Chapter 7: Financial Crises and Regulations

Global Crisis

According to Mishkin, “a financial crisis occurs when an increase in asymmetric information from a disruption in the financial system prevents the financial system from channeling funds efficiently from savers to households and firms with productive investment opportunities”. Although it is a controversial issue what the concept of crisis refers to, there is a consensus on that there exists four types of financial or economic crises in general:

• money crisis
• banking crisis
• external debt crisis
• systemic financial crisis

A speculative attack on the value of a currency is called a currency crisis, if it leads to a depreciation of the foreign exchange reserves or a significant rise in interest rates in order to prevent the depreciation of the currency. A banking crisis arises when the actual or potential bank failures prevent banks from fulfilling their obligations, or when the government is forced to intervene to prevent this failure.

An external debt crisis occurs if an entity cannot pay the foreign debts, whether it is a government or private sector. On the other hand, systemic financial crises are defined as financial distortions that have significant effects on the real economy by preventing the efficient functioning of financial markets.

Financial crises are usually caused by the following factors:

• Mismanagement of financial liberalization
• Asset Price bubbles or booms, meaning market prices of assets realized above economic values
• High uncertainty, usually following economic downturns or stock market crashes
• Current account deficits
• Budget deficits
• Excessive borrowing of government
• Excessive borrowing of businesses
• Vulnerability or fragility of banking industry

The effects of financial crises, in general, may include:

• Economic downturn
• Deterioration of cash flows
• Decline of lending The common feature of all types of financial crises is that they have significant fluctuations in financial asset prices (or exchange rate) and unsustainable economic imbalances.
• Deterioration in the balance sheets of financial institutions
• Deterioration in the balance sheets of businesses
• Currency crises
• Rises in debt burdens
• Bank failures
• Company failures
• Increased volatility in financial markets
• Rises in inflation and interest rates
• Rises in unemployment

We can classify crises in the world as crises prior to 1980 and crises after 1980.

Crises Prior to 1980

Financial Crises and Panics Before the 1929 Great Depression: The Tulip Madness occured in a time when the Netherlands lived in the Golden Age. In this period, the prices of newly emerging tulip bulbs have risen to high prices and suddenly hit the bottom. In February 1637, when the tulip madness reached the stage, the onions of some rare tulips were sold to more than 10 times the annual income of a skilled craftsman. 18. Century is called the era of stock market balloons. The first two famous stock market balloons are: the South Sea Company (UK), which was based in the UK, and the Mississippi Company (Project), which was based in France. These two balloons suddenly burst out in 1720 and thousands of unsuspecting investors went bankrupt. On the other hand, in the 19. Century, firstly.

The Danish government declared a moratorium on January 5 1813, after six years of naval wars. Expenditures related to the war dried up the national resources of the country, the employment fell at very low levels and the tax revenues decreased at unprecedently low levels. There were panics every decade in this century, and in the last quarter of the century there was a period of depression that affected the whole world, including the USA and Britain. This depression led to an economic stagnation in the United States between 1873 and 1879. In the years 1819, 1824, 1837, 1947, 1957, 1866, 1873, several panics occurred due to various reasons. Ultimately, the panic in 1873 turned into an international economic crisis in many parts of the world, including the USA and Europe. In some countries, including Britain, it continued to the mid-1890s and was named “Long (Great) Depression”. At the end of this process, Britain lost its leadership position in the economy.

1929 Great Depression: The Great Depression is the name given to the economic depression that started in 1929 and continued throughout the 1930s. The depression created destructive effects in the rest of the world (especially in the industrialized countries), despite the fact that it centers on North America and Europe. The 1929 Crisis was the cause of unemployment, economic contraction, and stagnation.

In the days of the outbreak of the crisis, the reason for the rapid sinking of the banks was that they traded in the New York stock exchange with the deposits they had collected. The New York stock market went down and the banks went bankrupt. There were also no legal measures to protect investors from fraud. The Securities Exchange Commission was founded after the crisis. In the same period, there were also disruptions in the real sector. The prevailing economic view was preparing a suitable ground for the formation of monopolies, which was proposed at the lowest level of economic intervention by the government. As a result, competition decreased and prices and production were affected, and also manipulations in the financial sector were experienced.

In this context, one of the reasons for the crisis was the excessive financial strength of the companies in America. In the 1870s, there were many large and small companies in America. Small companies had to merge in the face of the difficulties of World War I, and they formed a monopoly after the war. In 1929 the number of conglomerates controlling 50% of the American economy was only 200. This meant that even a single conglomerate bankruptcy would shake the whole economy. A second reason was that the banks were badly structured. There was no law governing the capital markets, reserves and credit ratios of banks. A third reason can be said to be the inexperience of the president Hoover administration in the economy.

A demonstration of government inexperience was the government’s insisting on adhering to the gold standard. The government refused to print money and followed a tight monetary policy, and economic activity ceased when the money was not available on the market, and the real sector shrank. This means more unemployment, less income. The last reason to be emphasized is that America was the major creditor of the world. In addition, he demanded that Germany and England pay the compensation they deserve after the First World War as gold. However, the gold stock in the world was inadequate, and the existing stock was already controlled by the USA.

Despite speculative danger warnings, many people believed that high price levels could remain unchanged. Shortly before the crisis economist Irving Fisher made a famous statement, “Stock prices have reached what looks like a permanently high plateau”. On October 29 1929, -also known as ‘The Black Tuesday’-, the price of shares went down for a full month at an unprecedented rate. With the collapse of 1929, the Roaring Twenties came to an end. With the collapse, wide-ranging and longterm problems began for the United States. The ambiguous environment also affected the job security of the employees. As American workers faced insecurity about their incomes, consumption also declined.

Declines in stock prices led to significant macroeconomic problems such as:

• diminishing credits,
• closure of workplaces,
• firing of workers,
• bankruptcy of banks,
• declining money supply,
• other economically detrimental events.

Crises After 1980

The world debt crisis emerged on 12 August 1982 when Mexico declared a moratorium. Following this incident, many developing countries, mainly Latin American

countries, declared moratorium and thus the world recognized the existence of the global debt crisis.

The effects of the crisis were the rise in interest rates, increase in recession in the economies and the sudden capital outflows. There were various solutions to the global debt crisis: Baker’s plan, Brady’s plan, legal and political regulations and debt-equity changes. Some of the debt crises from past to today are as follows:

• The crisis in Southeast Asia in 1990s,
• The Mexican crisis in 1994,
• The crisis in Russia in 1998 -which is a classic bad management crisis-,
• The crisis in Argentina in 2000,
• European debt crisis that started in Greece,
• Portugal and Ireland in 2010 and later included Italy and Spain.

1980 Global Debt Crisis: After World War II, emerging economies started to receive debts from the international market and a worldwide debt problem did not arise until the last quarter of the 1970s. But, since the last quarter of 1970s, especially in Latin American countries a debt problem arose. Shortly after that, an international debt crisis broke out. In 1982, Mexico declared that it had temporarily suspended its external debt service and thus triggered the global debt crisis. In this period, thirty-four underdeveloped countries could not fulfill their debt services.

There are some external and internal reasons behind this crisis. Among the external factors, there are international conjunctural changes, changes in international credit markets and fluctuations in exchange rates. First of all, the post-war positive economic conjecture began to reverse from the mid-1970s. The fixed exchange rate system introduced by the Bretton Woods system ended in 1971, and oil prices rose four times after the oil crisis. The second oil crisis made the debt service of oil-importing countries troublesome. From the beginning of the 1980s, a number of developing countries began to experience a debt crisis. The Mexican moratorium in August 1982 gave a start to the period which is called the “Debt Decade” in the economic literature. This country was followed by some other Latin American countries such as Brazil, Chile and Argentina, and some African countries.

2008-2009 Global Financial and Economic Crisis: In the aftermath of September 11 2001, due to the economic downturn in the US, the Central Bank reduced the interest rate, which was 6.5% in 2001 to 3% in 2003 to stimulate the country’s economy. As expected, this fall in interest rates also affected the interest rates applied to housing loans. Demand for this sector has increased significantly as low inflation rates and low interest rates reduced the cost of acquiring a house.

Increased demand has also led to an increase in housing prices. For example, a house worth 100,000 Dollars in 2000 reached at a value of 160,000 Dollars in 2007.

Increasing housing prices during this period have also made housing a major investment instrument. The ratio of house ownership, which was 64 percent in 2004, increased to 69.2 percent in 2006 due to speculative housing purchases. With the impact of low interest rates, financial institutions took more risks and started to market the mortgage loans for low-income households in order to earn more profits.

Another reason for this crisis was the lack of transparency. According to Mehrez and Kaufmann, if financial liberalization is accompanied with poor transparency, such a situation increases the probability of a financial crisis. As transparency increases, less financial crises occur.

Non-objective behaviors of the credit rating agencies were another factor that escalated the financial crisis. One of the most important examples of this was the conflict of interest between rating agencies and companies. Rating agencies that give credit notes to banks and other financial institutions are funded by these companies. Therefore, the ability of rating agencies to make objective assessments is diminishing. On the other hand, rating agencies are not always able to determine the financial problems of firms. Sometimes they can see the problem partly or very delayed.

Due to the reemergence of the financial crisis in the real economy, the global financial crisis had very severe results. The US fell into economic stagnation in December 2007. Growth ratesin both the developed world and developing countries also decreased. The global crisis significantly affected the unemployment rates. Especially in the US and developed economies, the upward trend was striking. The rise in inflation in 2007 and 2008 was not only due to the financial crisis. In this period, increases in oil and food prices led to significant inflationary effects. Especially in developing countries where energy demand was increasing, inflation rates increased rapidly.

The reason for the start of the crisis was that housing loans given with low interest rates, which were not paid back to the banks when the due dates came. important While the rise in housing prices was one of the most important reasons of the global financial crisis, the decline in housing prices was among the most important results of this crisis. In the US, since the beginning of 2007, housing prices have decreased significantly.

2010 European Sovereign Debt Crisis: The financial crisis which broke out in the US real estate market in the second half of 2007 became global crisis in 2008 with the bankruptcy of “Lehman Brothers” in September 2008. The crisis has brought a serious recession in the economies of almost all countries worldwide and finally in Europe. The global crisis resulted in serious increases in public deficits and debt stocks in European Union (EU) countries and became a threat of sustainability of public finances in many member states.

As a matter of fact, the debt crisis that broke out in Greece in the second quarter of 2010 threatened the future of other Eurozone countries and even the economic and monetary union in a short time. The fact that some member states, especially Germany, were reluctant to help Greece, caused panic in the markets and, as a result, the public finance and banking sector in Ireland, Portugal, Spain and Italy faced threats to drift into the debt crisis. Consequently, the debt crisis in Greece once again revealed the importance of effective and responsible debt management, especially for emerging economies.

Crises in Turkey

We can classify crises in Turkey as crises prior to 1990 and crises after 1990.

Crises Prior to 1990 in Turkey

In October 1929, a great economic crisis started in the US and affected all the world. During this era the financial industry did not exist in Turkey yet. Turkish economy was mainly based on the agricultural sector. Yet, at the advent of the 1929 great depression, the agricultural sector had collapsed due to taxes, primitiveness and the damage caused by the war. During the crisis, due to the intense imports of minorities and lowering prices of agricultural products, Turkey had a relatively high level of foreign trade deficit and the value of the Turkish lira decreased rapidly.

In this process, the public was encouraged to use domestic goods. Industry and agriculture congresses led by Atatürk were organized. Savings measures were taken. On 30 November 1930, the “Economic Depression Tax Law” was accepted. Due to the small number of domestic capitalists in the country and their insufficiency in private enterprises, large industrial investments led by the state were established via state capital without external loans and aimed to recover in the country. The country was able to get rid of the negative repercussions of the 1929 economic crisis with these actions and decisions.

In this context, between 1930-1939, the economic policies implemented in Turkey were based on protectionism and statism. It is also appropriate to describe these years as the first industrialization period. Indeed, the crisis of 1929 created an opportunity for industrialization for undeveloped countries.

1946 was a turning point for Turkish economy. In 1946, Turkish economy was no longer protectionist and independent, but it was an open economy, which depended on foreign credit. In 1946, the first big devaluation in the history of Turkey was carried out. This decision caused cost inflation to increase. Imports were increasing rapidly, thus the foreign trade deficit was also rising. There was a temporary recession and contraction in the markets. Industrial projects were adjourned. The Government ruled by Recep Peker resigned and it was replaced by Hasan Saka on 10 September, 1947. The economy was again in a bad condition in 1948.

In the early 1950s, climate conditions in the country made agriculture unfavorable. Thus, Turkey’s export ratio decreased because the country was an agricultural product exporter. The increase in the input prices of the products whose raw materials came from abroad also increased the prices in the domestic market. In addition to these reasons, the unplanned investments, the political conditions inside, the increase of the foreign debt burden and the public deficits caused the country to experience double-digit inflation. Also, the Korean War increased raw material prices in the world market. Therefore, the costs of the factories using imported input also increased. The increasing inflation with other negative conditions caused another crisis in 1954.

In 1958,Turkey’s external debt due was 256 million dollars. However, Turkey did not have the resources to pay the foreign debt. A foreign exchange crisis occurred in the country. Unemployment, budget deficit and foreign trade deficit grew. The factories in the country had come to the point of closure as they could not provide imported inputs. Turkey in August agreed to implement a stabilization program with the IMF practices. OECD, IMF and World Bank provided loans with suggestions. These suggestions were implemented immediately. The value of the Turkish Lira was reduced. The prices of the products of the state-owned enterprises in the domestic market were raised.

In 1964, foreign currency inflows from exports and transfers from workers’ abroad could not be realized due to the excessive value of TL. There was a short-term economic crisis in the country this year. The government contacted the IMF and implemented IMF policies.

The Arabic countries agreed to increase the price of oil dramatically in 1973. Foreign trade deficit increased. Additionally, tourism revenues decreased in that era as well. The government entered a foreign currency bottleneck. To overcome this bottleneck, high-interest loans were borrowed from the outside. With the help of temporary measures, the crisis was overcome. Turkey simply tried to postpone the negative effects of this crisis and achieved it Turkey’s debt, which was 1.8 billion dollars in 1970, increased to 10 billion dollars in 1977. In 1978, the share of short-term debts in total debt reached 52 percent. The crisis broke out in 1978. As a continuation of the above factors, the fact that OPEC countries increased their oil prices by 150% completely destroyed the economy. OPEC members increased oil prices by 150 percent for the second time in 1979 and 1980. Inflation and unemployment increased. As a result of all these developments, the 1980 transformation took place and a liberal economy was adopted. In 1986, there was another crisis because of the factors such as the economic imbalance due to the increase in public expenditures and the decrease in export revenues and workers’ remittances. In this period, tight monetary policy policies such as convenience to foreign capital, privatization and freedom in foreign exchange transactions were implemented.

Crises After 1990

Over-regulation policies implemented in the financial markets in the pre-1980 period left its place to the financial liberalization process and deregulation practices in the 1980s. The globalization trend that emerged as a result of the technological developments and liberalization movements caused financial markets to take on a more sensitive structure.

1994 and 1997-1998 Crises: The financial liberalization process, which began with the decisions of January 20, 1980, caused a major financial crisis in 1994 at the end of 14 years. There had been an increase in foreign capital inflows to Turkey together with the liberalization of capital movements since 1989. Short-term foreign trade balance deficits, public borrowing in need of funds and the increase of portfolio investments in pre-crisis years exhibited a significant increase. This increase in hot money inflows led the open positions of banks to grow.

During Turkey’s currency crisis in 1994, output fell 6 percent, inflation rose to threedigit levels, the Central Bank lost half of its reserves, and the exchange rate (against the U.S. dollar) depreciated by more than half in the first three months of the year.

Turkey overcame the crises in a short time thanks to the effects of the 1994 crisis stabilization programs. Foreign capital inflows recorded an accelerated increase in the period 1995-1997, and this increase was replaced by a decline after the Russian crisis that erupted in 1998. The main reasons for the 1994 and 1998 crises were:

• existence of the unsustainable debt burden in an economic atmosphere, where there was high and volatile inflation and unstable growth performance
• structural problems, especially financial markets, which could not be resolved permanently

November 2000 Crisis: The crisis of November 2000 was a financial system crisis and the main reason for this crisis was the banking sector. Banks’ attempts to close their open positions caused public and private banks to enter into borrowing rush. Turkey started to increase the risk premium on the borrowing rate in the external market, which made foreign borrowing difficult. In addition to the problems of the banking sector, the lack of trust in the stability program, which was implemented under the standby treaty signed with the IMF in 1999 with the main goal of reducing inflation, accelerated the process towards the November crisis.

February 2001 Crisis: The markets, which were already sensitive due to the November 2000 crisis, turned upside down with the speculative effects of the political crisis between the President and the Prime Minister. The pressure on the exchange rates increased because of the people attacking the TL positions in the November crisis. There was a severe foreign currency attack in February, and a 40 percent increase was observed in the dollar exchange rate of the first 10 days of the crisis.

In this process, Turkey experienced both an economic and financial crisis at the same time facing the due date of the debt rollover problems. The payments system collapsed and the securities and money markets transactions stopped, especially because the state banks could not fulfill their obligations in the money markets.

Regulations in the Financial Industry

The regulation of financial institutions has been growing rapidly in many countries due to the two main reasons. The first one is the expanding freedom of financial markets. The second cause of the proliferation of financial regulations is the regulation itself. If a regulation is imposed on a particular financial sector, sooner or later, there will be a necessity for regulation to be applied to other types of institutions whose activities compete with it in one way or another.

Moreover, the failure of existing forms of regulation to prevent institutional collapse, fraud or other abuse tends to generate a demand for still tighter control. Governments and central banks have tended to act on the assumption that the increasing freedom of financial markets must be accompanied by an increasing supervision of financial institutions.

Financial Regulations

Since we are faced with asymmetric information problems in financial markets, regulations became a fact of life. Regulation is concerned with changing the behaviour of regulated institutions. Regulatory frameworks in regarding financial institutions utilize:

Disclosure requirements (disclosure of financial statements and relevant information)

• Deposit insurance
• Capital requirements
• Supervision
• Assessment of risk management
• Restrictions on competition

The main objectives of imposing financial regulations are as follows

• to sustain systemic stability,
• to maintain the safety and soundness of financial institutions,
• to protect the consumers

International Financial Regulations

The Basel Committee - initially named the Committee on Banking Regulations and Supervisory Practices - was established by the central banks Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets. Basel Committee was established to enhance financial stability by improving the quality of banking

supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters.

Starting with the Basel Concordat, first issued in 1975 and revised several times, the Committee has established a series of international standards for bank regulation, most notably its landmark publications of the accords on capital adequacy which are commonly known as Basel I, Basel II and, most recently, Basel III.

Basel I: The 1988 Basel Capital Accord was a milestone. For the first time, supervisors in the main banking markets agreed on a definition of capital and a minimum requirement. This is often summarized in two ratios: Tier 1 capital must be at least 4% of risk-weighted assets and Tier 1 + Tier 2 capital must be at least 8% of risk-weighted assets.

Basel II: In response to the criticism of Basel I, to address the changes in the banking environment that the 1988 accord could not deal with effectively, and in response to the view that Basel I was becoming outdated, the BCBS decided to design and implement a new capital accord, Basel II. Unlike Basel I, which had one pillar, Basel II has three pillars:

• Minimum regulatory capital requirements;
• The supervisory review process;
• Market discipline through disclosure.

The proclaimed features of Basel II and its differences from Basel I are the following:

• Base lII includes a measurement framework for evaluating capital adequacy;
• Basel II is not only about capital adequacy, but also about improving risk management in the finance industry by providing the correct incentives for better corporate governance and fostering transparency;
• In Basel II, an explicit weight is assigned to operational risk;
• Basel II is more risk-sensitive than Basel 1;
• Basel II allows a greater use of internal models for risk assessment and the calculation of regulatory capital

Basel III: The global financial crisis of 2008 revealed very serious deficiencies not only in financial markets, but also the supervisory and regulatory environment at international level.This led to the Basel III Accord, which is considered as an extension to address the weaknesses of the Basel II and provide concrete and innovative solutions to the emerging challenges in the global banking industry and financial system as well. Basel III Accord released in December 2010, the new Basel Accord is expected to be a stringent reference in prudential regulation in the global banking system. Unlike the previous accords, Basel III introduced macro-prudential norms in banking regulation to handle systemic risk.