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Triplet Crises: Lessons European Leaders Can Learn From Emerging Markets

Maria Soledad Martinez Peria's picture

Much of the discussion surrounding the current European crisis focused initially on whether a default by Greece was inevitable and how that would impact bond holders. Over time, the attention has shifted to banks and the potential for a generalized run and failure of the financial system, not only in Greece but also in other countries. Unfortunately, the developments in Europe are awfully similar to those in emerging economies in the past. The lessons learned in emerging markets might have helped European policymakers lessen the spillovers from macroeconomic risk to the financial sector, and even at this stage may still be useful for understanding how to manage the on-going crisis.

Many emerging economies used to follow exchange rate pegs, had large degree of liability dollarization, and ran fiscal deficits financed by the banking sector, which led to “triplet crises” involving debt, currency, and banking collapses. The  crises in Argentina and Uruguay in 2000–02 are illustrative. In a recent paper co-authored with Levy Yeyati, we show that macroeconomic risks like exchange rate devaluations or sovereign debt defaults can quickly cause the collapse of banking systems. These macroeconomic events are not random or driven by contagion across banks. Macroeconomic factors that are largely irrelevant in explaining depositor behavior during tranquil times can rapidly become the main driver of market response during crisis episodes, even after controlling for standard bank-specific traits. Furthermore, a crisis in one country (Argentina) can contaminate the banking system of a neighboring country (Uruguay) in a matter of days.

Do We Need Big Banks?

Asli Demirgüç-Kunt's picture

In the past several decades banks have grown relentlessly. Many have become very large—both in absolute terms and relative to their economies. During the recent financial crisis it became apparent that large bank size can imply large risks to a country’s public finances. In Iceland failures of large banks in 2008 triggered a national bankruptcy. In Ireland the distress of large banks forced the country to seek financial assistance from the European Union and International Monetary Fund in 2010.

An obvious solution to the public finance risks posed by large banks is to force them to downsize or split up. In the aftermath of the EU bailout Ireland will probably be required to considerably downsize its banks, reflecting its relatively small national economy. In the United Kingdom the Bank of England has been active in a debate on whether major U.K. banks need to be split up to reduce risks to the British treasury. In the United States the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10 percent of the aggregate consolidated liabilities of all financial companies, to prevent the emergence of an oversized bank.

So public finance risks of systemically large banks are obvious. But what are some of the other costs (and benefits) associated with bank size? This is the question Harry Huizinga and I try to address in a recent paper. Specifically, we look at how large banks are different in three key areas: