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Working Paper 190 - Early Warning Systems and Systemic Banking Crises in Low Income Countries: A Multinomial Logit Approach
23/12/2013 16:15
Working Paper 190 - Early Warning Systems and Systemic Banking Crises in Low Income Countries: A Multinomial Logit Approach
The global financial crisis has stimulated new interest in models aimed at providing early warning about the risk of a systemic banking crisis based on early warning systems (EWSs). While most of the focus has been on advanced economies; which have been at the epicenter of the recent turmoil, the relevant empirical literature has devoted inadequate attention to low income countries (LICs). This paper aims at filling this gap by building an early warning system (EWS) for predicting systemic banking crises in LICs. Our contribution to the literature is twofold. The first and more obvious is to build a body of literature on LICs and banking crises in Sub-Saharan Africa (SSA). The second contribution is methodological and refers to the use of the multinomial logit model in EWS, which is shown to improve upon the widely-used binomial model in terms of number of crises correctly called and number of false alarms produced. This paper estimates an EWS for predicting systemic banking crises in a sample of 35 low income countries in Sub-Saharan Africa. Since the average duration of crises in this sample of countries is longer than one year, the predictive performance of standard binomial logit models is likely to be hampered by the ‘crisis duration bias’. The bias arises from the decision to either treat crisis years after the onset of a crisis as non-crisis years or remove them altogether from the model. To overcome this potential drawback, we propose a multinomial logit approach, which is shown to improve the predictive power compared to the binomial logit model. The results of the study show that banking systems in SSA LICs are more likely to collapse when economic growth declines two years prior to the crisis. Undiversified economies contribute to a build-up of banks’ exposures to a few sectors and customers so that credit risk is magnified during an economic downturn. Sectoral concentration of loans ranges from 50-70 percent in SSA LICs, with the majority of loans being provided to just one or two economic sectors. Such undiversified banking systems are more vulnerable to sector-specific shocks, which exert pressure on bank profitability and solvency with a time lag due to the provisioning rules that tend to delay recognition of losses. The paper also shows that banking systems that engage in excessive credit activity relative to the deposit base one year before a crisis are more likely to experience sustained systemic crises. Banks in SSA LICs tend to rely heavily on volatile customer deposits for funding. In particular, checking accounts, which are typically perceived as the most unstable category of deposits, represent the bulk of total deposits in many countries. On the other hand, savings accounts, which are normally a stable source of funding for banks in advanced economies, exhibit a relatively high turnover in SSA LICs due to the low income of most depositors. Liquidity risk in SSA LICs’ banking system is exacerbated by the high degree of dollarization which characterizes these economies. The findings also indicate that banking systems that are characterized by excessive direct FX risk through currency mismatches between the value of their assets and liabilities are more likely to experience a distress; especially one year prior to the crisis. In SSA LICs, rapid fluctuations of the exchange rate, which often reflect thin FX markets, expose commercial banks to potentially sizeable losses, threatening the soundness and the stability of the banking system. Exposure to direct FX risk is intensified by the absence of derivatives markets, which limit hedging opportunities. Both the liquidity position and the currency mismatch of the banking system deteriorate once a crisis occurs due to a generalized loss of confidence and pressures on the exchange rate. Moreover, we find that negative credit growth and high banking system capitalization are associated with the crisis regime relative to tranquil times. Credit growth indicates that a credit crunch increases the likelihood of remaining in a state of crisis; on the other hand, a positive and significant coefficient for leverage is a sign that the recapitalization of banks lowers the probability of remaining in a crisis. The results have important policy implications at a time when financial regulators and central banks in SSA LICs are reassessing their financial regulatory agenda in the context of recent reforms spurred by the global financial crisis. In particular, the findings underscore the importance of implementing an effective macro-prudential framework for monitoring systemic risk arising out of credit concentrations as well as from maturity and currency mismatches. Many LICs in SSA already use a number of tools which are now considered of macro-prudential nature such as reserve requirements, caps on FX positions and limits on loan concentration. With a history of recurrent banking crises arising from specificities of their economies and financial markets, several SSA LICs have adopted financial regulations beyond traditional capital adequacy rules. Nevertheless, most countries do not have a macro-prudential framework in place and often regulators have no explicit objective to prevent the build-up of systemic risk.Read more
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