Banking crises happen with alarming regularity. But that doesn’t mean that every crisis will result in a global economic meltdown. Recognising that there are common traits among episodes of financial turmoil can help to prevent the next crash from becoming a great crash.
Examining a century of economic crashes highlights that there are three phases common to crises (Yueh, 2023). Learning about these can help to prevent the inevitable next crash from becoming a global meltdown, like the global financial crisis of 2007-09.
The first phase is euphoria or exuberance. Every crisis is preceded by a belief in ever-rising asset values. When the market deflates, a key factor as to whether a crash will follow is the amount of debt.
This is followed by the second phase, in which it is important to have credible policies from public authorities like central banks and finance ministries to resolve the crisis.
The final and third phase is the aftermath, which depends on the first two phases. If there isn’t a large amount of debt and policies are credible, then resolution of the crisis need not lead to economic misery for millions of people.
Among financial crises, banking crashes lead to the worst outcomes
Financial crises are broader than, but certainly include, banking crashes. But it is banking disasters that result in the worst economic outcomes.
In 18 banking crises since the end of the Second World War, the aftermath was a protracted economic recovery. For example, national output declined for two years on average after these crises. Unemployment rose by seven percentage points over four years, while output fell by 9%. House prices plunged, while equity prices declined by an average of 55% over three and a half years (Reinhart and Rogoff, 2014).
An important difference from other financial crises is that after a banking crash, a process of ‘deleveraging’ follows, where firms and households are repaying debt and not spending. At the same time, banks are rebuilding their balance sheets and so they are reluctant to lend.
The resulting ‘credit crunch’ hampers economic activity and contributes to the scale of the downturn.
Lessons from history
An important lesson from history is to ensure that banks have sufficient capital to weather a bust in asset markets, whether that’s housing or shares.
This requires not only effective regulation, but also risk management by financial institutions so that they can monitor and adjust when debt and leverage are on the rise.
In 2008, there was nearly a collapse of the entire banking system in the United States and some parts of Europe because banks were insufficiently capitalised to withstand a collapse in the US housing market. Further, the banks did not hold enough liquidity when credit markets seized up.
Since then, banks have been required by regulators to hold higher levels of capital and liquidity. They must also have resolution plans so that they can fail in a way that does not bring down the economy (Passmore and von Hafften, 2007).
A related lesson is for economic policy to be counter-cyclical (to counteract the effects of the economic cycle) in order to stem rising levels of debt. Major central banks now have macroprudential tools to ‘lean against the wind’ (Van der Ghote, 2021).
For example, some will limit loan-to-value ratios of mortgages when the housing market looks bubbly to reduce lending and therefore the level of debt on banks’ balance sheets. Rather than allowing debt to rise when house prices rise – since rising values increase the value of collateral – macroprudential policy seeks to ‘lean’ against a rising market.
This is a shift in approach from when US Federal Reserve (‘the Fed’) Chair Alan Greenspan decided that it wasn’t feasible to determine if the dotcom boom driving strong economic growth during the late 1990s was a bubble or a fundamental shift towards e-commerce (Shiller, 2001).
This cautious approach dates back to 1955 when the then Fed Chair William McChesney Martin gave his famous ‘punch bowl’ speech. He described the Fed raising interest rates to dampen the economy as being like ‘the chaperone who has ordered the punch bowl removed just when the party was really warming up’ (Martin, 1955).
Central bankers are now more inclined to take away the punch bowl instead of letting the bubble burst and dealing with the consequences.
A further lesson is the need for supra-national regulatory supervision since lending easily crosses borders both globally and within the European Union’s (EU) single market. Thus, there is a greater role for global bodies like the Financial Stability Board to set capital requirements, as well as the EU’s Banking Union to oversee the activities of major banks.
The importance of economic policies in resolving a crisis
Another set of lessons centres on the importance of credibility in terms of the economic policies deployed to resolve a financial crash. A lack of credibility is how a banking crisis in Europe led to a sovereign debt crisis in 2010, when bond market investors sold off the debt of weaker countries in the eurozone (Van Der Heijden et al, 2018).
This in turn led to an existential debate about the future of the single currency. The crisis was eventually ended by the creation of new institutions and political pledges about the future of the euro, which worked because they were viewed as credible by financial markets.
When it comes to the aftermath of a crisis, the final set of lessons centres on limiting the fallout from a crash. The more debt-fuelled it is, the more likely it could cause a banking crisis, which can lead to deep recessions.
In such circumstances, banks need to rebuild their balance sheets and call in or halt lending, while households and firms repay debt. This deleveraging leads to a credit crunch. When credit does not flow through the economy, the recovery stalls since new financing for mortgages and investments are stymied.
To prevent a slow recovery from a banking crisis, an important lesson is to try to reduce the impact of the credit crunch by ensuring that funding is available to support households and viable businesses.
Central banks and finance ministries have done so recently, providing liquidity so that banks can offer loans for mortgages and for investments by small and medium-sized businesses, both after the banking crash of 2007-09 and then again during the recent Covid-19 crisis. It seems that this lesson has been heeded (Gourinchas et al, 2020).
By learning the lessons from history, it is not inevitable that a banking crash will result in a crisis that could bring down the system and cause an economic meltdown. When the inevitable next banking crash happens, we must hope that these lessons have been learned.
Where can I find out more?
- The Great Crashes: Lessons from Global Meltdowns and How to Prevent Them: Book by Linda Yueh
- Boom and Bust: A Global History of Financial Bubbles: Book by William Quinn and John Turner
- This Time Is Different: Eight Centuries of Financial Folly: Book by Carmen Reinhart and Kenneth Rogoff
Who are experts on this question?
- Linda Yueh
- John Turner
- William Quinn