Banking Crises and Economic Growth

Article excerpt

Over the summer of 2007 problems began to emerge in financial markets as a result of debt defaults, particularly on US housing lending to individuals with low credit ratings. The globalisation of financial markets has meant that such risks are shared across banks throughout the world and a number of European banks suffered major losses as a result of purchasing high yield high risk bundles of these assets. In this note we discuss the possibility of a systemic banking crisis as a result of debt defaults, putting this risk and its impact on the economy into recent historical context. We also look at the vulnerability of the personal and business sectors to increases in borrowing rates, and at the evidence for a risk related rise in borrowing rates. We then use our model, NiGEM, to investigate the impacts of a significant rise in the spread between lending and borrowing rates for both producers and consumers. Such an increase in spreads might arise when banks wish to rebuild their capital after a crisis or reflect significant capital rationing. In either case they represent the immediate impacts of a crisis in the banking sector. The spread between borrowing and lending rates for producers reflects a risk premium in the business sector, and was used in the September EFN report to the European Commission, (1) whilst the spread between consumer lending and borrowing rates is in use for the first time on the model. The debt-to-income ratio has been rising in the personal sector in a number of countries, and especially in the UK, Ireland and Spain, as we can see from figure 1, and this might indicate where problems could arise.


Financial liberalisation is often accompanied by increases in borrowing by high risk individuals, and this increases general welfare and the risk of banking crises. Levels of borrowing differ greatly between countries, and they have been low in Italy where the personal sector debt-to-income ratio is around 0.6, whilst they have been high in Denmark for some time and currently stand at around 2 1/2 times personal disposable incomes. (2) Risks of default increase as new borrowers with no history of borrowing build up liabilities on which their default risk is unknown. We should therefore be as concerned about risks of default in countries with high increases in borrowing as in countries with high, but stable levels of borrowing.

Between the start of 1998 and the current date the borrowing-to-incomes ratio in the UK rose by 48 per cent or 46 percentage points of personal disposable income, whilst in Germany it fell marginally. The absolute and proportional increases were larger in Ireland (210 per cent) and Spain (117 per cent) than in the UK, but they were similar in the US (48 per cent) and smaller in France (41 per cent). Increases in debt-to-income ratios on this scale are in part the result of financial liberalisation, but also result from the low inflation and low real interest rate environment that has been established in the past decade and is expected to persist in the future. The debt service burden is not expected to rise significantly. Gross interest payments on debts have risen less than these numbers indicate, especially in the UK, where interest rates are 16 per cent below the 7.5 per cent per annum seen in the first quarter of 1998, and Ireland, where they are 26 per cent below the level of 5.9 per cent per annum seen at the same time. Interest rates rose by around 25 per cent from 3.5 per cent per annum in France and Germany during this period, raising the debt--service ratio.

Banking sector turmoil can lead to higher levels of borrowing rates even when central bank rates remain stable. The effects of increases in borrowing rates depend on the structure of borrowing by firms and individuals. Table 1 reports the proportion of consumer debt that is based on housing, and also the proportion of the mortgage debt that at an adjustable rate. …