Are Banking Crises Predictable

• Author: Daniel C. Hardy
• Position: Senior Economist in the IMF's Middle Eastern Department

Many countries have experienced financial sector distress at some time. Although bank failures can come as a surprise, information is often available that can signal a banking system's vulnerability to crisis.

Strains and disturbances anywhere in an economy are likely to have repercussions on the banking system. Because of the nature of the business, banks are exposed to many potential sources of danger: reliance on deposits many times larger than their capital, uncertain claims on different sectors of the economy, assets that are longer term and less liquid than liabilities, and, for banks involved in international transactions, assets and liabilities denominated in different currencies. To these variables should be added the possibility that problems will originate within the banking system itself, perhaps because of lax internal controls or poor management. When a bank is facing possible bankruptcy, its owners and managers may take greater risks if they expect to avoid being held accountable. As a result, problems that can ordinarily be contained may be magnified, and sooner or later the banking system will run into difficulties. Furthermore, complex relationships and mutual dependency typically develop between banks and their clients, as well as among banks, so that difficulties that are initially localized can spread throughout the banking sector and into the economy as a whole.

Ultimately, the institutional and structural features of an economy and, in particular, its banking sector will determine its susceptibility to crisis. The government-including the central bank and the regulatory and supervisory authorities-plays an important role in establishing the legal and institutional framework. It must implement adequate prudential supervision and regulation, which includes requiring banks to address problems as soon as they emerge. The government is also responsible for ensuring that accounting and auditing practices meet certain standards so that banks cannot mask problems, such as a high proportion of nonperforming loans, until they become unmanageable. Accounting standards in enterprises and nonbank financial institutions also need to be rigorous enough to ensure that their creditworthiness can be assessed. Laxity in these areas increases the likelihood of widespread banking sector distress.

Although these structural factors may make it easier to identify which countries are more likely to experience a banking crisis eventually, they provide little indication of when one might occur. Under favorable circumstances, a country with poor institutional arrangements can coast for a long time without serious banking sector difficulties, but when the environment deteriorates, a crisis can emerge very rapidly.

History of banking crises

Given these myriad vulnerabilities, it is not surprising that banking crises have a long history. The Great Depression of the 1930s was exacerbated by bank failures in the United States and elsewhere. In recent decades, a large number of countries have experienced financial distress of varying degrees of severity, and some have suffered repeated bouts of distress.

In the early 1980s, the governments of several Latin American countries, including Chile and Mexico, felt compelled to make up for losses in the banking system-for instance, by buying substandard loans from the banks for more than their true worth-to preserve its solvency. During the 1980s and 1990s, many African countries also had to restructure and recapitalize their banking systems, which in the past had suffered large losses on loans to parastatal companies (companies at least 50 percent owned by the state) and on...