FINANCIAL CRISES

I. Introduction ...............................................................................................................

.............

II. Explaining Financial Crises ...............................................................................................

...

A. Asset Price Booms and Busts....................................................................................

B. Credit Booms and Busts ............................................................................................

C. Impact of Asset Price and Credit Busts ...................................................................

III. Types of Financial Crises.................................................................................................

..

A. Currency Crises .......................................................................................................

B. Sudden Stops ...........................................................................................................

C. Foreign and Domestic Debt Crises ..........................................................................

D. Banking Crises ........................................................................................................

IV. Identification, Dating and Frequency of Crises .................................................................

A. Identification and Dating ........................................................................................

B. Frequency and Distribution .....................................................................................

V. Real and Financial Implications of Crises ..........................................................................

A. Real Effects of Crises ..............................................................................................

B. Financial Effects of Crises ......................................................................................

VI. Predicting Financial Crises ...............................................................................................

VII. Conclusions ..............................................................................................................

........

References ....................................................................................................................

............ 

INTRODUCTION

A Financial crises is a major disruption in the financial system that impedes the economy’s ability to the intermediate between those who want to save and those who want to borrow and invest not surprisingly, given the financial system central role, financial crises  have a broad macroeconomics impact. Throughout history, many of the deepest recessions have followed problems in the financial system. This downturn include the great depression of the 1930s and the great recession of 2008-2009

The 2007-09 global financial crises have been a painful reminder of the multifaceted nature of crises. They hit small and large countries as well as poor and rich ones. As fittingly described by Reinhart and Rogoff (2009a), “financial crises are an equal opportunity menace they can have domestic or external origins, and stem from private or public sectors. They come indifferent shapes and sizes, evolve over time into different forms, and can rapidly spread across borders. They often require immediate and comprehensive policy responses, call for major changes in financial sector and fiscal policies, and can necessitate global coordination of policies

 The widespread impact of the latest global financial crisis underlines the importance of having a solid understanding of crises. As the latest episode has vividly showed, the implications of financial turmoil can be substantial and greatly affect the conduct of economic and financial policies. A thorough analysis of the consequences of and best responses to crises has become an integral part of current policy debates as the lingering effects of the latest crisis are still being felt around the world.

This paper provides a selected survey of the literature on financial crises. Crises are, at a certain level, extreme manifestations of the interactions between the financial sector and the real economy. as such, understanding financial crises requires an understanding of macro financial linkages, a truly complex challenge in itself. The objective of this paper is more modest: it presents a focused survey considering three specific questions. First, what are the main factors explaining financial crises? Second, what are the major types of financial crises? Third, what are the real and financial sector implications of crises? The paper also briefly reviews the literature on the prediction of crises and the evolution of early warning models.

Section II reviews the main factors explaining financial crises. A financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices, severe disruptions in financial intermediation, notably the supply of external financing, large scale

Balance sheet problems and the need for large scale government support. While these events can be driven by a variety of factors, financial crises often are preceded by asset and credit booms that then turn into busts. As such, many theories focusing on the sources of financial crises have recognized the importance of sharp movements in asset and credit markets. In light of this, this section briefly reviews theoretical and empirical studies analyzing the developments in credit and asset markets around financial crises.

Section III classifies the types of financial crises identified in many studies. It is useful to classify crises in four groups: currency crises; sudden stop (or capital account or balance ofPayments) crises; debt crises; and banking crises. The section summarizes the findings of theliterature on analytical cause and empirical determinants of each type of crisis. The identification of crises is discussed in Section IV. Theories that are designed to explain Crises are used to guide the literature on the identification of crises. However, it has been difficult to transform the predictions of the theories into practice. While it is easy to design quantitative methods to identify currency (and inflation) crises and sudden stops, the Identification of debt and banking crises is typically based on qualitative and judgmental analyses. Irrespective of the classification one uses, different types of crises are likely to Overlap. Many banking crises, for example, are also associated with sudden stop episodes and Currency crises. The coincidence of multiple types of crises leads to further challenges of Identification. The literature therefore employs wide range of methods to identify and classify crises. The section considers various identification approaches and reviews the Frequency of crises over time and across different groups of countries

Section V analyzes the implications of financial crises. The macroeconomic and financial implications of crises are typically severe and share many commonalities across various types. Large output losses are common to many crises, and other macroeconomic variables typically register significant declines. Financial variables, such as asset prices and credit, usually follow qualitatively similar patterns across crises, albeit with variations in terms of duration and severity of declines. The section examines the short- and medium-run effects of crises and presents a set of stylized facts with respect to their macroeconomic and financial implications

The last section concludes with a summary and suggestions for future research. It then considers the most relevant issues for research in light of these lessons. One is that future research should be geared to eliminate the “this-time-is-different “syndrome. However, this Isa very broad task requiring addressing two major questions: How to prevent financial crises? And, how to mitigate their costs when they take place? In addition, there have to be more intensive efforts to collect necessary data and to develop new methodologies in order to guide both empirical and theoretical studies

THE ANATOMY OF CRISES

Financial crises are not all alike, but they shares some common features .in a nutshell, here the six elements that are the center of the most financial crises.

• Assets-price booms and busts
• Insolvencies at financial institutions
• Falling confidence
• Credit crunch
• Recession
• A vicious circle 

The Anatomy of a financial crisis: this figure is a schematic illustration of the six elements of a financial crisis.

Policy responses to a crisis

Conventional monetary and fiscal policy

Lender of last resort

Policies to prevent crises

Focusing on shadow banks restricting size

Reducing excessive risk taking

Making regulation work Better

Financial crises have been a major source of economic fluctuations and a main driver of economic policy. In 1873 Walter Bagehot published a celebrated book called Lombard Street about how the bank of England should manage a financial crisis. His recommendations that it should act as a lender of last resort has over time become the conventional wisdom. In 1913.in aftermath of the banking has over time become the conventional wisdom. In 1913, in the aftermath of the banking panic of 1907, congress passed the act establishing the Federal Reserve. Congress wanted the new central bank to oversee the banking system in order to ensure greater financial and macroeconomics stability.

The fed has not always been successful in accomplishing this goal. To this day, many economist believe that the great depression was so serve because the fed failed to failed to follow Bagehot’s advice and act as lender of last resort .if it had acted more aggressively, the crises of confidence in the banks and the resulting collapse in the money supply and aggregate demand  might have been averted. Mindful of this history, the fed played a much more active role in trying to mitigate the impact of the financial crises of 2008-2009

The anatomy of a crisis

Financial crises are not all alike, but they share some common features, in a nut shell here are the six elements that are the centre of the most financial crises. The financial crises of 2008-2009 provides a good example of each element

Assets –price booms and busts: 

Often, a period of optimisms, leading to a large increase in assets prices, precedes financial crises. Sometimes peoples bid up  the price of assets  above its fundamental value(that is, the true value  based on an objective analysis of the  cash flows the assets will generate)in this case ,the market for the assets is said to be in the grip of a speculative bubble. Later, when sentiment shifts and optimisms turn to pessimism, the bubble bursts and prices begin to fall. The decline in assets prices is the catalyst for the financial crises.

In 2008 and 2009, the crucial asset was residential real estate. The average price of houses in united state had experienced a boom earlier in the decade. This boom was driven in part by lax lending standards; many subprime borrowers those with particular risky credit profiles were lent money to buy house while offering only a very small down payment. In essence the financial system failed to do its job of dealing with asymmetric information by making loans to many borrowers who, it turned out, would later have trouble making their mortgage payments .the housing boom was also encouraged by government policies that promoted home ownership and was fed by excessive   optimism on the part of home-buyers who thought prices would rise forever. The housing boom, however, proved unsustainable. Over time the number of homeowners falling behind on their mortgage payments rose,, and sentiment among home-buyers shifted . Housing prices fell by about 30 percent from 2006 to 2009. The nation had not experienced such a large decline in housing prices since the 1930s.

Insolvencies at Financial Institutions;

A large decline in assets prices may cause problems at banks and other financial institutions. To ensure that borrowers reply their loans, banks often require them to post collateral. That is, a borrower has to pledge assets that a bank can seize if the borrower defaults. Yet when assets decline in price, the collateral falls in value, perhaps below the amount of the loan in this case, if the borrower defaults on the loan, the bank may be unable to recover its money.

Banks rely heavily on leverage, the use of borrowed funds for the purpose of investment, leverage amplifies the positive and negative effect of assets returns on banks financial position. A key number is the leverage ratio: the ratio of bank assets to bank capital. A leverage ratio of 20 for example, means that for every $1 in capital. Put into the bank by its owners the bank has borrowed $19, which then allows the bank to hold $20 in assets. In this case, if defaults cause the value of the bank’s assets to fall by 2 percent, then the bank’s capital will fall by 40 percent. If the value of bank assets falls more than 5 percent, then its assets will fall below its liabilities, and the bank will be insolvent. In this case, the bank will not have the resources to pay off all its depositors and other creditors. Widespread insolvency within the financial system is the second element of financial crises.

In 2008 and 2009 many banks and other financial firms had in effect placed bets on real estate prices by holding mortgages backed by the real estate. They assumed that housing prices would keep rising or at least hold steady, so the collateral backing these loans would ensure their repayment. When housing prices fell however large number of homeowners found they underwater, the value of their homes was less than the amount they owned on their mortgages.  When many homeowners stopped paying their mortgages, the banks could foreclose on the house, but they could recover only a fraction of what they were owned. These defaults pushed several financial institutions towards bankruptcy. These institution include major investment banks,, government-sponsored  enterprises involved in the mortgage markets  and a large insurance company.

Falling confidence

The third element of financial crises is decline in confidence in financial institution. While some deposits in banks are insured by government policies, not all are, as insolvencies mount every financial institution becomes a possible candidate for the next bankruptcy. Individuals with uninsured deposits in those institutions pull out their money. Facing a rash of withdrawals, banks cut back on new lending and start selling of assets to increase their cash reserves.

As banks sell off some of their assets, they depress the market prices of these assets. Because buyers of risky assets are hard to find in the midst of a crises, the assets prices can sometime falls precipitously. Such a phenomenon is called a fire sale, similar to the reduced prices that a store might charge to get rid of merchandise quickly after a fire. These fire-sale prices, however,, causes  problems at other banks. Accountants and regulators may require these banks to revise their balance sheets and reduced the reported value of their own holding of these assets. In this way, problems in one bank can spread to others.

In 2008 and 2009, the financial system was seized by great uncertainty about where the insolvencies would stop.  The collapse of the giants bear Stearns and Lehman brothers made people wonder whether other large financial firms such as Morgan Stanley, Goldman Sachs, and citigroup, would meet a similar fate. The problem was exacerbated by the firm’s interdependence. Because they had many contracts with one another, the demise of any one of these institution would undermine all the others. Moreover, because of the complexity of the arrangements, depositors could not be sure how vulnerable these firms were. The lack of transparency fed the crises of confidence.

Credit crunch

The fourth element of financial crises is a credit crunch. With many financial institution facing difficulties would-be borrowers have trouble getting loans, even if they have profitable investment projects. In essence, the financial system has trouble performing its normal function of directing the resources of savers into the hands of borrowers with the best investment opportunities.

The tightening of credit was clear, during the 2008-2009 financial crises. Not surprisingly, as banks realized that housing prices were falling and that previous lending standard had been too lax, they started raising standards for those applying for mortgages. They required larger down payments and scrutinized borrow affect home-buyers. Small business found it harder to borrow to finance business expansions or to buy inventories. Consumers found it harder to qualify for a credit card or car loan. Thus banks responded to their own financial problems by becoming more cautious in all kinds of lending.

Recession:

The fifth element of financial crises is an economic downturn. With people unable to obtain consumer credit and firms unable to obtain financing for new investment projects, the overall demand for goods and services declines. Within the context of the is-lm model this event can be interpreted  as a contractionary  shift in the consumption and investment function, which in turn leads to similar shifts in the is curve  and the aggregate demand curve. As a result national income falls and unemployment rises.

Indeed the recession following the financial crises of 2008 to 2009 was a deep one. Unemployment rose above 10 percent. Worse yet, it lingered at a high level for a long time. Even after the recovery began, growth in GDP was to meager that unemployment declined only slightly.

A vicious circle 

The sixth and final element of a financial crisis is a vicious circle. The economic downturn reduces the profitability of many companies and the value of many assets. The stock market declines.  Some firms go bankrupt and default on their business loans. Many workers become unemployed and default on their personal loans. Thus, we return to steps 1(assets price busts) and 2 (financial institution insolvencies). The problems in the financial system and the economic downturn reinforce each other.

In 2008 and 2009, the vicious was apparent. Some feared that the combination of a weakening economy would cause the economy to spiral out of control, pushing the country into another great depression. Fortunately, that did not occur, in part because policymakers were intent on preventing it

II. TYPES OF FINANCIAL CRISES

While financial crises can take various shapes and forms, in terms of classification, broadlyTwo types can be distinguished.Reinhart and Rogoff (2009a) distinguish two types of crises:Those classified using strictly quantitative definitions; and those dependent largely on qualitative and judgmental analysis. The first group mainly includes currency and sudden.

 A. Currency Crises 

 Theories on currency crises, often more precisely articulated than for other types of crises, have evolved over time in part as the nature of such crises has changed. In particular, the literature has evolved from a focus on the fundamental causes of currency crises, to emphasizing the scope for multiple equilibrium, and to stressing the role of financial variables,

Especially changes in balance sheets, in triggering currency crises (and other types of financial turmoil). Three generations of models are typically used to explain currency crises that took place during the past four decades. The first generation of models, largely motivated by the collapse in the price of gold, an important nominal anchor before the floating of exchange rates in the 1970s, was often applied to currency devaluations in Latin America and other developing countries (Claessens, 1991).13These models are from seminal papers by Krugman (1979) and Flood and Garber (1984), and hence called “KFG” models. They show that a sudden speculative attack on a fixed or pegged currency can result from rational behavior by investors who correctly foresee that a government has been running excessive deficits financed with central bank credit. Investors continue to hold the currency as long as they expect the exchange rate regime remain intact, but they start dumping it when they anticipate that the peg is about to end. This run leads the central bank to quickly lose its liquid assets or hard foreign currency supporting the exchange rate. The currency then collapses

SUDDEN STOPS

Models with sudden stops make a closer association with disruptions in the supply of external financing. These models resemble the latest generation of currency crises models in that they also focus on balance sheet mismatches – notably currency, but also maturity – in financial and corporate sectors (Calvo et al., 2006). They tend to give greater weight, however, to the role of international factors (as captured, for example, by changes in international interest rates or spreads on risky assets) in causing “sudden stops” in capital flows. These models can account for the current account reversals and the real exchange rate depreciation typically observed during crises in emerging markets. The models explain less well the typical sharp drops in output and total factor productivity (TFP). In order to match data better, more recent sudden stop models introduce various frictions. While counterintuitive, in most models, a sudden stop concurrency crisis generates an increase in output, rather than a drop. This happens through an abrupt increase in net exports resulting from the currency depreciation. This has led to various arguments explaining why sudden stops in capital flows are associated with large output losses, as is often the case. Models typically include Fisherman channels and financial accelerator mechanisms, or frictions in labor markets, to generate an output drop during a sudden stop, without losing the ability to account for the movements of other variables. Following closely the domestic literature, models with financial frictions help to account better for the dynamics of output and productivity in sudden stops. With frictions, e.g.,When firms must borrow in advance to pay for inputs (e.g., wages, foreign inputs),

a fall in credit – the sudden stop combined with rising external financing premium – reduces aggregate demand and causes a fall in output (Calvo and Reinhart, 2000). Or because of collateral constraints in lending, a sudden stop can lead to a debt-deflation spiral of declines in credit, prices and quantity of collateral assets, resulting in a fall in output. Like the domestic financial accelerator mechanism, financial distress and bankruptcies because negative externalities, as banks become more cautious and reduce new lending, in turn inducing a further fall in credit, and thereby contributing to a recession (Calvo, 2000). These types of amplification mechanisms can make small shocks cause sudden stops. Relatively small shocks – to imported input prices, the world interest rate, or productivity – can trigger collateral constraints on debt and working capital, especially when borrowing levels are high relative to asset values. Fisher's style debt-deflation mechanisms can then cause sudden stops through a spiraling decline in asset prices and holdings of collateral assets (Fisher, 1933). This chain of events immediately affects output and demand. Mendoza (2009) shows how a business cycle model with collateral constraints can be consistent with the key features of sudden stops. Korinek (2010) provides a model analyzing the adverse implications of large movements in capital flows on real activity.

Sudden stops often take place in countries with relatively small tradable sectors and largeForeign exchange liabilities. Sudden stops have affected countries with widely disparate perCapita GDPs, levels of financial development, and exchange rate regimes, as well as countries with different levels of reserve coverage. There are though two elements most episodes share, as Calve, Izquierdo and Mejia (2008) document: a small supply of tradable goods relative to domestic absorption – a proxy for potential changes in the real exchange rate – and a domestic banking system with large foreign–exchange denominated liabilities, raising the probability of a “perverse” cycle. Empirical studies find that many sudden stops have been associated with global shocks. For a number of emerging markets, e.g., those in Latin America and Asia in the 1990s and in Central and Eastern Europe in the 2000s, following a period of large capital inflows, a sharp retrenchment or reversal of capital flows occurred, triggered by global shocks (such as increases in interest rates or changes in commodity prices). Sudden stops are more likely with large cross-border financial linkages. Milesi-Ferretti and Tile (2011) document those rapid changes in capital flows were important triggers of local crises during the recent crisis. Other papers, e.g., Rose and Spiegel (2011), however, find little role for international factors, including capital flows, in the spread of the recent crisis. 

C. Foreign and Domestic Debt Crises 

Theories on foreign debt crises and default are closely linked to those explaining sovereignLending. Absent “gun-boat” diplomacy, lenders cannot seize collateral from another country,or at least from a sovereign, when it refuses to honor its debt obligations. Without an enforcement mechanism, i.e., the analogue to domestic bankruptcy, economic reasons, instead of legal arguments, are needed to explain why international (sovereign) lending exists at all.Models developed rely, as a gross simplification, on either intertemporal or intratemporal sanctions. Intertemporal sanctions arise because of threat of cutoff from future lending if a country defaults (Eaton and Gersovitz, 1981). With no access (forever or for some time), the Country can no longer smooth idiosyncratic income shocks using international financial Markets. This cost can induce the country to continue its debt payments today, even though There are no immediate, direct costs to default. Intratemporal sanctions can arise from the inability to earn foreign exchange today because trading partners impose sanctions or otherwise shut the country out of international markets, again forever or for some time (Bulow and Rogoff, 1989a). Both types of costs can support a certain volume of sovereign lending (see Eaton and Fernandez, (1995) and Panizza, Sturzenegger and Zettelmeyer (2009) for reviews).

These models imply that inability or unwillingness to pay, i.e., default, can result from different factors. The incentives governments face in repaying debt differ from those for corporations and households in a domestic context. They also vary across models. In the inter temporal model, a country defaults when the opportunity cost of not being able to borrow ever again is low, one such case presumably being when the terms of trade is good and is expected to remain so(Kletzer and Wright, 2000). In the intratemporal sanction model, in contrast, the costs of a cutoff from trade may be the least when the terms of trade is bad. Indeed, Augier and Gopinath (2006) demonstrate how in a model with persistent shocks, countries default in bad times to smooth consumption. The models thus also have different implications with respect to a country’s borrowing capacity.

 Such models are unable, however, to fully account why sovereigns default and why creditors lend as much as they do. Many models actually predict that default does not happen in equilibrium as creditors and debtors avoid the dead-weight costs of default and renegotiate debt payments. While some models have been calibrated to match actual experiences of default, models often still under predict the likelihood of actual defaults. Notably, countries Do not always default when times are bad, as most models predict: Toms and Wright (2007)Report that in only 62 percent of defaults cases output was below trend. Models also underestimate the willingness of investors to lend to countries in spite of large default risk.Moreover, changes in the institutional environment, such as those implemented after the debt Crises of the 1980s, do not appear to have modified the relation between economic and Political variables and the probability of a debt default. Together, this suggests that models Still fail to capture all aspects necessary to explain defaults (Panizza, Sturzenegger and Zettelmeyer, 2009).

 Although domestic debt crises have been prevalent throughout history, these episodes had received only limited attention in the literature until recently. Economic theory assigns a trivial role to domestic debt crises since models often assume that governments always honor their domestic debt obligations—the typical assumption is of the “risk-free” government Assets. Models also often assume Ricardian equivalence, making government debt less relevant. However, recent reviews of history (Reinhart and Rogoff, 2009a) show that few countries were able to escape default on domestic debt, with often adverse economic consequences.

 This often happens through bouts of high inflation because of the abuse of governments’ monopoly on currency issuance. One such episode was when the U.S. experienced a rate of inflation close to 200 percent in the late 1770s. The periods of hyperinflation in some European countries following the World War II were also in this category. Debt defaults in the form of inflation are often followed by currency crashes. In the past, countries would often “debase” their currency by reducing the metal content of coins or switching to another metal. This reduced the real value of government debt and thus provided fiscal relief. There have also been other forms of debt “default,” including through financial repression (Reinhart, Kierkegaard, and Sbrancia, 2011). After inflation or debasing crises, it takes a long time to convince the public to start using the currency with confidence again. This in turn significantly increases the fiscal costs of inflation stabilization, leading to large negative real effects of high inflation and associated currency crashes

D. Banking Crises

What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a currency peg it has has sworn to be eternal and unbreakable? Several European countries are in this position today, but there is nothing really new about it. It's all happened before, most recently in Argentina in the winter of 2001-02. So what became of Argentina? Are there any lessons there for today's Europe?
Argentina introduced what it called its "convertibility plan" in April 1991 as a way of stopping its latest episode of recurrent hyperinflation. Rather than opting for outright dollarization, as Ecuador would do a few years later, Argentina introduced a new version of its own currency, the peso, and pegged it to the U.S. dollar at a 1-to-1 rate. The peg was underpinned by a currency board arrangement, which required the central bank to hold sufficient dollar reserves to back the entire monetary base (paper currency in circulation plus bank reserves) and to exchange pesos freely for dollars.

At first it worked. A fixed exchange rate can be a powerful tool to stop run-away inflation. As inflation came down, Argentina experienced a few years of good growth. However, it was not long before the fixed exchange rate showed its negative side: inflexibility in the face of external shocks. The Mexican "tequila crisis" and a devaluation of the Brazilian real, among other things, left Argentina with an overvalued currency, a big trade deficit, and excessive dependence on foreign borrowing. In addition, Argentina had a hard time mustering the fiscal discipline needed to live with a fixed exchange rate. By the end of the 1990s, Argentina was again in crisis. With IMF encouragement, it first tried fiscal austerity, and when that did not work, more radical measures, including a freeze on withdrawals of bank deposits. "This buries whatever hypothesis may exist that we will devalue," said Finance Minister Domingo Cavallo, speaking, in December 2001, of the banking freeze. But just a month later devalue they did, and they defaulted too.
What happened next is very interesting. Devaluation and default did not bring the end of the world. Hyperinflation did not return. The peso, when floated, did not go into free fall, but instead settled into a range between 3 and 4 to the dollar, where it remains to this day. Most importantly, the real economy recovered strongly. Since 2003, Argentina has grown more rapidly even than neighboring Brazil, widely touted as a developing-world success story. One of my students dubbed Argentina's recovery the "Nike effect" because of the resemblance between a graph of Argentine GDP growth and the shoe company's famous "swoosh" logo.

Does Argentina's Nike effect hold a lesson for embattled euro area countries like Ireland, Greece, Spain and Portugal, or for those like Latvia, Lithuania, and Bulgaria, whose currencies are pegged to the euro with currency boards or similar policies? Could devaluation and even default be a better path to recovery than forced austerity?

The first lesson is that fixed exchange rates work best when all partners in a currency area have similar exposure to shocks. In the case of Argentina, probably the greatest problem lay in pegging the peso to the currency of the United States, a country with which it carried on only about 8 percent of its trade. Shocks like the Mexican crisis and the Brazilian devaluation, which hit Argentina hard, were hardly noticed in the U.S. With regard to trade in goods and services, the euro area makes much more sense than did the Argentine currency board. Intra-euro trade shares run in the 60 to 70 percent range. However, asymmetrical financial shocks remain a problem for the euro. Germany and a few other countries with persistent trade surpluses are sources of financial outflows. During the boom of the mid-2000s, countries like Ireland, Spain, and Latvia were in the opposite position, with large current-account deficits and huge financial inflows. When the global financial crisis exposed the fragility of the asset values that had attracted the inflows, those countries were left high and dry.
The second lesson is that a fixed nominal exchange rate does not protect countries from real exchange rate misalignment. A 22 percent real appreciation of the Argentine peso from 1998 through 2001 contributed to the problems of the convertibility policy by undermining the country's competitiveness and adding to its current account deficit. Similarly, as the following chart shows, some of the most distressed EU members experienced real currency appreciation in the years leading up to the crisis, both relative to the rest of the world, and relative to Germany, the anchor economy of the euro. Since Ireland, Spain and Germany all use the euro, and Latvia's lats has been pegged to the euro since 2005, nominal exchange rate changes account for none of differences in the evolution of real exchange rates. Instead, most of the real appreciation in the peripheral euro countries was caused by higher inflation than in Germany, and the inflation, in turn, was largely fueled by financial inflows chasing real estate bubbles.
The third lesson is that when all options are bad, the unthinkable may become the least bad. The orthodox recovery path for a currency-area member is "internal devaluation," that is, real devaluation through deflation of wages and prices rather than through nominal devaluation. Tax increases plus public sector wage and spending cuts are used to bring the budget back into balance. High unemployment, perhaps supplemented by labor market reforms, is used to force down private sector wages and prices. Once prices fall enough and creditor confidence is restored, growth can resume again. The IMF has traditionally favored this set of policies when giving assistance to countries like Argentina, Greece, and Latvia, in part because they protect foreign creditors, who tend to include the most influential IMF members. But it is a slow path to recovery, and one that is socially and politically painful for the patient.

The alternative to austerity and internal devaluation is to abandon the fixed exchange rate. That option, too, is not free of pain. For one thing, in an attempt to make the fixed exchange rate maximally credible, it will often have been locked in by constitutional amendment or treaty or some other mechanism above the reach of mere administrative authority. In addition, it may not be possible to devalue without triggering both public and private defaults on borrowing denominated in foreign currencies. If banking problems have not already been a trigger of the crisis, as in Ireland, devaluation is likely to bring about a banking collapse, as it did in Argentina. Despite all those drawbacks, however, devaluation can open the door to a more rapid recovery than is possible under internal devaluation - -a Nike effect.
The Bottom Line: Life in a fixed-rate currency area is not for everyone. Some countries are structurally unsuited for a fixed exchange rate because of their patterns of trade, their exposure to external shocks, or their inflexible labor markets. Others may be structurally suited but lack the needed fiscal or financial discipline. A country locked into a currency union for which it is not suited is like a spouse locked in a bad marriage. Sticking to one's vows and blaming one's own failures for all the problems of the relationship is certainly one alternative. But the option of divorce should not be too hastily taken off the table.

Banking crises are quite common, but perhaps the least understood type of crises. Banks are inherently fragile, making them subject to runs by depositors. Moreover, problems of individual banks can quickly spread to the whole banking system. While public safety nets –Including deposit insurance – can limit this risk, public support comes with distortions that Can actually increase the likelihood of a crisis. Institutional weaknesses can also elevate the Risk of a crisis. For example, banks heavily depend on the information, legal and judicial environments to make prudent investment decisions and collect on their loans. With institutional weaknesses, risks can be higher. While banking crises have occurred over century’s and exhibited some common patterns, their timing remains empirically hard to pin down.

Bank Runs and Banking Crises

Financial institutions are inherently fragile entities, giving rise to many possible coordination problems. Because of their roles in maturity transformation and liquidity creation, financial institutions operate with highly leveraged balance sheets. Hence, banking, and other similar forms of financial intermediation, can be precarious undertakings. Fragility makes coordination, or lack thereof, a major challenge in financial markets. Coordination problems arise when investors and/or institutions take actions – like withdrawing liquidity or capital – merely out of fear that others also take similar actions. Given this fragility, a crisis can easily take place, where large amounts of liquidity or capital are withdrawn because of a self-fulfilling belief – it happens because investors fear it will happen. Small shocks, whether real or financial, can translate into turmoil in markets and even a financial crisis

. A simple example of a coordination problem is a bank run. It is a truism that banks borrow shorthand lend long. This maturity transformation reflects preferences of consumers and borrowers. However, it makes banks vulnerable to sudden demands for liquidity, i.e., “runs” (the seminal reference here is Diamond and Diving, 1983). A run occurs when a large number of customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run proceeds, it generates its own momentum, leading to a self-fulfilling prophecy (or perverse feedback loop): as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy as it cannot liquidate assets fast enough to cover its short-term liabilities.

These fragility have long been recognized, and markets, institutions, and policy makers have developed many “coping” mechanisms (see further Dewar point and Tirol, 1994). Market discipline encourages institutions to limit vulnerabilities. At the firm level, intermediaries have adopted risk management strategies to reduce their fragility. Furthermore, micro-prudential regulation, with supervision to enforce rules, is designed to reduce risky behavior of individual financial institutions and can help engineer stability. Deposit insurance can eliminate concerns of small depositors and can help reduce coordination problems. Lender of last resort facilities (i.e., central banks) can provide short-run liquidity to banks during periods of elevated financial stress. Policy interventions by public sector, such as public guarantees, capital support and purchases of non-performing assets, can mitigate systemic risk when financial turmoil hits.

. Although regulation and safety net measures can help, when poorly designed or implemented they can increase the likelihood of a banking crisis Regulations aim to reduce fragilities (for example, limits on balance sheet mismatches Stemming from interest rate, exchange rate, maturity mismatches, or certain activities of financial institutions). Regulation (and supervision), however, often finds itself playing catch up with innovation. And it can be poorly designed or implemented. Support from the public sector can also have distortionary effects (see further Barth, Caprio and Levine, 2006). Moral hazard due to a state guarantee (e.g., explicit or implicit deposit insurance) may, for example lead banks to assume too much leverage. Institutions that know they are too big to fail or unwind, can take excessive Risks, thereby creating systemic vulnerabilities. More generally, fragilities in the banking System can arise because of policies at both micro and macro levels (Laeven, 2011).

 History of banks runs

Runs have occurred in many countries throughout history. In the U.S., bank runs were common during the banking panics of the 1800s and in the early 1900s (during the Great Depression). Only with the introduction of deposit insurance in 1933, did most runs stop in the U.S.(Calomiris and Gorton, 1998). Wide-spread runs also happened frequently in emerging markets and developing countries in recent decades, such as in Indonesia during the 1997 Asian financial crisis. Runs occurred more rarely in other advanced countries, and even less so in recent decades, in part due to the wide spread availability of deposit insurance. Yet, Northern Rock, a bank specializing in housing finance in the U.K., constitutes a very recent example of a bank run in an advanced country (Shin, 2011). Rapid withdrawals of wholesale market funding also took place during the recent financial crisis, when several investment and some commercial banks faced large liquidity demands from investors. Widespread runs can also take place in non-bank financial markets. For example, in the U.S. during the fall of 2008, some mutual funds “broke the buck”,

IV. IDENTIFICATION ,DATING  AND  FREQUENCY  OF CRISES

A large body of work has been devoted to the identification and dating of crises, but Ambiguities remain. Methodologies based on the main theories explaining various types of crises can be used to identify (and accordingly classify) crises.19In practice, however, this is not straightforward. While currency (and inflation) crises and sudden stops lend themselves to quantitative approaches, the dating of debt and banking crises is typically based on qualitative and judgmental analyses. Irrespective of type, variations in methodologies can lead to differences in the start and end dates of crises. And, as noted, various types of crises can overlap in a single episode, creating possible ambiguities as to how to classify the episode.

 This is part because the frequency and types of financial crises have evolved over time. In practice, a wide range of quantitative and qualitative methods involving judgment are used to identify and classify crises. The data also shows that crises have evolved over time. For example, currency crises were dominant during the 1980s whereas banking crises and sudden stops became more prevalent in the 1990s and 2000s. This section begins with a summary of common identification and dating methods (seealso IMF WEO 1998; Reinhart and Rogoff, 2009a; and Laeven and Valencia, 2008, 2012). It then provides a summary of the frequency of crises over time, across groups of countries, and the overlap among types of crises.

A. Identification and Dating

Currency crises

 As they involve large changes in exchange rates, and (related) inflation crises, are relatively easy to identify. Reinhart and Rogoff (2009a) distinguish these episodes by assigning threshold values for the relevant variables. In the case of currency crises, they consider exchange rate depreciations in excess of 15 percent per year as a crisis, while, for inflation, they adopt a threshold of 20 percent per year. A currency crisis is defined in Frankel and Rose (1996) as a depreciation of at least 25 percent cumulative over a 12-month period, and at least 10 percentage points greater than in the preceding 12 months. The dates identified are obviously sensitive to such thresholds used. These thresholds can also be universal, specific to the sample of countries under study, or country-specific (as when the threshold is adjusted for the country’s “normal” exchange rate variations).

A measurement issue naturally arises when there was no significant adjustment in currency, even if there were pressures or attacks. Movements in international reserves or adjustment in interest rates can absorb exchange rate pressures and prevent or moderate the fluctuations in the rate. However, episodes involving such pressures and/or attacks are also important to document and study. To address this, starting with Eichengreen, Rose and Wyplosz (1996), different methodologies have been employed. A composite index of speculative pressure is often constructed based on actual exchange rate changes, and movements in international reserves and interest rates, with weights chosen to equalize the variance of the components, thereby avoiding one component dominating the index. Thresholds are then set to date the currency events, including both large exchange rate movements and periods of pressure (see Frankel and Saravelos (2012) and Glick and Hutchison (2012) for reviews; Cardarelli, Elekdag and Kose (2010) for applications).

Sudden stops and balance-of-payments

 Crises can also be objectively classified. Calvo, Izquierdo and Talvi (2004) define systemic sudden stop events as episodes with output collapses that coincide with large reversals in capital flows. Calvo, Izquierdo and Mejía

(2008) expand on these criteria in two ways: one, the period contains one or more year-on-year fall in capital flows that are at least two standard deviations below its sample mean (this addresses the “unexpected requirement of a Sudden Stop); two, it starts (ends) when the annual change in capital flows falls (exceeds) one standard deviation below (above) its mean (Mauro and Becker, 2006). Since methodologies vary, various samples of events follow. Calvo et al. (2004) identified 33 Sudden Stop events with large and mild output collapses in a sample of 31 emerging market countries. While studies use different cutoff criteria (Calvo and Reinhart (1999), Calvo, Izquierdo and Loo-Kung (2006),

And Milesi-Ferretti and Razin (2000), for example differ), the dating of events are very similar. Some studies also require a falling output, but later studies excluded this requirement (since a fall may be endogenous) and replaced it with the requirement of large spikes in the Emerging Markets Bond Index (EMBI) spread, indicating a shift in the supply of foreign capital (see further Izquierdo, 2012). Cardarelli, Kose and Elekdag (2010) consider a large capital inflow episode to end “abruptly” if the ratio of net private capital inflows to GDP in the year after the episode terminates is more than 5 percentage point lower than at the end of the episode – closely following the definition of “sudden stops” in the literature. An episode is also considered to finish abruptly if its end coincides with a currency crisis. the dating of events are very similar. Some studies also require a fall in output, but later studies excluded this requirement (since a fall may be endogenous) and replaced it with the requirement of large spikes in the Emerging Markets Bond Index (EMBI) spread, indicating a shift in the supply of foreign capital (see further Izquierdo, 2012). Cardarelli, Kose and Elekdag (2010) consider a large capital inflow episode to end “abruptly” if the ratio of net private capital inflows to GDP in the year after the episode terminates is more than 5

Percentage point lower than at the end of the episode – closely following the definition of “sudden stops” in the literature. An episode is also considered to finish abruptly if its end coincides with a currency crisis.

Balance-of-payments Crises and other parallel episodes can similarly be identified using capital flows data. Although there are some differences in approaches (e.g., how reserves losses are treated) and statistical variations across studies (e.g., whether the same current account deficit threshold is used for all countries or whether country-specific variables thresholds are used), but many of them point to similar samples of actual events. Forbes and Warnock (2012) analyze for a large set of country yes gross flows, instead of the more typical net capital flows (or current account). They identify episodes of extreme capital flow movements using quarterly data, differentiating activity by foreign errand domestics. They classify episodes as “surge”, “stop”, “flight,” or “retrenchment, with surges and stops related respectively to periods of large gross capital in- or outflows by foreigners, and flights and retrenchments respectively related to periods of large capital out- or inflows by domestic residents.

 External sovereign debt crises are generally easy to identify as well, although there remain differences in classifications across studies. Sovereign defaults are relatively easy to identify since they involve a unique event, the default on payments. Typical dating of such episodes relies on the classification of rating agencies or on information from international financial institutions (see McFadden, Eckaus, Feder, and Hajivassiliou (1984); and papers summarized in Schwarzenegger and Zettelmeier (2007)). Still, there are choices in terms of methodology. For Example differences arise from considering the magnitude of defaults (whether default has to be widespread or on just one class of claims), default by type of claims (such as bank claims or bond claims, private or public claims), and the length of default (missing a single or several payments). Others look instead at the increases in spreads in sovereign bonds as an indicator of (the probability of) default (Edwards, 1984). The end of a default is harder to date though. A major issue with dating, including of default and sovereign debt crises, can be identifying their end, i.e., when default is over. Some studies date this as when countries regained access in some form to private financial markets. Others use as a criteria when countries regain a certain credit rating (IMF, 2005 and 2011). Differences consequently arise as to how long it takes for a country to emerge after a sovereign default. Domestic debt crises are more difficult to identify. First, consistent historical data on domestic public debt across countries was missing, at least until recently. Furthermore, following a crisis, unrecorded debt obligations can come to light. However, Abbas et al (2011) and Reinhart and Rogoff(2009a) have since made significant progress in putting together historical series on (domestic) debt. Second, countries can default in many ways: outright direct defaults; periods of hyper- or high inflation; punitive taxation of interest payments; forced interest rate or principal adjustments or conversions; gold clause abrogation; debasing of currency; and forms of financial repression. Reinhart and Rogoff (2009a) describe these and make clear that there remains considerable ambiguity in classifications of defaults, especially of “inflation-related default” episodes. Banking crises can be particularly challenging to date as to when they start and especially when they end. Such crises have usually been dated by researchers using a qualitative approach on the basis of a combination of events – such as forced closures, mergers, or government takeover of many financial institutions, runs on several banks, or the extension of government assistance to one or more financial institutions. In addition, in-depth assessments of financial conditions have been used as a criterion. Another metric used has been the fiscal costs associated with resolving these episodes. The end of a banking crisis is also difficult to identify, in part since its effects can linger on for some time

B. Frequency and Distribution

Crises have afflicted both emerging markets and advanced countries throughout centuries. In the three decades before 2007, most crises o

ccurred in emerging markets. Emerging market crises during those decades include the Latin American crises in the late 1970s-early 1980s, the Mexican crisis in 1995, and the East Asian crises in the mid- to late 1990s.“Emerging” markets being more prone to crises is not new (Reinhart and Rogoff, 2013). History shows that many countries which are developed today experienced financial crises when they were going through their own process of emergence, including Australia, Spain, the U.K. and the U.S. in the 1800s. For example, France defaulted on its external debt eight times over the period 1550-1800. Some advanced countries experienced crises in recent decades as well, from the Nordic countries in the late 1980s, to the Japan in the 1990s. The most recent crises starting with the U.S. subprime crisis in late 2007 and then spreading to other advanced countries show (once again) that crisis can affect all types of countries.

 Some claim that crises have become more frequent over time. The three decades after the World War II were relatively crises-free, whereas the most recent three decades have seen many episodes . Some relate this increase to more liberalized financial markets, including floating exchange rates, and greater financial integration. Indeed, using macroeconomic and financial series for 14 advanced countries for the 1870-2008 periods, Jordà, Schularick and Taylor (2012) report no financial crises during the Bretton Woods period of highly regulated financial markets and capital controls. Also, Bordo et al. (2001) argue that the sudden stop problem has become more severe since the abandonment of the Gold Standard in the early 1970s.

More recent crises seem to have lasted shorter though, but banking crises still last the longest. The median duration of debt default episodes in the post-World War II has been much shorter than for the period 1800-1945, possibly because of improvement in policies in the later period, improved international financial markets, or the active involvement of multilateral lending agencies (see further Das and others (2012)). Currency and sudden stop crises are relatively short (almost by definition). With the major caveat that their end is hard to date, banking crises tend to last the longest, consistent with their large real and fiscal impacts.

Financial crises clearly often come in bunches. Sovereign defaults tend to come in waves and in specific regions. Jordà,Schularick and Taylor (2012) report that there were five major periods when a substantial number of now-advanced countries experienced a crisis: 1893, the early 1890s, 1907, 1930-31, and 2007-08. Earlier crises bunched around events such as theNapoleonic Wars. Examples of bunches over the last three decades include in the 1980s, the Latin America debt crises; in 1992, the European ERM currency crises; in the late 1990s, the East Asian, Russia and Brazil financial crisis; the multiple episodes observed in 2007-2008, and the ongoing crises in Europe. Periods of widespread sovereign defaults often coincide with a sharp rise in the number of countries going through a banking crisis. These coincidences point towards common factors driving these episodes as well as spillovers of financial crises across borders.

 Some types of crises are more frequent than others. Comparisons can be made for the post Bretton Woods period (while some types of crises have been documented for longer periods, not all have; and currency crises were non-existent during the fixed exchange rate period; together this necessitates the common, but shorter period). Of the total number of crises Laeven and Valencia (2013) report, there are 147 banking crises, 217 currency crises, and 67 sovereign debt crises over the period 1970 to 2011 (note that several countries experienced multiple crises of the same type).

 However, as noted before, there is some overlap between the various types of crises. Currency crises frequently tend to overlap with banking crises – so called twin crises (Kaminsky and Reinhart, 1999). In addition, sudden stop crises, not surprisingly, can overlap with currency and balance-of-payments crises, and sometimes sovereign crises (Figure 5). Of the 431 banking (147), currency (217) and sovereign (67) crises Laeven and Valencia (2013) report, they consider 68 as twin crises, and 8 can be classified as triple crises. The overlaps are thus far from complete. There are also relative differences in coincidences of these episodes. A systemic banking crisis, for example, often involves a currency crisis and a sovereign crisis sometimes overlaps with other crises, 20 out of 67 sovereign crises are also a banking and 42 also a currency crisis.

V. REAL AND FINANCIAL IMPLICATIONS OF CRISES

Macroeconomic and financial consequences of crises are typically severe and share many commonalities across various types. While there are obviously differences between crises, there are many similarities in terms of the patterns macroeconomic variables follow during these episodes. Large output losses are common to many crises and other macroeconomic variables (consumption, investment and industrial production) typically register significant declines. And financial variables like asset prices and credit usually follow qualitatively similar patterns across crises, albeit with variations in terms of duration and severity. This section provides a summary of the literature on the macroeconomic and financial implications of crises

VI. PREDICTING FINANCIAL CRISES

It has long been a challenge to predict the timing of crises. There is obviously a great benefit in knowing whether and if so when a crisis may occur: it can help put in place measures aimed at preventing a crisis from occurring in the first place or limiting the damage if it does happen. As such, there is much to be gained from better detecting the likelihood of a crisis. Yet, in spite of much effort, no single set of indicators has proven to explain the various types of crises or consistently so over time. Periods of turmoil often arise in endogenous ways, with possibilities of multiple equilibrium and many non-linearities.27And while it is easier to document vulnerabilities, such as increasing asset prices and high leverage; it remains difficult to predict with some accuracy the timing of crises. This section presents a short review of the evolution of the empirical literature on prediction of crises.28Early warning models have evolved over time, with the first generation of models focusing on macroeconomic imbalances. In early crisis prediction models, mostly aimed at banking and currency crises, the focus was largely on macroeconomic and financial imbalances, and often in the context of emerging markets. Kaminsky and Reinhart (1999) show that growth rates in money, credit, and several other variables exceeding certain thresholds made a banking crisis more likely. In a comprehensive review, Goldstein, Kaminsky and Reinhart (2000) report that a wide range of monthly indicators help predict currency crises, including the appreciation of the real exchange rate (relative to trend), a banking crisis, a decline in equity prices, a fall in exports, a high ratio of broad money (M2) to international reserves, and a recession. Among annual indicators, the two best were both current-account indicators, namely, a large current-account deficit relative to both GDP and investment. For banking crises, the best (in descending order) monthly indicators were: appreciation of the real exchange rate (relative to trend), a decline in equity prices, a rise in the money (M2) multiplier, a decline in real output, a fall in exports, and a rise in the real interest rate. Among eight annual indicators tested, the best were a high ratio of short-term capital flows to GDP and a large current-account deficit relative to investment. In the next generation of models, still largely geared towards external crises, balance sheet variables became more pronounced. Relevant indicators found include substantial short-term debt coming due (Berg et al. 2004).  The ratio of broad money to international reserves in the year before the crisis was found to be higher (and GDP growth slower) for crises in emerging markets.  In these models, fiscal deficit, public debt, inflation, and real broad money growth, however, were often found not to be consistently different between crisis and non-crisis countries before major crises. Neither did interest rate spreads or sovereign credit ratings generally rank high in the list of early warning indicators of currency and systemic banking crises. Rather, crises were more likely preceded by rapid real exchange rate appreciation, current account deficits, domestic credit expansion, and increases in stock prices.

VII. CONCLUSIONS

A Summary 

This paper presents a survey on financial crises to answer three specific questions. First, what are the main factors explaining financial crises? Although the literature has clarified some of the main factors driving crises, it remains a challenge to definitively identify their causes. Many theories have been developed over the years regarding the underlying causes of crises. These have recognized the importance of booms in asset and credit markets that turned into busts as the main driving forces of most crises episodes. Given their central roles, the paper briefly summarizes the theoretical and empirical literature analyzing developments in credit and asset markets around financial crises.

 Second, what are the major types of crises? While financial crises can take various shapes and forms, the literature has focused on four major types of crises: currency crises; sudden stop (or capital account or balance of payments) crises; debt crises; and banking crises. It is possible to classify crises in other ways, but regardless they can often overlap in types. A number of banking crises, for example, are also sudden stop episodes and currency crises. The paper examines the literature on the analytical causes and empirical determinants of each type of crisis. In addition, it presents a review of studies on various approaches for the identification of crises, their frequency over time and across different groups of countries.

Third, what are the real and financial sector implications of crises? Large output losses are common to many crises and other macroeconomic variables (consumption, investment and industrial production) typically register significant declines. Financial variables like asset prices and credit usually follow qualitatively similar patterns across crises, albeit with variations in terms of duration and severity of declines.

The paper provides a summary of the literature on the macroeconomic and financial implications of crises. The paper also briefly reviews the literature on the prediction of crises. While there are many benefits in knowing whether and if so when a crisis may occur, it has been a challenge to predict crises. It is easy to document vulnerabilities, such as increasing asset prices and high leverage, but it remains difficult to predict with some accuracy the timing of crises. No single set of indicators has proven to predict the various types of crises. The paper reviews how the empirical literature on prediction of crises has evolved and analyzes its current state.