Early Warning System for Banking Crisis: Causes and Impacts

Early Warning System for Banking Crisis: Causes and Impacts

Qaiser Munir, Sook Ching Kok
DOI: 10.4018/978-1-4666-9484-2.ch001
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The purpose of this chapter is to present with an overview of the early warning systems (EWS) applied to global banking crises. Numerous past studies have focused on the EWS of banking crisis. The majority of these studies have developed a predictive model to forecast the likelihood of banking crisis. Relatively less studies in the past show an attempt to predict both crisis likelihood and timing of the crisis likelihood. Precision of timing with respects to a specific type of financial crisis is undeniably difficult. Nonetheless, knowing the timing of crisis likelihood will make policy more effective. Policy makers will be able to response promptly to the upcoming banking crisis by taking pre-emptive measures which are crucial to mitigate the impact from the crisis. Specifically, this would help to avoid the widespread of crisis. It is aware that a banking crisis can transform into a systemic banking crisis which possibly ruins the function of the domestic financial system.
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In last few decades, countries around the world have had experienced a number of devastating banking crises. The U.S. credit or subprime mortgage crisis is probably the recent most striking banking crisis episode that heightens global awareness of the severity of banking crisis. The crisis began in the second-half of 2006 (Eubanks, 2010) and co-exists with the Great Recession which started in 2007:12 and last until 2009:6.1 The chronology of the crisis event is available from Bassarab (2010). More than 25 subprime lending companies in U.S. had declared bankruptcy during the short time period of 2007:2-3. Bank of America announced to purchase Countrywide Financial, a major domestic mortgage lender for about US$4 billion on 11 January 2008. On 16-17 March 2008, Bear Sterns, formerly the fifth largest U.S. investment bank agreed to a purchase deal by JPMorgan Chase with US$2 per share which was then revised to US$10 per share. On 11 July 2008, IndyMac Bancorp, Inc., another major U.S. mortgage lender was seized by the Federal regulator after a bank run. Lehman Brothers, previously the U.S. fourth largest investment bank declared bankruptcy on 15 September 2008. On the same day, Merrill Lynch, the world largest brokerage agreed to a US$50 billion purchase deal by Bank of America. Just after a few days, on 21 September 2008, two other US largest investment banks, Goldman Sachs Group and Morgan Stanley became bank holding companies under the regulation by the Federal Reserve Board. According to Mehl (2013), the demise of Lehman Brothers had pushed risk aversion and global uncertainty to the historic level. In fact, the U.S. subprime crisis had triggered the 2007-2009 financial crisis that spread over to the European Union's (hereafter, EU) economies and United Kingdom. Much of the U.S. securitized-debt was originated to be distributed to European institutions and investors which caused them to suffer substantial losses for investing in the U.S. subprime mortgage securities, for instance, a large German bank, IKB undergone a massive bailout by the German government (see Eubanks, 2010). Further, in United Kingdom, banks were highly depending on short-term funding for financing the holding of long-term mortgages. The weakened securitized products market forced them to depend upon the funding provided by wholesale money market. Problem arose when these banks could not attract fund from the money market. Northern Rock, for example, was forced to seek for assistance form the Bank of England. This provoke a run by depositors and resulted in nationalization (Dimsdale, 2009).

Key Terms in this Chapter

Bank Run: Bank run is an episode of withdrawals run experienced by a commercial bank. It occurs when the bank is unable to repay the withdrawals demanded by depositors as the bank has run out of short-run liquid funds and a large number of withdrawals are made simultaneously.

Financial Crisis: Financial crisis refers to particular extreme shock in the financial system which leads to disruption of the financial system's function. Financial crises are such as banking crisis, currency crisis, debt crisis, stock market crash, and speculative bubble and burst.

Banking Panic: Banking panic occurs when more banks in the financial system experience bank runs, or when the banking crisis is widespread and expanded to more banks in the financial system.

Banking Crisis: Banking crisis reflects the crisis of liquidity and insolvency of one or more banks in the financial system. Due to bank's sizable losses, bank encounters critical liquidity shortage to the extent this has disrupted its ability in repaying the debt contracts and the withdrawals demanded by depositors.

Early Warning System: Early warning system is a predictive tool used for financial crises prediction. A predictive system is designed exclusively for a specific type of financial crisis, or it can be applicable to various types of financial crises. The systems are used to predict the likelihood as well as the timing of financial crises.

Systemic Banking Crisis: Systemic banking crisis reflects the nationwide banking crisis which its impact spreads to the whole banking sector. In other words, the crisis is affecting the entire banking sector. In which, domestic banks experience a large number of defaults by borrowers, leading to a sharp increase in the banking sector's non-performing loans. When the crisis is systemic, total banks' losses is beyond the banking system capital.

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