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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.

Ex ante, the signals might not be very transparent. Bank-specific exposure to macroeconomic factors may not be factored into banks’ funding costs in the pre-crisis period, but deposit withdrawals during the crises can become positively associated with banks’ exposure to exchange rate or sovereign default risks. Furthermore, the informational content of bank-specific characteristics deteriorates relative to macroeconomic factors as aggregate risk mounts, which explains why risk-aware depositors may increase their response to macroeconomic indicators at the expense of bank-specific characteristics.

These findings have implications for the existing views on depositor behavior. Most of the literature on how depositors behave emphasizes their response to bank-specific characteristics—what is known in banking as market discipline. The idea is that depositors would respond to increases in bank risk (bank-specific characteristics) by demanding higher interest rates on their deposits or by withdrawing their funds, penalizing managers for excessive risk taking. To the extent that market discipline is present, it tends to lower the probability of individual bank failures and the incidence of banking crises and lead to a healthier banking sector as a whole. An alternative explanation holds that generalized deposit runs can be random events or triggered by contagion from weak banks to strong banks and thus unrelated to bank-specific characteristics. However, both of these explanations have ignored another factor: the incidence of macroeconomic risks, in particular sovereign default and devaluation risk.

In light of our findings, we believe that a careful discussion of how a debt restructuring or the possibility of abandoning the euro would affect banks in Europe deserves more attention. These macroeconomic risks can influence depositor actions both irrespective of and through bank-specific characteristics. The effects of macroeconomic factors irrespective of bank-specific characteristics can take place when worsening macroeconomic conditions directly threaten the value of market participants’ assets (such as bank deposits). A classic example of direct macroeconomic effects is currency risk: depositors might flee from domestic banks, regardless of the fundamentals of individual banks, if convertibility to a foreign currency might not be possible. For example, an increasing possibility of readopting the drachma, the lira, or the peseta might instantaneously produce a bank run.

The effects of macroeconomic risk on depositor behavior through bank-specific characteristics can take place either through exposure to macroeconomic risk (not typically captured by the most frequently used indicators) or through a gradual deterioration of traditional bank-specific characteristics. An example of exposure to macroeconomic risk not captured by typical bank-specific measures of fundamentals is foreign currency lending. A real exchange rate devaluation in peripheral Europe (even when keeping the euro) may significantly increase credit risk as they impinge on the repayment capacity of unhedged foreign currency borrowers (for example, those in the nontradable sector), and thus affect the banks that made the loans. A gradual deterioration in traditional bank-specific indicators due to macroeconomic risk might occur, for example, as a result of an increase in sovereign risk, which will adversely affect the return on assets for banks holding government paper.

These findings yield important lessons for the policy debate as well. In the short-term, current discussions about how to deal with the currency-growth-debt trap that engulf several European nations should focus on how proposed exit strategies might affect the banking system. Avoidance of a bank run would significantly reduce the magnitude of an already large problem. If conditions deteriorate and contaminate the banking system even more, a freeze on bank deposits might become the only alternative when a generalized bank run is already under way. In fact, banks in Greece for example have already suffered significant deposit drainage (Levy Yeyati, Martínez Pería, and Schmukler, 2011). Furthermore, there are already signs that bank runs are spreading to other economies exposed to Greek debt. In Germany, deposits by financial institutions, which account for one third of total banking system deposits, have declined by 12 percent since the start of 2010. In France and Spain, the same deposits have declined by 6 and 14 percent, respectively.

Beyond the short-term crisis management problem, the quest for market discipline, embedded in the Basel principles, moves in the right direction by addressing bank supervisors’ limitations in enforcing prudential regulation. But it faces serious shortcomings when market reactions are driven by macroeconomic conditions largely beyond the control of bank managers. This raises questions about the perception of market sensitivity as a disciplining device, and highlights the risk of focusing on micro factors when macro factors may be much more potent. Moreover, regulators would benefit from paying more attention to structural susceptibility to macroeconomic shocks and cannot expect price signals to alert them to those susceptibilities.

In recent years much effort has been put into strengthening banks. Surprisingly, there has been relatively less emphasis placed on limiting the exposure to macroeconomic risk that can ultimately bring down the entire system. The long experience of emerging markets and the recent cases in developed ones suggest that a more balanced effort is indeed warranted to enhance the stability and resilience of the banking sector where macroeconomic risk prevails. At least for now, many emerging markets seem to have learned the lessons. It is our hope that Europe will too.

Further Reading:

Eduardo Levy Yeyati, Maria Soledad Martínez Pería, and Sergio Schmukler. 2010. “Market Discipline under Macroeconomic Risk: Evidence from Bank Runs in Emerging Economies.” Journal of Money, Credit, and Banking 42 (4): 585–614.

Eduardo Levy Yeyati, Maria Soledad Martínez Pería, and Sergio Schmukler. 2011. Levy Yeyati, Eduardo, Martinez Peria, Maria Soledad, and Schmukler, Sergio, 2011. “Triplet Crises and the Ghost of a New Drachma,” VoxEU.org, June 29.

Comments

Submitted by Tarot on
It does seem that politicians are always being reactive. As this article shows there is plenty that can be done that is not simply reacting to the situation as it unfolds.. We need strong leadership and some tough decisions need to be made.... Will it happen??

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