M. Kairlenov, PhD in Economics DEFINING A BANKING CRISIS Banking crises have become an integral part of the modern economy.

For instance, the IMF experts1 identified 124 systemic banking crises in the period from 1970 to 2007. Considering the consequences of the recent financial-economic crisis, their number has even increased, i.e. over the last 40 years the world faced on average 3-4 banking crises a year. As many studies indicate2 the drop of credits goes in parallel with the GDP fall. However, if the decline of GDP volume was insignificant and did not lead to the exhaustion of the banking capital, then granting of a credit was pretty fast. Otherwise, recovery of granting of a credit was a protracted process. In that regard, with few reservations3, we could argue that a banking crisis is indeed one of the necessary conditions within a cyclical period of economic decline. This problematique has a special relevance for countries with a continental model of financial system, in which banks dominate the economy. A banking crisis in that situation means the crisis of the overall financial system of the country. It determines largely social-economic consequences. In its turn, banking crises in a country with strong capital markets (US, for instance) are not so detrimental for the economy. From that point of view, it is interesting to examine two models of financial systems. As a rule4, any financial system is regarded from the position of having two channels of capital movement through financial markets (Anglo-Saxon model) and financial mediators (Continental model). This interpretation has a serious shortage as another important channel of capital distribution is disregarded, namely, state financial resources, including public budget and states funds in the form of state development institutes. Functioning of this channel is based upon other principles compared to financial markets, which regard profit-making as a major objective. However, this channel is a way the state implements its functions. Until recently, in a developed economy the importance of this channel is insignificant as the recent crisis has dramatically changed the situation. Apart from that, countries having a transition or emerging market economy need to have a strong public channel of capital movement. This has to do with a critical role of the state in a transition economy. As a rule, implementation of economic reforms requires a structural change in the economy, what requires movement of vast amount of financial resources. Such movement bears high risks. In that kind of a situation, private business not only incapable of realizing this capital movement, but is also unwilling to participate in it without state guarantee, as a minimum. Therefore, budgets in these countries are large with respect to investment policy (both directly and indirectly). They are called development budgets. For instance, according to the recently adopted Kazakhstan National Program of Forced Industrial and Innovative Development, 6% of GDP have to be annually directed from the public budget to investments. Thus, we can argue that a market economy has three channels of capital movement: through financial markets, financial institutions and state financial institutions (see picture 1).

Systemic Banking Crises: A New Database, L. Laeven, F. Valencia, IMF Working Paper, Research Department, November 2008, available at: http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf 2 See for instance Phoenix miracles in emerging markets: recovery without credit from systemic financial crises Calvo, Izquierdo, Talvi, 2006, Dinamika kreditovania v padajushei ekonomike: kreditnoe szhatie ili padenie sprosa na krediti? K. Judaeva, N. Ivanova, K. Kozlov, N. Kamenskih. The Center of Macroeconomic Research of Sberbank of Russia, December 2009. 3 The issue is both to define a banking crisis and the state-of-the-art of a banking sector and a financial system in general on the eve of a crisis. It also relates to state measures etc. 4 Finance p.38, Z. Bodie, R. Merton, translation edited by V. Kravchenko, publishing house "", 2000, Moscow-St Petersburg-Kiev

Picture 1. Financial scheme of capital movement Financial Institutes Economic players with surplus of financial resources Financial Markers Economic players with deficit of financial resources

Financial System of the State In that regard we can classify financial crises, which may appear in one of three internal dimensions and in one of two external ones. External dimension relates to the argument that a financial system of the state is part of the international financial system and is largely influenced by the globalization processes in the financial area. A crisis in the area of financial institutions means a banking crisis, considering a special role banks play for the overall economy. A crisis in the area of financial markets is a capital marker crisis. A crisis in the state financial system is a budget crisis of the state. A crisis in the international financial area is an exchange crisis (according to the above mentioned classification). In that paper the theoretical approach in analyzing banking crises will be presented. In particular, definition of a banking crisis is very important. We can point out three different definitions in that regard. One of the most prevailing definitions of a banking crisis was formulated by the Bank of International Settlements and is the following: A banking crisis happens if one of the following four conditions is fulfilled: Share of non-performing loans exceeds 10% of assets; Cost of bail-outs of banks exceeded 2% of GDP; Problems of the banking sector led to large nationalization of banks; Customers begin to panic or extraordinary measures have been taken, such as freeze on deposits or state guarantees introduction as a response to the crisis.

We can also stress the definition used in the joint work of the Governor of the Federal Reserve of San-Francisko R. S. Kroszner and IMF experts L. Laeven and D. Klingbiel. The authors stick to the following definition: an episode during which the capital of the banking sector has been depleted due to loan losses, resulting in a negative net worth of the banking sector. One of the recent definitions of a systemic crisis was offered by IMF experts - L. Laeven and F. Valencia, in the abovementioned work Systemic Banking Crises: A New Database.5 In particular, under it the situation is meant when: in a systemic banking crisis, a countrys corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by depressed asset prices (such as equity and real estate prices) on the heels of run-ups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. In some cases, the crisis is triggered by depositor runs on
5

Banking Crises, Financial Dependence, and Growth, Federal http://www.federalreserve.gov/newsevents/speech/kroszner20070906a.htm#fn4

Reserve,

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banks, though in most cases it is a general realization that systemically important financial institutions are in distress. Authors imply that bank run is understood as a deposits drop on 5% in a month. Extensive liquidity support by monetary authorities is considered to be so, if they require 5% as a minimum with regard to the general volume of deposits in banks or a minimum redoubling of the same level vis--vis the previous year. These definitions of a banking crisis are quite exact and appropriate for running comparisons between countries. At the same time, they put a special emphasis on consequences of a crisis (cost of bail-out, level of capital outflow etc.). However, by doing this the phenomenon itself is less stressed. Moreover, as evolution of most banking crises demonstrates6, state measures and their adoption are usually done in a subjective way. Recognition of a crisis, elaboration and adoption of anti-crisis measures lag behind not only for months, but even for years. At the same time, the key point for overcoming a banking crisis by the state is the inability of a banking system to exercise its functions necessary for the economy of the country. In that regard a more appropriate definition is done by in the work A Banking Crisis: Fog is Dispersing edited by S. Aleksashenko: A banking crisis is a systematic inability of a banking system to fulfil its basic functions to accumulate temporarily free cash assets in the country, provide credits and exercise payment transactions. This definition is comprehensive as it aggregates various forms of a banking crisis. In particular, we may point out the liquidity crisis, bank run and a credit crisis. These types of a crisis may take place together or separately. For instance, the beginning of the world economic crisis in 2007 led to the liquidity crisis in the banking system of Kazakhstan. World capital markets became of the major sources of funding for the banking system of the country. In particular, external borrowings in the mid 2007 equaled to 54% of the aggregate debt of the sector. It was accumulated mainly by three major banks7, assets of which totaled to 60% of the whole sector, making its part of international debt approximately 2/3. Considering that the credits given to the companies oriented into domestic market (construction, trade etc.) began deposits (the rests on settlements accounts) role of the international financial market as a stable source of resources for the banking system was getting even bigger. In that regard, the National Bank of Kazakhstan in the period from August September 2007 injected into the banking system almost 10% of the GDP of the country, what smoothed out the problem. The next step in that direction became the measures to reduce external commitments of the banking system. This task was implemented due to restructuring of commitments of a number of large banks of the country, namely of two constituent banks out of four, with the dominance of the national capital. The main cure to the problem of external dependence became the inflow of deposits of national companies with state shares, basically resource giants, the capitalization of which improved after 25% devaluation of tenge and price increase on raw materials. In particular, in the period from 2007 to January 2011 the volume of foreign debt of the sector decreased on $30 bln, 1/5 of were written off. At the same time, the volume of customers deposits increased from 38% in January 2008 to 64% of aggregate commitments in January 2011 ($20 bln nominal). On the whole the share of external commitments decreased to 21% in relation to the aggregate commitments of second-tier banks in January 2011. The protracted credit crisis started after the subsequent rise of non-performing loans in the banking system from few percent in 2007 to 36% of the loan portfolio in the end of 2009.
6

See for instance the example of CMI Review Sberbank Russia, Strategies Strategii vihoda iz bankovskogo krizisa: mejdunarodnij opit, K. Judaev, M. Godunov, K. Kozlov, N. Ivanov. 07.04.2009, available at: http://www.sbrf.ru/common/img/uploaded/files/pdf/press_center/Review_6.pdf 7 BTA, KKB and Alliance Bank.

Moreover, it was accompanied by the fall of loans in the period from 2008-2009 three times lower the pre-crisis period. In particular, as of January 20118 the official level of non-performing loans reached 32,6%. The announced measures to launch the Fund of Stressed Assets failed due to the scale and complexity of the problem. So, the Fund was only established without any further activity. Today, the market regulators have again started to suggest various schemes of clearing the balance, however, this is currently only debated. At the same time, for this definition of a banking crisis we need some more precision. First of all, a banking crisis may well occur also when a banking system cannot fulfill some of its functions. For instance, in case it cannot provide loans and/or accumulate temporarily free cash assets in the economy. Another important point is to add qualitative indicators into the definition of a crisis. In particular, the quality of a loan portfolio is used to demonstrate inability of a banking system to implement the function of crediting the economy (credit crisis). It is considered that, the system is in the crisis, if a non-performing portfolio exceeds 10% of a loan portfolio. This indicator is also important for the general definition of a banking crisis as well. The logic is so that quality decline of a loan portfolio will lead to banking losses, which means exhaustion of own capital, i.e. in that case it serves an indicator and precursor of a banking crisis. However, as mentioned above, banks may disguise for a long period of time the level of non-performing loans. In that respect it is obvious that quality decline of a loan portfolio is a delayed precursor of a crisis. Besides, in that regard we may point out two key moments. 1. The indicator of non-performing loans of 10% to the loan portfolio means reduction of own capital up the critical level for banking systems with the 10% threshold, what is inherent in developed nations. A lower threshold capital level in the developed countries compared to developing ones has traditionally to do with more transparency and more advanced level of business technologies (including risk management, asset management etc.) both at the bank level and financial systems development level (from the point of view of developing hedging tools, resource diversification and capital acquirement instruments and others). This all implies a low risk level. At the same time, the recent world economic crisis has brightly demonstrated that intransparent overbalanced operations of the global bank may lead to their bankruptcy. In its turn, the capital threshold at banks in emerging markets is higher. For instance, for a banking system with the threshold of 15%, the non-performing portfolio at the level of 10% does not mean inability of a banking system to exercise its functions. This situation may be often observed at emerging markets, when banking systems quite effectively function with significant level of de-facto non-performing loans. In particular, we may point out that the National Bank of China introduces the 17,5% level of provisions in relation to the loan portfolio. In that regard it is necessary to mention that the report of the Sberbank of Russia points that bank crises may be easily divided into the categories according to the maximum level of non-performing loans: A) 15% (+5%) of a loan portfolio, for instance - Norway (1991 - 16%), Sweden (1991 13%), Mexico (1994 19%) etc. B) Countries, in which the maximum level of non-performing loans scored two times more, were, Chile, for instance in 1981 it reached 36%, Japan (1997 35%), South Korea (1997 35%), Turkey (2000 28%) and others. 2. The indicator of the assets/credits for the current date is to a large extent a vulnerable indicator. As the analysis of banking crises shows the volume of a loan portfolio and assets during the crisis may actually grow. As a rule, especially at the first stage, banks offer their
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AFN, Kazakhstan, available at: http://www.afn.kz/ru/information-for-entities-of-financial-market/bankssektor/2009-11-09-11-41-37/2009-11-12-05-55-10/2009-11-12-06-14-08

clients delays in current payments, by adding planned payments to the amount of the major debt (interest capitalization). As a result, the size of a loan portfolio may actually grow, but a debtor does not get enough sources for his or her own development and activity. For instance, according to the data of AFN of Kazakhstan, the size of the aggregated loan portfolio of banks of the country grew in 2008 to 4%, whereas the level of non-performing loans grew from 3,2% to 8,1%. At the same time, crediting activity reduced to 40%, from 9,6 bln tenge to 5,9 bln tenge, thus clearly showing the crisis development. In that regard non-performing loans indicator can be complemented by adding the indicator of bank crediting over a certain period. Similarly to currency crises, we may take quantitative indicators, which show decline in giving loans over the period of 3-4 months to 2530% to the respective period of the last year. Saving function outflow of investments of natural persons and rating of loan securities and their SPV. We will consider only persons deposits as deposits of enterprises may mainly bank loans received before. It can be considered that the situation, which occurred in Kazakhstan is more the exception. In particular, deposits of legal persons during the crisis did not decrease, as the companies with state shares (raw giants and monopolies) transferred their capital from deposits abroad to the accounts in the country. As regards national companies, the transferred amount is equivalent to 5% of GDP of Kazakhstan.9 In its turn, this accounted for 23% of all deposits of legal persons 10 in the beginning of 2008 or 15% from all deposits. Function of carrying out payments. Due to the fact that inability to perform this function by a banking system has the most negative and protracted consequences for the economy, monetary authorities seek to avoid it. As a rule, extensive liquidity support programs are deployed. For instance, after the beginning of the first wave of the current economic crisis, the Kazakh banking system faced the liquidity crisis. In that regard, the National Bank of Kazakhstan in the period from August firth half of September 2007 injected into the system around 1,3 bln tenge, what is equivalent to 10% of GDP of Kazakhstan or 30% of deposits in the banking system. In that regard it is logical to utilize the criteria, set by L. Laeven and F. Valencia, which mean achieving by monetary authorities 5% of deposits as a minimum with regard to the general volume of deposits in banks or redoubling as a minimum of the same level vis--vis the previous year. It also implies extension of the corridor boundaries for emerging countries. Thus, the following definition of a banking crisis is to be considered: A banking crisis is a systemic inability of a banking system to perform all or part of its basic functions accumulation of temporarily free cash assets in the economy; provision of loans; carrying out of payments, if one of the following conditions applies: 1. Decline in giving loans on 25-30% to the respective period of the previous year over the period of 3-4 months or if the level of non-performing loans exceeded 10% of a loan portfolio (credit crisis) for a typical banking crisis and around 30% for a systemic crisis; 2. Reduction of the deposits volume 5% as a minimum in a month (bank run);

Statistica pozvoliaet dostatochno tochno konkretisirovat problemnie mesta kazahstanskoi bankovskoi sistemi, N. Kenzheev / Respublica Delovoe Obozrenie, 18.09.2009, 35 (170), available at: http://www.respublikakaz.biz/archive/num/50/page_4/ 10 Here and further data on Kazakhstan without consideration of sources of SPV banks. The Kazakh banks attracted foreign loans to their SPV, which placed received sources to the deposits in head banks, i.e. these deposits are part of foreign loans of a bank itself.

3. Extensive liquidity support by monetary authorities and/or the government accounted to 5% of deposits as a minimum or doubled as a minimum compared to the previous year (liquidity crisis).