Banking crises

Banking crises are periods when many banks in the economy are on the brink of collapsing. Depositors rush to get their money out and, often, the government intervenes to save the banks. It might nationalize, close, or merge banks to contain the problem. It takes about 5 years for the banking system to get back to normal.

Notice on the chart the rapid increase of bank credit to the private sector before the 2008 banking crisis in Ireland. Notice also the collapse of the Irish GDP and the growth of government debt when the crisis began. These dynamics are typical during banking crises.

Leading indicators of banking crises

Rapid credit growth: Banking crises are preceded by a rapid expansion of bank credit to firms and households for several years. The credit expansion is usually fueled by optimism about the economy that motivates households to buy assets (real estate) and firms to invest in plant and equipment.

Real estate bubbles: Typically, much of the new credit goes into real estate and pushes prices up. The rising prices contribute even more to the optimism.

Capital inflows: Often, the expansion of credit is funded by the inflow of international capital. In essence, foreign banks lend to domestic banks which then lend to households and firms.

Eventually, asset (real estate) prices reach very high levels and stop rising. Demand for real estate drops, prices start falling, borrowers cannot pay back the bank debts, and banks start losing money. The government intervenes to support them.

Negative effects of banking crises

Recession: When banks go into trouble they reduce drastically their lending to households and firms. Respectively, households and firms reduce their consumption of goods and services and the economy goes into recession.

Steep rise in government debt: The government assistance to banks requires a lot of money during a recession when government revenues are down. Therefore, the government borrows and keeps borrowing for several years.

Resolving crises

It takes 4-6 years for the effect of a banking crisis to fade away. In comparison, the average recession without a banking crisis is about 1-2 years long. Gradually, banks are restored to health and start lending again. Households and firms start spending and the economy picks up. However, the large government debt that accumulates during the crisis is a long-term legacy. It has to be paid off for significantly longer than 4-6 years.

The frequency of banking crises

Two well known economists, Carmen Reinhart and Kenneth Rogoff identify 156 banking crises in 110 countries from 1963 to 2007. The frequency of banking crises has varied over time but it seems to have trended upwards. For instance, only 3 banking crisis in their dataset occurred between 1960 and 1975, whereas about 35% of all crises occurred in the 1980s and 45% in the first half of the 1990s. This trend declined in the latter years as only 16% of the crises happened after 1995, including the recent crises.

The data also show that different regions have been affected differently by banking crises. Latin American economies have experienced a high number of banking crises. For example, Argentina, Brazil, and Bolivia represent the most extreme cases, having suffered more than 3 crises each. Many countries in Sub-Saharan Africa, Eastern Europe, and Central Asia have also suffered from multiple banking crises. Only a quarter of the countries in these regions have not experienced a banking crisis, while 13 countries experienced two crises.

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