Question 1. What are the main factors explaining financial crises?

Financial crises can stem from problems of the private or public sectors’ balance sheets and have domestic or external origins. Irrespective of its origins, a financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices, severe disruptions in financial intermediation, notably a reduction in the supply of external financing, large scale balance sheet problems, and often a need for substantial government and international support.

Although crises can be driven by a variety of factors, they are often preceded by asset and credit booms. Busts, financial crises, and poor growth often follow such booms (Figure 1). Given these types of associations, many theoretical and empirical studies have recognized the need to explain sharp movements in asset and credit markets. These studies have been able to identify some proximate causes, such as financial liberalization, productivity gains, and a variety of distortions, such as weak supervision and regulation, underpriced deposit insurance, and poorly designed safety nets. However, many puzzles remain in terms of what factors drive asset price bubbles and credit booms in the first place.

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Coincidence of Financial Booms and Crises

(fraction of total, in percent)

Citation: IMF Research Bulletin 2013, 004; 10.5089/9781484378434.026.A003

Note: This graph, except in the last column, shows the percent of cases in which a crisis or poor macroeconomic performance happened after a boom was observed (out of the total number of cases where the boom occurred).Source: Dell’ Ariccia and others (2013).

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Question 2. What are the major types of financial crises?

It is useful to classify crises into four groups: currency crises; sudden stops (in capital flows); debt crises; and banking crises. While there are many common causes, the available literature has also identified specific theoretical factors and empirical determinants of each type of crisis. It has sometimes been difficult to transform the predictions of theories into empirical applications, including practical ways to identify crises. While it is easy, for example, to design quantitative methods to identify currency crises and sudden stops, the identification of debt and banking crises remains typically based on qualitative and judgmental methods. The literature therefore employs a wide range of methods to identify and classify crises.

While there are issues with establishing a timeline, it is clear that financial crises are quite common and tend to cluster over time (Figure 2). They also tend to hit small and large countries as well as poor and rich ones. History also shows that crises come in different shapes and sizes, evolve over time—with certain types being more important in some periods than others—and can rapidly spread across borders (as they did in the 2007–09 global financial crisis).

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Average Number of Financial Crises over Decades

Citation: IMF Research Bulletin 2013, 004; 10.5089/9781484378434.026.A003

Note: This graph shows the average number of financial crises in respective decades. Sources: The dates of banking, currency, and debt crises are from Laeven and Valencia (2013) and the dates of sudden stops are from Forbes and Warnock (2012).

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Irrespective of the classification used, different types of crises can often overlap. Many banking crises, for example, are associated with sudden stop episodes and currency crises. The overlap of multiple types of crises leads to further challenges for the identification of crises and examination of their underlying causes. For example, since banking and sovereign crises often coincide, it is difficult to answer definitively whether a banking crisis leads to a sovereign crisis or vice-versa.

Question 3. What are the real and financial sector implications of crises?

Macroeconomic and financial implications of crises are typically severe, with many commonalities across various types. Recessions with large output losses are common to many crises. Other macroeconomic variables typically register significant declines as well. Financial variables, such as asset prices and credit, usually follow qualitatively similar patterns across crises, albeit with variations in terms of duration and severity. Besides their negative effects over the short run, financial crises often have adverse medium- to long-run effects on activity.

Question 4. How severe are the medium- and long-term effects of crises?

The effects of financial crises on the real economy are quite persistent. Output tends to be depressed substantially and persistently following banking crises, with no rebound, on average, to the pre-crisis trend in the medium term. However, growth eventually returns to its pre-crisis rate for most economies. The depressed output path tends to result from long-lasting reductions of roughly equal proportions in the employment rate, the capital-to-labor ratio, and total factor productivity. In the short term, the output loss is mainly accounted for by total factor productivity losses, but, unlike the employment rate and capital-to-labor ratio, the level of total factor productivity recovers somewhat to its pre-crisis trend in the medium term.

Question 5. What are the main policies to resolve banking crises?

The policies used to remedy the consequences of a banking crisis can be grouped into two sets. The first involves what are often called containment policies, which are deployed during the early stages of a banking crisis. This phase is often characterized by deteriorating sentiment on the viability of the financial system and the economic prospects of the country in the short term. It may involve runs on banks, on entire markets, and even runs on the domestic currency. Typically, at this stage it is difficult to tell whether the crisis reflects just liquidity shortages or solvency problems. In order to buy time to determine the true nature of the crisis, governments resort to policies such as emergency liquidity provision to banks, other financial intermediaries, and even entire markets. They often announce guarantees on bank liabilities and in extreme cases governments use deposit freezes and capital controls.

The second set of policies encompasses the resolution phase. By this stage governments have had time to design a plan to address solvency problems and enact any necessary changes in legislation or secured funding for the restructuring of the financial sector. This phase includes policies such as recapitalization of banks with public funds, closure of insolvent institutions, restructuring of viable ones, setting new institutional arrangements such as asset management companies, as well as restructuring of private debt.

Not all policies mentioned above are used in every crisis, but they are all the most common policies that are used in remedying the effects of a banking crisis. The effect of interventions on economic costs and the fiscal accounts depends, to a large extent, on the policy mix. The use of guarantees on bank liabilities can contain liquidity pressures on banks, for example, without involving a disbursement of public funds upfront, but with potentially substantial fiscal contingencies, although they may not necessarily materialize. In contrast, direct capital injections have a certain impact on the public purse upfront, but some of these resources can be recovered in the future when public shareholdings are returned to private hands. The timing of the policy mix can also affect the fiscal costs of a crisis. If macroeconomic policies are used to avoid a sharp contraction in activity, this may discourage more active bank restructuring that would allow banks to recover more quickly and renew lending, with the risk of prolonging the crisis and depressing growth for a prolonged period of time. This, in turn, can increase indirect fiscal and economic costs.

Question 6. What is the importance of household debt restructuring as a tool to resolve crises?

The historically high levels of household debt in many recent crisis-hit countries heightened demands for government intervention. If unaddressed, household debt distress can be a drain on the economy and even lead to social unrest. Well-designed and well-executed government interventions may be more efficient than leaving debt restructuring to the marketplace and standard court-based resolution tools. Empirically, there is evidence that housing busts and recessions preceded by larger run-ups in household debt tend to be more severe and protracted. Government policies can help prevent prolonged contractions in economic activity by addressing the problem of excessive household debt. In particular, bold household debt-restructuring programs such as those implemented in the United States in the 1930’s and in Iceland in the aftermath of the global crisis can significantly reduce debt-repayment burdens and the number of household defaults and foreclosures.

Question 7. Can future crises be avoided?

Banking crises have affected countries for centuries and history has been a great laboratory for academics and policymakers to study early detection of crises, their consequences on the real economy, and the effectiveness of policies used to resolve them. Progress has been made in all these directions, but not sufficiently to claim that they can be avoided at all costs. Nevertheless, important lessons have been learned about vulnerabilities, the role of excessive credit growth—perhaps the single most important predictor of a banking crisis—the role of excessive maturity mismatches, and excessive exposure to exchange rate risk. While not perfect, these lessons will be important in designing regulatory policies and reducing the incidence of crises in the future; one concrete example includes advances in the design of macropru-dential regulation.

However, just as the policy toolkit evolves, the nature of crises evolves as well. Complexity in financial markets and institutions makes the identification of vulnerabilities more challenging. Therefore, efforts on crisis prevention are important, but it is unlikely that they will ever reach a level of effectiveness as to eradicate crises completely.