This book describes how the 1997 Asian Financial Crisis transpired.
Only 2 of these three conditions can be allowed to be true without causing inflationary recession
Fixing the currency exchange rates against other reserve currencies
Control over domestic interest rates
Control over capital inflow
On foreign capital flows
huge volume of foreign capital flows into a country
economic growth rate increases
inflation rate stays low
huge volume of foreign capital flows out of country
economic growth rate decreases
inflation rate goes up
Common pattern across countries
The build up
Long periods of high export lead GDP growth attracts high levels of foreign investments. Huge volume of foreign funds originated from Japan which was having a very loose monetary policy
Countries peg their exchange rates to reserve currency to ensure stable prices for both imports of raw materials and exports value added products
Countries currencies are not reserve currency, hence foreign loans were denominated in foreign currency
Excessive leverage within the country by domestic parties who take on short term loans denominated in foreign currencies at lower interest rates to finance long term projects that generate returns in domestic currencies
Stocks are purchased with borrowed money. These stocks are then further used as collaterals to borrow more money
Real estate are purchased with borrowed money. These real estates are then further used as collaterals to borrow more money
Moral hazard due to corruption of financial system
banks are arm twisted to finance projects that are not financially viable by governments and politicians
The economic headwinds
countries face increasing export market pressure
Competition at the low end of the export markets from China
Competition at the high end of the export markets from Japan
Japanese government instructs central bank to tighten monetary policy to reduce real estate. This severely restricted liquidity from Japan and reduced availability of short term foreign loans to affected countries
Borrowers within these countries increasingly experienced difficulties rolling over their foreign denominated short term loans to finance their long term illiquid domestic projects
Many of them started defaulting on their loans
Foreign investors started getting spooked and started withdrawing their funds or refusing to allow their loans to roll over
Non-performing loans builds up amongst banks within these countries
Capital flight continues causing downward pressure on the exchange rates of these countries
Countries continued defending their exchanges rates by buying up their own currency and selling off foreign reserves (assets held in foreign currencies)
Countries deplete their foreign reserves and are unable to uphold their exchange rates. Since most debts are denominated in foreign currencies, they are not able to print money to pay off these loans.
The economy grinds to a halt and hyper-inflation occurs within their financial system at this point
domestic production stops and locally produce foods is no longer available for sale
due to shortage of foreign reserves imported products become very expensive in local currency
Countries approach IMF for loans to tide through this liquidity crunch.
IMF steps in and with a lack of understanding of the economic patterns imposes these requirements:
Countries required to impose high domestic interest rate. It has the effect of further reducing the money supply within these countries causing more defaults domestically.
Countries will reform the financial systems to remove cronyism lead financing
Riots ensures and Anti-establishment governments get elected in some countries
IMF releases the misstep in policies and relents
Countries lower their domestic interest rates to increase liquidity within their financial system
Countries allow their exchange rates to float freely
Relatively cheap asset prices within these countries starts attracting foreign investments again
After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.
Their income is thus restricted to investment banking commissions and net interest incomes.
This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.
The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.
They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates.
Events leading to massive failure
During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
De-regulation of short term interest rates which lead to increased competition by other banks for deposits. This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
Entrance of new entities
mutual funds competed for deposits
Freddie Mae and Freddie Mac competed for mortgages
SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.
Government meddling in market mechanism to further political agenda is generally a recipe for disaster
Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster
In a world where currencies are not pegged to gold or other currencies price stability is achieved when major trading partners all target the same inflation rates. Otherwise wild fluctuations in rear asset prices and exchange rates will likely occur.
We should expect the following loops to occur.
Loop #1 – When central bank pursues expansionary monetary policy
Central bank pursues an expansionary monetary policy
investors expect inflation rates to go up
investors expect currency value to drop in overseas market
investors sell off real assets within country and exit funds out of country to other countries
due to decreased demand, stocks, real estates and commodity drops in value.
Exports become more competitive and balance of trade surplus results.
Loop #2 – When central bank pursues deflationary monetary policy
Central bank pursues deflationary monetary policy
investors expect inflation rates to go down
investors expects currency values to increase in overseas market
investors move funds into country to buy up real assets
Due to increased demand, stocks, real estate and commodities within the country appreciates in value
Exports become less competitive overseas and trade deficit results
US has been experiencing a balance of trade deficit since 1980. This is partially due to the result of going off the gold standard.
While it did not actively pursued a deflationary monetary policy, it’s stable politic system and high level of technology innovation, relative to other countries, has an overall deflationary effect on its economy.
The net effect is the same as if the central bank pursues a deflationary policy.
“Panics do not destroy capital, they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”, John Stuart Mill
Overviews on crisis
Crisis tends to only be obvious in hindsight. People tend to be biased towards optimism even in the darkest times.
Crisis are generally triggered by a momentary lack of liquidity which leads to a whole cascade of events. This sends the entire system into a negative tail spin. A loss of trust in the system is the fundamental problem.
Types of crisis
usually triggered by rapid deregulation leading to excessive levels of volatility within system
A single bank or the entire banking system experiencing a shortfall of liquidity which deteriorates into a massive bank run.
takes place before financial crisis
reaches highest point after financial crisis
country whose currency is not a reserve currency experiencing a shortfall of liquidity triggering off rapid exit of funds trying to avoid the negative currency exchange dip
when both bank crisis and financial crisis occur together resulting in cross feeding.
economic fundamentals are deteriorating in periods preceding twin crisis
Bank failure cause by banking crisis
Quality of management plays a very important role in averting such crisis
If bank is too big to fail
government will attempt to step in.
To restore trust
will get absorbed by larger banks
when seen as too ready to step in will encourage moral hazard
results in banks taking excessive risk
want the funds to restore liquidity to come as much as possible from the private
Indicators for banking crisis
It is generally difficult to assess banks due to information asymmetry. Banks and government will want to delay the release of bad news to prevent deterioration of an already bad condition
Spreading the financial statements across different banks will help analysis risk
Non-performing loans/assets as a percentage to total loans/assets
Non-performing loans as ratio to loan-loss reserves
Lagging indicator: net interest income falls
Risk assessment method
Roles of Banks
Hubs of financial networks that connect supply and demand for money
Intermediary to smooth out friction in the flow of money
Spread risk of loaning money
Ease of liquidity
Securitization to move loans off balance sheets
Support national payment system
Providing backup liquidity to non-banks
transmission belt for monetary policy
Types of Banks
Large banks – extensive network able to pull in consumer deposits at relatively low cost
regional banks – has deep relationships with local territory and is able to meet the needs of local business better than large banks
Types of capital
Consumer deposits – very sticky but small in amount
Commercial deposits – very volatile but large in amount
Types of banking instruments
Negotiable Certificate of Deposits
Letters of Credit
The possibility of not getting the loan and interest back due to inability or unwillingness of the borrower. Assessed qualitative and quantitative elements
Components to model credit risk, a.k.a. Expected Loss
PD – probability of default
EAD – exposure at default: percentage of the amount of loan that will be affected by a default event
LDG – loss given default
Time horizon – the longer the time horizon the more likely the default
Risk assessment method
general – Value at Risk (VaR) model
fixed income analysis – fundamental and technical analysis
Currency risks triggered by sovereign/country risk
policy lending – subsidizing industries through banking industry
state-owned enterprises – encourages inefficiency
Components to consider
GDP growth – a growing GDP will help buffer shocks to the system
Balance of trade
consumer confidence index
inventories to sale
consumer credit to personal income
credit spread risk
Risk assessment method
general – Value at Risk (VaR) model
Managing banking risk, Eddie Cade
The dollar crisis, Richard Duncan
A failure of capitalism, Richard A Posner
Bank restructuring, Andrew Sheng
When genius failed, Roger Lowenstein
Manias, panics and crashes, Charles P. Kindleberger and Robert Aliber