As subtle as it is, this article on banking crises is a subtle warning for China. Despite (and also because) her spetacular year-on-year growth of at least 7%, the chinese enterprise is full of hole. Highly insolvent banks, an over-regulated and highly centralized market, sub-par standards, opaque bookkeeping, and the continued peg to the dollar, makes the Chinese system ready for a catastrophic bust and massive reforms. The Chinese market has been hot for too long. I say its high time for investors to abandon ship and vultures to sharpen their claws. Caveat Emptor.
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Guiding the pack
Regulators should worry less about individual banks and more about systems
IN THE past 20 years or so, banking crises and financial instability have come around with depressing frequency and at considerable cost. According to estimates by the International Monetary Fund, more than a dozen banking crises in the past 15 years have cost the countries afflicted 10% or more of their GDP. Latin America seems to suffer about once a decade. The miracle economies of East Asia were caught in the late 1990s. Not even rich countries are immune, as the Japanese have come to know only too well.
The blame is often?and rightly?laid on macroeconomic policy: an unsustainable exchange rate, poor budgetary control and so forth. Yet bank regulators, too, should do more to ward off crises in the banking system. If they did their job differently, might financial systems and economies be more stable? In a recent paper* Claudio Borio, an economist at the Bank for International Settlements (BIS), argues that they might. Bank regulation, he says, has two basic components. First, there is what he calls a ?microprudential? element. This concentrates on avoiding problems at individual banks, and at protecting depositors when things go wrong. The second, ?macroprudential? component is concerned with stopping the banking system as a whole getting into trouble, and thus with limiting the damage to the economy.
Mr Borio thinks that regulation has hitherto focused too much on the micro and too little on the macro. The main way of keeping banks safe is through international rules, known as the Basel accord, that limit their exposure to risk by stipulating that their capital must at least equal a minimum proportion of their assets (weighted by risk). If banks do get into trouble, depositors' money is insured, up to set limits. That not only protects depositors, but should also dissuade them from withdrawing all their money, and perhaps setting off a systemic crisis, when a bank looks like failing.
One reason for shifting to a more macro footing is the huge economic costs of systemic crises. Although deposit insurance can protect people's savings, it cannot insulate them from the possibly far greater costs of widespread financial distress, such as unemployment. A second reason is that deposit insurance might make bank failures and financial distress more likely, by fostering moral hazard. Knowing that their savings are safe in almost any event, depositors are less likely to monitor how wisely bankers use their money. If bankers believe that regulators will not let their institutions collapse, they may not worry enough about the riskiness of their assets.
A third reason stems from the way in which financial crises happen. One common view is that a crisis starts when a single bank collapses. Trouble then spreads to other banks: maybe those that have lent to it are hit, or maybe a general panic takes hold. This fits in well with the microprudential approach to regulation: stop the trouble happening at one bank, and the system as a whole will be safe. But another way that systemic crises start is when a country's banks are exposed to the same common risks. For example, suppose that they have borrowed a lot of dollars, but most of their loans are to local companies, in local currency. If the dollar appreciates, all the banks will be in a similar pickle. If this scenario is closer to reality, regulators ought to worry more about system-wide risks and less about the balance sheets of individual banks. Mr Borio says that all the biggest recent crises, in Latin America, East Asia and Japan, had their origins in common risks, not in trouble spreading from one or a few blighted banks.
Bother Basel
New rules on bank capital, known as Basel 2, are due to come into force in 2007. But there is a risk that, in one respect at least, Basel 2 will make the system less not more stable. As now, the emphasis will remain on individual banks, not whole systems; and regulators will put more weight on credit ratings in assessing the sturdiness of banks. The trouble is that ratings, along with other measures of the riskiness of banks, such as credit spreads, are cyclical: they look best at the top of a boom, when things are about to turn bad, and worst at the bottom of a slump, when business is about to pick up.
A paper? by Jeffery Amato, another BIS staffer, and Craig Furfine, of the Federal Reserve Bank of Chicago, finds that rating agencies seldom change their assessments of big companies. However, when ratings do change, they go too far, becoming overly optimistic in upswings and overly pessimistic in downturns. The new rules might thus increase the supply of credit during a boom, helping to fuel the fire, and reduce it in a downturn, impeding recovery.
Mr Borio's macroprudential perspective might suggest that capital requirements should be tightened in upswings and eased in downswings. Macroeconomic policy works in much the same way: built-in fiscal stabilisers automatically adjust taxes so that consumer spending is dampened in booms and encouraged in recessions. Yet a more macroprudential method of regulation is easier to ask for than to deliver, although Mr Borio offers some ideas. He would like to see an explicit distinction between system-wide risks and those peculiar to individual banks. It might also be worth assessing risk over a longer period than just one year, now the standard practice, or raising some banks' capital requirements if their size means that they make a disproportionate marginal contribution to system-wide risk. Steps in this direction might not stop banking crises, but they could help.
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Guiding the pack
Regulators should worry less about individual banks and more about systems
IN THE past 20 years or so, banking crises and financial instability have come around with depressing frequency and at considerable cost. According to estimates by the International Monetary Fund, more than a dozen banking crises in the past 15 years have cost the countries afflicted 10% or more of their GDP. Latin America seems to suffer about once a decade. The miracle economies of East Asia were caught in the late 1990s. Not even rich countries are immune, as the Japanese have come to know only too well.
The blame is often?and rightly?laid on macroeconomic policy: an unsustainable exchange rate, poor budgetary control and so forth. Yet bank regulators, too, should do more to ward off crises in the banking system. If they did their job differently, might financial systems and economies be more stable? In a recent paper* Claudio Borio, an economist at the Bank for International Settlements (BIS), argues that they might. Bank regulation, he says, has two basic components. First, there is what he calls a ?microprudential? element. This concentrates on avoiding problems at individual banks, and at protecting depositors when things go wrong. The second, ?macroprudential? component is concerned with stopping the banking system as a whole getting into trouble, and thus with limiting the damage to the economy.
Mr Borio thinks that regulation has hitherto focused too much on the micro and too little on the macro. The main way of keeping banks safe is through international rules, known as the Basel accord, that limit their exposure to risk by stipulating that their capital must at least equal a minimum proportion of their assets (weighted by risk). If banks do get into trouble, depositors' money is insured, up to set limits. That not only protects depositors, but should also dissuade them from withdrawing all their money, and perhaps setting off a systemic crisis, when a bank looks like failing.
One reason for shifting to a more macro footing is the huge economic costs of systemic crises. Although deposit insurance can protect people's savings, it cannot insulate them from the possibly far greater costs of widespread financial distress, such as unemployment. A second reason is that deposit insurance might make bank failures and financial distress more likely, by fostering moral hazard. Knowing that their savings are safe in almost any event, depositors are less likely to monitor how wisely bankers use their money. If bankers believe that regulators will not let their institutions collapse, they may not worry enough about the riskiness of their assets.
A third reason stems from the way in which financial crises happen. One common view is that a crisis starts when a single bank collapses. Trouble then spreads to other banks: maybe those that have lent to it are hit, or maybe a general panic takes hold. This fits in well with the microprudential approach to regulation: stop the trouble happening at one bank, and the system as a whole will be safe. But another way that systemic crises start is when a country's banks are exposed to the same common risks. For example, suppose that they have borrowed a lot of dollars, but most of their loans are to local companies, in local currency. If the dollar appreciates, all the banks will be in a similar pickle. If this scenario is closer to reality, regulators ought to worry more about system-wide risks and less about the balance sheets of individual banks. Mr Borio says that all the biggest recent crises, in Latin America, East Asia and Japan, had their origins in common risks, not in trouble spreading from one or a few blighted banks.
Bother Basel
New rules on bank capital, known as Basel 2, are due to come into force in 2007. But there is a risk that, in one respect at least, Basel 2 will make the system less not more stable. As now, the emphasis will remain on individual banks, not whole systems; and regulators will put more weight on credit ratings in assessing the sturdiness of banks. The trouble is that ratings, along with other measures of the riskiness of banks, such as credit spreads, are cyclical: they look best at the top of a boom, when things are about to turn bad, and worst at the bottom of a slump, when business is about to pick up.
A paper? by Jeffery Amato, another BIS staffer, and Craig Furfine, of the Federal Reserve Bank of Chicago, finds that rating agencies seldom change their assessments of big companies. However, when ratings do change, they go too far, becoming overly optimistic in upswings and overly pessimistic in downturns. The new rules might thus increase the supply of credit during a boom, helping to fuel the fire, and reduce it in a downturn, impeding recovery.
Mr Borio's macroprudential perspective might suggest that capital requirements should be tightened in upswings and eased in downswings. Macroeconomic policy works in much the same way: built-in fiscal stabilisers automatically adjust taxes so that consumer spending is dampened in booms and encouraged in recessions. Yet a more macroprudential method of regulation is easier to ask for than to deliver, although Mr Borio offers some ideas. He would like to see an explicit distinction between system-wide risks and those peculiar to individual banks. It might also be worth assessing risk over a longer period than just one year, now the standard practice, or raising some banks' capital requirements if their size means that they make a disproportionate marginal contribution to system-wide risk. Steps in this direction might not stop banking crises, but they could help.
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