LENDING BOOMS AND BANK FRAGILITY: THE SOUTH AFRICA EXPERIENCE

 

POTENTIAL CHANNELS OF BANKING FAILURES 

Bank literature demonstrates that the stability of the financial system is important for
economic development around the world (see, for example, Pagano, 1993; Leitão,
2012; Allen & Oura, 2004; Koivu, 2002; Duican & Pop, 2015). In this regard, banks
play an important role in the economy, and theory predicts that a banking crisis in all
or part of the system may lead to significant costs to the economy. Almost all
participants in the banking system lose out when this happens. Theory predicts that
shareholders lose their equity holdings, while depositors risk losing all or part of their
savings and must pay costs of portfolio reallocation. Bank creditors may miss their
payments, while bank-dependent borrowers such as households and small firms risk losing funding and face further difficulties finding alternative finance sources. Bank
failures may develop into a banking crisis leading to an unanticipated contraction in
the stock of money and this subsequently leads to a recession (Hoggarth, Reis &
Saporta, 2002). Therefore, in this section, we highlight the potential channels of
banking crises or failures as suggested in the bank literature.

As discussed in the previous section, banks are deposit-taking financial institutions
whose liabilities are short-term, while their assets are a combination of short- and long-
term loans. Banks are said to be insolvent if their liabilities are greater than their
assets. The borrowers’ ability to repay borrowed loans affects banks’ assets. As
discussed above under the banking theory section, information problems (moral
hazard and adverse selection) experienced by banks make them susceptible to credit
risk. To counter credit risk, the Stiglitz and Weiss (1981) credit rationing model
highlights that banks apply a number of strategies such as strict screening of loan
applications, diversification of loan portfolios by lending to customers with different risk
profiles, and requesting collateral. The screening of borrowers enables banks to
predetermine (ex-ante) profitable and non-profitable projects. This enables profitable
projects to be funded (ex-post). However, in a country such as South Africa with high
levels of unemployment, poverty and inequality, it should be noted that these
strategies do not necessarily reduce credit risk, especially for banks that lend to small
developing sectors. In addition, the collateral would be expensive to establish and
monitor, and its value is typically subject to volatility. In this regard, bank insolvency
may occur when a wave of loan losses occurs, especially when they are more than
reserve requirements and equity cushions.

A systemic crisis may occur because of a significant percentage of loan losses relative
to bank capital. According to Demirgüç-Kunt and Detragiache (1998), banks that are
not well capitalised are more vulnerable to shocks such as declines in asset prices,
cyclical output decline and decline in terms of trade, et cetera (Lindgren, Garcia &
Saal, 1996; Kaminsky & Reinhart, 1999). These shocks can adversely affect the
economic performance of borrowers and ultimately their ability to honour their
obligations to the banks. Demirgüç-Kunt and Detragiache (1998) write that “shocks that adversely affect the economic performance of bank borrowers and whose impact
cannot be reduced through risk diversification should be positively correlated with
systemic banking crises” (Demirgüç-Kunt & Detragiache, 1998, p. 85).

The credit channel of monetary policy notes that, even in the absence of loan losses,
banks’ balance sheets are also vulnerable to short-term adjustments in monetary
rates. Since bank assets consist of long-term loans at fixed interest rates, return on
assets cannot adjust quickly to counter the short-term policy rate adjustments. This
sudden change in the interest rate exposes banks even in instances where this can
be transferred to borrowers. Furthermore, short-term policy rate adjustments may
affect the borrower’s ability to repay their loans. In some instances, short-term interest
rates adjustment may also affect the deposit interest, thus eroding banks’ assets in
the immediate future. According to the Mishkin (1996) model, short-term increases in
interest rates might be a likely source of systemic risk. He argues that most bank
panics in the U.S. were a result of short-term interest rate adjustments.

Literature shows that banks’ ability to borrow in international markets to bridge the
domestic funding gap is susceptible to risk. Akerlof, Romer, Hall and Mankiw (1993),
Drees and Pazarbasioglu (1995) and Mishkin (1996) demonstrate that a shock in the
foreign currency exchange market affects bank profitability. Foreign currency
dominated loans were cited as the major cause of banking crises in Chile, Mexico,
Nordic countries and Turkey (Drees & Pazarbasioglu, 1995).

Speculative euphoria regarding banks’ asset portfolio quality has also been cited as a
possible cause of bank runs18. Literature shows that this occurs when deposits are not
insured (deposit insurance). Since bank assets are illiquid, large withdrawals of
deposits may result in liquidity risk. In some cases, bank runs occur simply because
depositors are aware of other depositors withdrawing their funds from one or more banks. Such actions might force a sudden withdrawal of deposits even in the absence
of risks. It should be noted that withdrawal of funds from one bank might not
necessarily lead to a bank run (contagion) unless informed depositors take this as a
sign of poor asset quality among all banks in the system. Demirgüç-Kunt and
Detragiache (1998) argue that bank runs should not occur in countries with
compulsory deposit insurance. However, Demirgüç-Kunt and Detragiache (1998)
argue that, if the premiums of the compulsory insurance do not fully reflect the
riskiness of the bank portfolios, this may lead to reckless bank behaviour, i.e. a moral
hazard problem. This occurs because of a mismatch between the level of risk and
premiums. However, the moral hazard problem is minimised in instances where there
are adequate prudential regulation and strict supervision of banks as recommended
by the Basel Committee on Banking Supervision.

Other authors also predict that the introduction of financial liberalisation19 increases
bank risk-taking. Financial liberalisation mostly poses problems in countries with
deposit insurance, where banks are tempted to take excessive risk in pursuit of more
profits. Again, this leads to moral hazard problems. In countries with a liberalised
financial system but with a weak bank supervision framework, banking crises can
occur because of widespread fraudulent activities. Banks may be tempted to invest in
projects that are too risky or projects that are a sure failure in order to create an
opportunity to divert funds for personal use. Akerlof et al. (1993) suggest that looting
behaviour by bank managers was the cause of the U.S. and Chile banking crisis of the
1970s. 

As predicted by Minsky’s model and supported by a number of studies (Calvo,
Leiderman & Reinhart, 1995; Bakker & Gulde, 2010; Shin & Shin, 2011; Dell’Ariccia,
Igan & Laeven, 2012; Lane & McQuade, 2014; Fielding & Rewilak, 2015), short-term
foreign capital inflows into banks also cause banking crises. These studies predict that
a sudden withdrawal of foreign investment funds within the financial system creates a huge funding gap in the local banking system. This occurs due to either an increase
in foreign interest rates or a decline in domestic interest rates and investor confidence.
Calvo et al. (1995) predict that this causes liquidity shortages in the financial system.

In countries with a fixed exchange regime, speculative attacks on their currencies
might also trigger problems in the financial sector. As speculation increases, the value
of the local currency is devalued while bank depositors quickly rush to withdraw their
funds and convert them to other investments. This leaves the local banking system
with liquidity gaps and in distress. For example, banking problems in Asia, Eastern
Europe and Latin America in the 1990s were partly due to sudden withdrawals in short-
term foreign capital. 

Source:

Stellenbosch University

LENDING BOOMS AND BANK FRAGILITY: THE
SOUTH AFRICA EXPERIENCE

Dissertation presented for the degree of
Doctor of Philosophy in Development Finance
in the Faculty of Economics and Management Sciences
at Stellenbosch University

MICHAEL MAPHOSA

Supervisors: Professor Eon Smit
&
Professor Sylvanus Ikhide

March 2020 

Mozambique Doing Business South Africa

2025

Link: https://scholar.sun.ac.za/server/api/core/bitstreams/b58ac6d9-2c57-4f00-9811-94b5df303a62/content