context, the most important institutional feature was
a period of financial liberalization--a period of financial liberalization
frequently is associated with, and often precedes, the onset of a serious
banking problem. The particular measure of financial liberalization in
Hutchison and McDill is the deregulation of interest rates. In many economies,
this era usually heralded liberalization not only in the pricing of financial
assets, but also in the types of assets allowed and the development of
more open and competitive financial markets. In other words, banks faced
greater market competition at a time when they also were taking on new
and unfamiliar risks on both the asset and liability side of balance sheets.
The evidence suggests that this is a particularly vulnerable time for
banks in managing risk that sends a clear warning signal for financial
supervisors.
Avoiding banking crises
An example of the model's (modest) predictive power is Japan. Figure
1 shows the model's forecasts of the probability of the onset of Japanese
banking distress that did in fact emerge in the early 1990s. Only one-year
lagged macroeconomic variables were used in the forecast, so the reported
forecasts of the probability of the onset of an episode may be interpreted
as an early warning indicator of impending problems. The forecast probability
of a problem rises from 2% in 1990 to 13% in 1992, roughly tracking the
emergence of serious banking distress in Japan. (The model with contemporaneous
variables predicts a 20% probability of banking distress in 1992.) Though
13% may not seem a high probability, it should be seen in light of the
magnitude of the event: the sharp rise warns that something is amiss.
Early warning systems of impending banking sector problems are not very
accurate. Nonetheless, case studies and the empirical evidence point to
some policy implications. In particular, the vulnerable transition period
as financial markets liberalize appears to warrant a larger commitment
of resources and a more vital role for the regulatory and supervisory
authorities. Financial liberalization in many countries proceeded without
these safeguards. Resources devoted to the supervision of U.S. thrifts,
for example, were reduced as the industry was increasingly deregulated
in the early 1980s. The supervisory authorities of Japan, Sweden, and
elsewhere were similarly unprepared for the enhanced banking risks associated
with the era of financial liberalization. Banking problems have provided
an impetus to institutional reform of the supervisory agencies of the
U.S. and elsewhere. For example, recently created financial supervisory
agencies in Japan and Korea--allowing greater autonomy, emphasizing rules
rather than discretion in dealing with problem institutions, and forcing
greater disclosure and transparency in the supervisory process--appear
to be appropriate responses to these countries' banking problems.
Michael Hutchison
Professor of Economics, U.C. Santa Cruz,
and Visiting Scholar, FRBSF
References
Caprio, G., and D. Klingebiel. 1996. "Bank Insolvencies: Cross-Country
Experience." Working Paper 1620, World Bank (July).
Glick, R., and M. Hutchison. 1999. "Banking and Currency Crises: How
Common Are Twins?" Mimeo. Federal Reserve Bank of San Francisco (June
18).
Hutchison, M., and K. McDill. 1999. "Are All Banking Crises Alike? The
Japanese Experience in International Comparisons." FRBSF Pacific Basin
Working Paper No. PB99-02. Forthcoming in Journal of the Japanese
and International Economies.
Opinions expressed in this newsletter do not necessarily reflect
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or of the Board of Governors of the Federal Reserve System. Editorial
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