[Column] No time to relax for financial crisis

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[Column] No time to relax for financial crisis

Ha Joon-kyung
The author is a professor of economics at Hanyang University.

Concerns about a possible financial crisis triggered by the bankruptcy of Silicon Valley Bank (SVB) have been calmed down by the swift action of the U.S. authorities. In fact, expectations that the Federal Reserve will raise the benchmark rate less in the future or lower it soon seem to be spreading in the financial market.

But it is too early to feel relieved. The more the expectations of relief spread, the greater the risk of a financial crisis increases. The collapse of SVB is also linked to the expectations that interest rates would be cut. Banks betting too high on base rate cuts were shaken when the Fed announced it would keep the rate higher for longer. They simply had been managing their assets with an assumption that the rates would go down.

A crisis has many different faces. Even if you own massive U.S. treasury bonds — safe assets with virtually no risk of default — you cannot avoid the risk of fluctuating interest rates. If you conduct a stress test by assuming only a “landing” situation in which the economy is slow and interest rates go down, you will never know the risk of a “no landing” situation in which the rates do not fall. Poor judgment of the bank’s management and lax regulations by the authorities have triggered a crisis in the rapidly changing environment of the financial market. Will this never happen again?

It is necessary to refer to the experiences of the U.S. in the 1980s to answer this question. In the early ‘80s, the Fed sharply raised base rates to control inflation. In 1984, the Continental Illinois National Bank and Trust Company — then the seventh largest bank in the United States — became insolvent. The roots of this crisis go back to the rise of oil prices in the 1970s. At that time, the bank made a big profit by investing in the oil industry. After oil prices plunged, loans to the oil industry became insolvent and depositors — particularly large depositors whose money was not subject to protection — withdrew their funds to cause a bank run.

At the time, the U.S. financial authorities also offered a massive bailout to protect depositors, fearing a systemic crisis. But the financial crisis did not stop there. From 1985 to 1988, 357 savings and loan associations, or 11 percent of the local deposit institutions specializing in long-term housing loans, went bankrupt. They financed a real estate boom in Texas, which coincided with high oil prices but became insolvent after facing plummeting oil prices and real estate stagnation. Deposit insurance institutions struggled to manage the situation, and the crisis was finally over only after the government provided $115 billion, an astronomical amount at the time, to the industry under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.

Financial instability continued for more than five years. The development of the situation showed poor risk management, although risk factors were relatively simple. When you look at the property boom in Texas, home prices slowed down slightly during the period of soaring interest rates in the early 1980s but continued to rise until 1986. At the time, the thrifts were nicknamed “great money printers” that fund real estate investments. Risky business was possible in an environment that encouraged the moral hazard of the management.

In the early 1980s, the upper limit of deposit protection was raised from $40,000 to $100,000 while financial regulations were eased. Even when a speculator could not repay the principal and interest, they could still lend more. The government’s decision to strengthen protection weakened market discipline, and regulations also became lax. The financial industry, where regulations and disciplines disappeared, speculated in the name of innovation and drove the system into a crisis. As a result, massive taxpayer money was injected.

For any country to not repeat this situation, market and regulatory disciplines must be harmoniously established to avoid planting seeds of a new crisis. The effectiveness of a “clawback” policy must be raised to prevent the executives from taking hefty incentives even after making poor management decisions. Stress tests must be conducted for various scenarios, and soundness control must function properly. When necessary, liquidity measures must be prepared along with a process of separating the wheat from the chaff.

Translation by the Korea JoongAng Daily staff.
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