ABSTRACT
Bank risks are inherently cyclical. As financial intermediaries, banks are exposed to different types of risk such as credit and interest rate risk. Since the underlying sources of these risks are closely connected to the business cycle, bank health is related to the economic conditions in which they operate. Banking crises, or significant deteriorations in overall bank health, typically occur in economic downturns. For a large sample of developed and developing countries, Kaminsky and Reinhart (1999) show that banking crises occur as the economy enters into a recession, often following a prolonged boom in economic activity fueled by increased bank lending. However, while financial crises have often been preceded by sharp fluctuations in the macroeconomy and in asset prices, it would be a mistake to seek their origin exclusively in macroeconomic instability. While macroeconomic conditions may often be the proximate cause, banking problems usually emerge because of existing weaknesses in the banking system that have taken some time to build up (Llewellyn, 2002). In Europe, the typical example is the Scandinavian banking crisis in the early 1990s caused by a combination of imprudent lending and asset price collapses. An analysis of the time profile of bank risks in the Scandinavian banking crisis reveals that risks were gradually building up in the overlapping periods of financial liberalization, intensified competition, changing macroeconomic conditions, resulting in the ultimate banking crisis (Hyytinen, 2002). Moreover, while banking crises are often caused by an economic downturn, they may also amplify the recession. In most cases, banking crises are associated with a significant decline of real activity, sometimes caused by a credit crunch. As the profitability of financial institutions declines and confidence wanes, financial institutions tend to seek higher rewards for risk-taking or even withdraw from such activity altogether. Rising risk aversion or a crisis of confidence can have pronounced adverse effects on the real economy especially when the capital base of financial institutions has been eroded. The propagation mechanism results in falling bank loans and generates persistent declines in aggregate investment and output (Chen, 2001).
