Michael Hutchison & Kathleen Mcdill - Determinants, Costs, And Duration Of Bank Sector DistressPdf

This paper examines episodes of banking sector distress for a large sample of countries,highlighting the experience of Japan. We estimate a model that links the onset of bankingproblems to a set of macroeconomic variables and institutional characteristics. The modelpredicts a high probability of banking sector distress in Japan in the early 1990s, matching actualdevelopments closely, and suggests that the Japanese episode fits a well-established patterncharacterizing banking sector problems elsewhere. An empirical model explaining the outputcost of banking sector distress is also investigated. The results indicate that output loss issmaller the more quickly banking sector problems are resolved and when exchange...
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Michael Hutchison & Kathleen Mcdill - Determinants, Costs, And Duration Of Bank Sector DistressPdf Determinants, Costs, and Duration of Banking Sector Distress: The Japanese Experience in International Comparison October 8, 1998 Michael Hutchison and Kathleen McDill* Department of Economics Social Sciences 1 University of California, Santa Cruz Santa Cruz, CA 95064 USA email: hutch@cats.ucsc.edu AbstractThis paper examines episodes of banking sector distress for a large sample of countries,highlighting the experience of Japan. We estimate a model that links the onset of bankingproblems to a set of macroeconomic variables and institutional characteristics. The modelpredicts a high probability of banking sector distress in Japan in the early 1990s, matching actualdevelopments closely, and suggests that the Japanese episode fits a well-established patterncharacterizing banking sector problems elsewhere. An empirical model explaining the outputcost of banking sector distress is also investigated. The results indicate that output loss issmaller the more quickly banking sector problems are resolved and when exchange rate stabilityis maintained. Explicit deposit insurance also appears to lessen the output cost of banking sectordistress. The real output loss to Japan of not resolving banking sector problems is estimated atalmost 1 percent of GDP annually.The authors thank the UC Pacific Rim Research Program, the International Centre for the Studyof East Asian Development and the UCSC Committee on Research and Division of SocialSciences for financial support. This paper was prepared for presentation at the NBER-TCERJapan Project Meeting in Tokyo, October 29-30, 1998.1. Introduction Recent events in Japan and East Asia draw renewed attention to the many problemsassociated with financial sector distress— how quickly and unexpectedly crisis situations arise,disruption in credit channels, economic contraction, and the difficulty in designing effectivepolicy responses. Japan’ banking problem emerged gradually in the early 1990s and has since sattracted increasing attention, evidenced most recently (October 1998) when representatives ofthe Bank of Japan had a public row with the Ministry of Finance over measures of bank capitaland the extent of the non-performing loan problem. The general features of banking sector distress in Japan are by now well recognized (e.g.Cargill, Hutchison and Ito, 1997, 1998; Hutchison, 1997; OECD, 1998). In important ways theJapanese case resembles episodes of banking sector distress seen in many countries-- boomingeconomies and sharply rising asset prices, followed by recession, severe asset price decline andthe emergence of banking problems. The international character of the asset price boom, andsubsequent collapse, suggests common explanatory factors. This paper investigates the causes and consequences of banking sector distress in a largesample of countries, highlighting the special circumstances of the Japanese case. We reviewsome of the basic statistical characteristics of countries experiencing banking sector distress andtest several empirical propositions about the factors that affect the probability of having bankingproblems. In particular, we estimate a model that links the onset of 65 episodes of bankingsector distress to a set of macroeconomic variables and institutional characteristics. We employthis model to predict the likelihood of banking sector distress emerging in Japan, and investigatewhether this episode fits an internationally recognized pattern. We also seek to identify factors that influence the way economies respond to bankingsector distress. We focus on the “output cost” associated with episodes of banking sectordistress, i.e. the (present discounted value) loss in output that may be attributed to bankingproblems. Beyond controlling for the state of the business cycle, potential determinants of theoutput cost that we consider include institutional features, such as the existence of depositinsurance, and policy measures such as the speed at which the banking problem resolved. 2 Our major finding is that Japan’ banking crisis follows a pattern found in many other scountries, and formal tests do not distinguish Japan as a special case. Our model predicts thatJapan was particularly “vulnerable” to banking sector distress in the early 1990s. That is, themodel indicated that there was almost a 20 percent probability of banking sector distress inJapan in 1992 given the configuration of asset prices, credit conditions and other economicfactors prevailing at the time. The results also indicate that output loss associated with anepisode of banking sector distress is smaller the more quickly banking sector problems areresolved and when exchange rate stability is maintained. Explicit deposit insurance also appearsto lessen the output cost of banking sector distress. The real output loss to Japan of notresolving banking sector problems is estimated at almost 1 percent of GDP annually. The mainfactor distinguishing Japan from other countries is the slow and poorly designed policy responseby the Japanese government to resolve the country’ financial crisis. s In the next section, Section 2, we briefly review the theoretical and empirical literature onfinancial and banking sector distress. In sec ...