Banks are highly leveraged institutions and are at the center of the credit intermediation process. In addition, credit and maturity transformation functions are vulnerable to liquidity runs and loss of confidence. A destabilised banking system affects the provision of credit and liquidity to the broader economy and ultimately leads to lost economic output.
The costs of banking crises are extremely high but, unfortunately, the frequency has been as well. Since 1985, there have been over 30 banking crises in Basel Committee-member countries. Roughly, this corresponds to a 5% probability of a Basel Committee member country facing a crisis in any given year – a one in 20 chance, which is unacceptably high. There tend to be a common set of features that seem to repeat themselves in various combinations from banking crisis to banking crisis. These include:
- Excess liquidity chasing yields
- Too much credit and weak underwriting standards
- Underpricing of risk, and
- Excess leverage
In the recent crisis, these recurring trends were magnified by:
- Weak bank governance practices, including in the area of compensation
- Poor transparency of the risks at financial institutions and in complex products
- Risk management and supervision focused on individual institutions instead of also at the system level
- Procyclicality of financial markets propagated through a variety of channels, and
- Moral hazard from too-big-too-fail, interconnected financial institutions.