Bank crises are not unfamiliar events in modern societies. However, in recent years they have drawn the attention of economists and the general public. This is due primarily to the high frequency of such events in the last two decades.

A study by the International Monetary Fund (IMF) observes, for example, that in the period 1980-1986, 133 of the IMF’s 181 member nations experienced systemic bank crises.

A second factor worthy of mention is that bank crises are not related to a country’s level of economic development. Such episodes have been observed both in industrialized nations (e.g. the USA, Finland, Japan, Norway, and Sweden) and in developing countries.

In the midst of a crisis it is common to seek ways to explain its causes. Regulators fault bank mismanagement. Bankers point to inadequate laws, ineffective government policies, and macroeconomic volatility. Journalists and opposition political parties signal crime and corruption. Finally, economists place special emphasis on inadequate incentives for effective bank management.

Today it is accepted that these episodes of systemic crisis are usually the result of a combination of macroeconomic and microeconomic factors. Microeconomic factors include deficient bank management, lack of effective regulation and supervision, excessive government intervention, credit granted to persons with ties to banks, politically motivated loans, insurance offering total coverage for deposits, and deficiencies in the legal and judicial framework. Macroeconomic factors include falling exchange rates, rising inflation, accelerated growth in credit to the private sector, unexpected capital flight, and economic recessions.

The International Experience

As mentioned before, the last twenty years have seen over a hundred bank crises, all of which can be qualified as systemic.

Volatility in the balance of trade and in interest and exchange rates can cause constant bank problems. The World Bank reports that 75 percent of developing countries that experience bank crises suffer trade deficits of at least 10 percent of GDP before the crisis. Trade deficits can restrict payments in foreign currency, as the drop in revenue has to be offset with a surplus in the capital account. This can have a dramatic impact on exchange rates and on interest rates, as governments intervene to protect their currencies and/or investors demand higher yields. In this climate many lenders lose the ability to pay interest on their loans, which can in turn limit their access to fresh working capital. If such problems are not overcome quickly, the resulting downward spiral will inexorably turn them into past-due credit for banks.

Internal mismanagement of risk and a lack of incentives can also lead to systemic problems. Bank administrators who concentrate a large portion of their funds in specific industries without diversifying their portfolios have been the source of many bank failures. Administrators who fail to cover their positions against losses are faced with increasing liabilities with major imbalances in both maturities and in currency, leaving them vulnerable to economic downturns.

Bank owners and administrators are often lured by the promise of attractive commissions and profits, which leads them to aggressively persist in risky credit policies. Often, such practices reflect a lack of expertise, training, and/or controls. However, experience has shown that incentives usually play a more important part. Offsetting programs based on poorly designed incentives can cause administrators to focus more on the number of new loans than on their quality. Owners and administrators of under-capitalized banks often encourage speculative policies in hopes of obtaining high yields.

Governments usually prevent their banks from failing with the primary aim of protecting savers and other creditors. Today, most countries offer some level of protection to their depositors. Faced with the threat of a systemic crisis, they usually provide guarantees for 100 percent of deposits.

Financial deregulation and ineffective controls on granting of authorizations can lead to heightened competition in the financial sector. Local banks are forced to compete with foreign banks, non-bank financial institutions, and newly authorized banks. As often occurs, competition for business leads to a relaxation of standards for loans. In the newly privatized banking industry, many governments fail to make the necessary changes to their regulatory frameworks and regulators are often caught unprepared.

Another common cause that has been observed in systemic crises is an inadequate legal framework. Outdated bankruptcy laws and laws on guarantee claims make collecting credit extremely difficult.

The case of Mexico in 1995

Starting in 1982, with the nationalization of Mexico’s banks, people’s savings were used fundamentally to finance the government deficit.

As a result of the bank nationalization, Mexico lost an entire generation of banking industry and credit professionals. The diminished status of the nationalized banks and their restricted activities also led to a loss of qualified bank supervisors.

Starting in 1989, financial strengthening of public finances and financial deregulation allowed for a substantial increase in credit to the private sector, which was not accompanied by an adequate structure for credit rating and effective supervision.

In 1991 and 1992 a process of bank privatization was carried out in a climate of considerable optimism regarding Mexico’s future prospects. In the course of this privatization process there was a problem of limited information on the moral solvency of the bidders, which prevented the filters designed for the process from working properly and resulted in some banks’ being awarded to unfit buyers. In a highly competitive environment and with a limited number of banks for sale, buyers paid excessive prices, which drove the new administrators to recur to unsound practices in their efforts to obtain a return on their investments.

The privatization of Mexico’s banks was not accompanied by timely and effective renewal of regulation and supervision of the financial system, which at the time showed major deficiencies.

Outdated accounting standards and a lack of transparency in information made it hard to assess banks’ real financial position. Past-due portfolio accounting considered only the number of past-due payments and not the total balance of outstanding loans; also, there was a longstanding government tradition of protecting all bank liabilities, which tacitly discouraged market discipline. Furthermore, little emphasis was placed on future problems that could result from the excessive leverage with which some shareholders acquired banks, a situation that created inadequate incentives in the management of several banks.

Most banks sought to increase their market share by taking an extremely aggressive approach to granting credit, which proved highly imprudent. In some cases this expansion was accompanied by irregular, or even fraudulent, operations that compromised the banks’ solvency.

By late 1993 past-due portfolio levels had risen significantly, with the default index at 13.9 percent. Portfolio reserves to past-due portfolio rose to 14.5 percent, which clearly showed a substantial shortfall. On the other hand, the capital ratio of 9.9 percent was clearly insufficient and the quality of capital was questionable.

This group of indicators evidenced the lack of capital and solvency of the system at large. Had the problems been made known at the time, it would have caused a run on the banks, as savers would have moved en masse to withdraw their deposits; however even the most solid credit institutions would have been unable to immediately liquidate their investments and meet their depositors’ demands.

By September 1994 the National Banking and Securities Commission (Spanish acronym CNBV) had taken over management of two banks, Union and Cremi, and three more, Banpais, Obrero, and Oriente, were under corrective programs. Meanwhile, the rest of Mexico’s banks were subject to stricter supervision.

The economic crisis that started to unfold in December 1994 further exacerbated the banking sector’s problems. In the first quarter of 1995, the peso underwent a sharp devaluation against the dollar, interest rates soared from 20 percent to 110 percent, and income levels fell abruptly. This situation was particularly severe for:

	Debtors individuals, whose real earnings fell;
	Debtor companies with excessive debt;
	The sectors most sensitive to domestic market contraction; and
	Companies that had taken on debt in foreign currency without any kind of coverage.

The crisis’s negative impact was reflected immediately in a significant deterioration of the quality of banks’ credit portfolio. Banks which, even before the crisis, had shown signs of fragility faced a dire situation. Also, banks’ financial margins were severely affected by the imbalance between terms for credit and its funding, on the one hand, and the speed of repreciation of asset and liability rates, on the other.

The high concentration of the Mexican banking system made it even more vulnerable. The three largest banks represented 50 percent of the assets and only 19 banks represented 97 percent of the banking system; thus the risk of contagion from one bank’s failure was increasingly evident.

By late 1994 and early 1995 the insolvency of some banks was clear, with the growing danger of facing a run on banks and the resulting total collapse of the financial system. Such a collapse was avoided due to:

	The economic adjustment program, which included, among other measures, lines of credit from the United States Treasury Department, the International Monetary Fund, and the World Bank;
	The bank aid package implemented by the financial authorities;
	Government support provided to practically all bank liabilities; and
	Substantial injections of capital by local and foreign investors in the banking industry.