Predicting Global Financial Meltdown and Systemic Banking Failure: An Assessment of Early Warning Systems (EWSs) and Their Current Relevance

Predicting Global Financial Meltdown and Systemic Banking Failure: An Assessment of Early Warning Systems (EWSs) and Their Current Relevance

Shefali Virkar (University of Oxford, UK)
DOI: 10.4018/978-1-4666-9484-2.ch003
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The last two decades of international financial history have witnessed an unprecedented increase in the number of episodes of financial distress; wherein the incidence of these episodes has not been restricted to national boundaries as localised systemic incidents but have instead been spread to other countries and across regions in the form of financial contagion. This book chapter proposes a detailed discussion and analysis of the scholarly and practitioner literature used to conceptualise and to encapsulate the theoretical construct of an Early Warning System (EWS) developed to predict and mitigate the onset and persistence of systemic banking failures and financial crises. The models that constitute the focus of this overview are pivotal to the prediction of systemic banking meltdowns, either on their own or as constituent elements of other methodological approaches that contribute significantly towards the design and development of an Early Warning System.
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Objective Of The Study

In the light of available evidence, this book chapter therefore attempts to examine, at their most definitional, Early Warning Systems (or EWSs) constructed to predict, pre-empt and mitigate systemic financial outages; together with the political, economic, and societal causes and impacts of global systemic banking and financial crises. More specifically, the research enumerates and analyses the role of both macroeconomic and microeconomic factors in precipitating such crises through a critical examination of the existing literature, and by attempting to illustrate the scope and reach of each factor with examples from key pan-global financial catastrophies. The work will also attempt to highlight the interplay of different economic and financial factors causing systemic banking and financial instability, and to root them in similar real world examples.

The East Asian Crisis of 1998 and the collapse of the U.S. Subprime Mortgage Markets in 2007-08 are of particular interest to the study of Early Warning Systems, and are both used regularly as prime examples of exceptions to the general heuristic rule of international financial meltdowns. More specifically, this book chapter will take note of and draw on these examples in the light that neither appear to follow either the model of a first generation crisis resulting from runaway fiscal deficits caused by poor exchange rate management, the model of a second generation crisis brought on by what Krugman (1999) terms macroeconomic temptation or poor, overindulgent economic policy setting, or their iterative third generation crisis counterparts. Instead, both crises may be seen as global financial upheavals brought on by worldwide financial excess and eventual systemic banking and financial collapse.

Key Terms in this Chapter

Theoretical Models of Financial Outages and Banking Crises (Second Generation): Are typically characterized by situations of or generally exhibit multiple economic and fiscal equilibria that result from cost-benefit analyses of both purposeful governmental intervention and individual agents’ expectations, highlighting that speculative attacks occur as a consequence of self-fulfilling expectations.

Early Warning System: Or EWS , refers to the sum total of the literature canon both scholarly and applicative practitioner, the methodological approaches, and the econometric and statistical models devised, constructed, and subsequently employed to predict the onset and the evolution of systemic banking failure and of financial meltdown within a localised economy, a region, or the international system.

Moral Hazard: Is a phenomenon resultant from the problem of asymmetric information that occurs post-economic transaction when a potential lender or investor is held subject monetarily to the uncertainties and vagaries of borrower or entrepreneur behaviour, or has accepted to invest money regardless of the hazard , or the off-chance that the borrower in question has incentives to engage in activities and behaviours that are wholly undesirable , unproductive , or even immoral from the point of view of a venture capitalist; in that any indulgence therein makes it that much less likely that a loan will be repaid.

Contagion: Refers to the economic and/or financial manifestation of the problem of asymmetric information that occurs when problems, insecurities, and structural failures at some banks within a system adversely affect other, otherwise financially sound, banks; leading to widespread systemic meltdowns.

Banking Crisis: Refers to a subset of financial crises that are felt particularly acutely within the banking sector of local financial markets, and that are generally thought of as situations having national and international implications wherein either the given capital of the banking system is practically exhausted, or where non-performing loans or assets amount to or exceed 15% -20% of the overall capital infrastructure, or where the cost of resolving the problems of a financial system amounts to at least 3-5% of the national Gross Domestic Product.

Financialisation: Defined broadly as a concept similar to that of globalization, is a term used to describe the increasing role of financial motives, financial markets, financial actors, and financial institutions in the smooth running and operation of both the domestic and the international economy.

Theoretical Models of Financial Outages and Banking Crises (Third Generation): Are typically characterized by situations wherein the importance of and impacts that the mechanisms of noise or of an asymmetry of information have on the engendering of the balance-sheet effects associated with dramatic or unplanned currency devaluations, particularly those resulting from changes in fiscal policy that cause speculative bank runs and systemic banking crises within a given financial sector, are highlighted and are more clearly defined.

Crisis Sample (Global): Refers to a subset of financial crises wherein in a significant portion of the world’s economies simultaneously experience a crisis leading to the declaration of contagion.

Adverse Selection: Is a manifestation of the problem of asymmetric information , c aused by prohibitive barriers to market entry and by asset opacity, wherein those players in a financial system who are most likely to produce undesirable or adverse credit-risk outcomes are also the actors who not only seek out credit and other financial services most actively, but whose propositions and proposals are also the most likely to get selected and backed financially.

Financial Crisis: Or Financial Outage or Financial Meltdown , may be defined broadly as a nonlinear disruption to financial markets wherein problems of asymmetries of information, namely adverse selection, moral hazard, and contagion, become increasingly accentuated; such that particular financial markets are unable to efficiently channel funds to those that have the most productive investment opportunities.

Theoretical Models of Financial Outages and Banking Crises (First Generation): Are typically characterized by situations where macroeconomic policy inconsistencies, in the form of a monetary expansion or similar changes to a fixed exchange rate system, have lead to a speculative attack on the foreign exchange reserves of a country, and to an eventual collapse of the national fixed or pegged exchange rate regime.

Systemic Banking Crisis: Refers to a banking crisis that might be defined as systemic or entrenched if two key conditions are met: firstly that significant signs of financial distress are in a majority part of the banking system, as indicated by significant bank runs, losses in the banking system, and/or in the form of bank liquidations; and secondly, significant banking policy intervention measures are implemented by the appropriate financial authorities in response to significant losses amongst the individual components of the banking system.

Asymmetric Information: A situation characterised by lopsided information and power relationships, wherein one actor group party to a financial contract has much less accurate information than any of the others. Asymmetries of information within banking systems and financial infrastructure often lead to three basic problems within an economic ecosystem: adverse selection, moral hazard, and economic contagion.

Crisis Sample (National): Refers to a subset of financial crises that involve by-and-large either isolated single-country episodes or a few contiguous events across two or three national economies only .

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