Insuring Against a Financial Crisis

Financial institutions, especially banks, have been at the heart of the recent global financial crisis. From the collapse of Lehman Brothers, widely noted as the trigger for the collapse of financial markets in the United States, to the debate on “too big to fail” and widespread taxpayer-funded bailouts of banks in most OECD countries, the recent troubles in the world economy focus on the behavior (and misbehavior) of banking institutions. While already the most heavily regulated industry in the world in every country, predictably, there continues to be a call for greater regulations, and banks around the globe face both the implementation of Basel III regulations in 2013 and the likelihood of more national-level regulations in the US and Europe.

But is continued regulation of the banking sector going to make the world a safer place? Will these new initiatives reduce the chance of a future financial crisis? Recent and ongoing research by the Institute for Emerging Market Studies (IEMS) looks at the transition economies of Central and Eastern Europe and the former Soviet Union over the past 20 years for lessons to financial sector development, and comes to just the opposite conclusion. Rather than making countries safer, high levels of financial regulation have made them more vulnerable.

The Transition Experience

Financial liberalization has been part and parcel of the transition to capitalism, help to create viable markets, financing the growth of the private sector, and providing a way for capital to be reallocated from non-productive, communist-era industry to new and profitable ventures. Financial liberalization came in two parts: external liberalization, or opening of the capital account and allowing foreign investment, and internal liberalization, or freeing interest rates, breaking up state-owned banks, and allowing substantial private competition. However, external financial liberalization also appears to have exposed the transition countries of Central and Eastern Europe (CEE) and the former Soviet Union (FSU) and their economies to volatility from international financial markets; similarly, internal liberalization has created its own set of problems in countries with no recent history of market-based financial sectors. A series of banking crises (shown in Table 1) hit the fledgling financial institutions and affected the real economies of the transition countries.

Despite the appearance of continual financial crisis in transition, however, the numbers tell a different story. We find that the lessons of transition economies are that financial liberalization means less probability of a crisis; moreover, if a crisis did indeed strike a transition economy (witness the Asian financial crisis of 1997-98 or the ongoing “Great Recession” from 2008 onward), more financially open countries fared much better than their closed counterparts. This result is especially true for internal liberalization, which shows the largest and most significant effects in buffering against a crisis, but external liberalization also helped countries to maintain foreign investment flows during times of trouble. Moreover, no matter which metric you look at, financially open economies did better: growth, foreign investment, and capital formation all were better in countries with more open financial sectors. The only area where we saw a decrease was in per capita savings, but this only holds for formal financial institutions. When we also examine the liberalization of non-bank financial institutions (NBFIs), we find that NBFI liberalization led to much higher rates of savings than non-liberalized NBFIs.

Table 1 – Banking Crises in Transition Economies

Source: Laeven and Valencia (2012)

Lessons for the Future

If financial liberalization makes it both less likely that a crisis occurs and helps mitigate the effects if a crisis does actually occur, what does this say about the likely bonanza of regulation the world can expect in 2013? As our numbers would predict, in reality, increased bank regulations (especially in the OECD countries) will make the world a more dangerous place. The main reason for this is the current regulatory obsession with systemic risk, as regulators try to avoid the creation of banks that are “too big to fail” (that is, if they crashed, they would bring down the whole real economy with them). The solution du jour to lessen systemic risk is to require banks holding more low-risk capital, with the “lowest” risk of all being government bonds. Indeed, highly-rated government debt is already classified as zero risk by the Bank for International Settlements (BIS), meaning that government loans do not qualify as part of a bank’s exposure for risk ratings.

However, this approach does precisely what our research would suggest in increasing the risk to the banking systems of all countries: by continuing to treat government debt as low-risk (and forcing banks to hold higher percentages of it), regulators will end up making everyone have the same kind of risk. As the most basic finance course would have taught anyone, the key to avoiding risk is diversifying, not concentrating. If a financial crisis does strike due to macroeconomic or exogenous factors, the fallout will be much worse if every bank is exposed in exactly the same way (especially if they’re holding a large amount of treasury bonds of an overleveraged and bankrupt government). One only need banks holding Greek bonds if they feel their risk profile has been strengthened by their acquisition of Greek government debt.

The solution is thus not to continue to force all banks into a “one-size-fits-all” risk management model, but to increase financial liberalization and let risk diversification come about due to market forces. Greater competition is what will drive down overall risk (while possibly increasing the risk in some individual banks, which will necessarily lead to more reward), and thus liberalization of banking entry rules, rather than attempting to protect financial institutions that already exist, would be a prudent way to lessen systemic risk.

This approach would also serve Russia well, as, while it has liberalized its financial sector internally somewhat, it still has a long way to go. The main problem facing Russia is the stratification of the banking sector: large, state-dominated financial conglomerates at the top and hundreds of scattered, small-scale operations at the bottom. Increased competition at all levels, and less state protection of existing financial institutions, could reap large dividends in the future and make the Russian economy less susceptible to a crisis.

2 Responses to "Insuring Against a Financial Crisis"

  1. Robert P. Coutinho   November 26, 2012 at 1:13 pm

    This appears to be an excellent article on the blind leading the blind.

  2. Nathan   November 28, 2012 at 8:18 am

    I like the concept of this article, but I think there's a big issue with moral hazard, particularly stemming from deposit insurance. The article says, "Greater competition is what will drive down overall risk (while possibly increasing the risk in some individual banks, which will necessarily lead to more reward)." That would be well and good if banks' investors bore the risk as well as the reward, but because of government-backed deposit insurance the investors bear the reward but the state bears the risks. This encourages otherwise irrational risk-taking, which drives overall risk up, not down. Banks that take more risk can advertise higher rates to their investors (with the same no-loss guarantee stemming from deposit insurance), which spurs a race to the bottom. The existence of this moral hazard is what drives the unfortunate need for financial regulation as a corollary to deposit insurance.