These notes form a short extract from the forthcoming monograph by John Crean and Frank Milne, The Anatomy of Systemic Risk, (2017a); and a shorter working paper, The Foundations of Systemic Risk (2017b).

By Frank Milne, Queen’s University

There are many historical financial crises that resemble the recent crisis of 2007-9. Crean and Milne provide a summary of various banking crises, discuss their similarities, provide a theory integrating their observations and examine the implications for Risk Management systems and financial regulation.

Here we will restrict our discussion to two major banking crises that should be of interest for Canadians. There are clear parallels with current Canadian banking and regulatory risks. We will draw some conclusions that are supported by the Crean-Milne framework.

The first example is the Australian Banking Crisis of the 1890s, and the second example is the Texas Banking Crisis of 1980-89.

What can we learn from these examples? Are there common elements that can be used in constructing a general theory and approach to apply to financial risk management and regulatory systems? In summary, here are the key ingredients for creating major banking credit risks:

In summary, here are the key ingredients for creating major banking credit risks:

1. An industry with high fixed costs and low marginal costs.
2. The industry has competitive pricing so that major falls in demand lead to over-capacity, major declines in output prices and a collapse in profits.
3. The industries described in 1 and 2 have large bank borrowing. This borrowing may be direct or indirect through credit instruments and derivatives.
4. Major declines in SIRS demand infrequently occur so that high-frequency data over moderate time periods will not reveal the downside risks.

Examples of such industries are Real Estate, Commercial Real Estate, Shipping, Auto Manufacturing, Mining, Oil, and Gas.

We refer to the risks associated with these industries as Strategic Industry Risks (SIRS). When a SIRS industry suffers a major decline in demand for its product, prices fall, profits plummet, and investment collapses. The industry struggles to pay its loans, and there is increased default risk. Banks with major exposures to the SIRS industry suffer severe credit losses, and some of these banks fail. The bank failures can appear via contagion through the interbank market. But even with no interbank market, banks that have similar SIRS exposures can fail. These properties can be illustrated in a variety of historical examples. Here will limit our discussion to two examples.

The Australian Banking Crisis of the 1890’s.

Australia was colonized by the British in the late 18^th Century, beginning as a penal colony. Agricultural land attracted moderate population growth from immigration. But starting in the 1850s Australia (especially the colony of Victoria) experienced very rapid development. Major gold discoveries in 1851 precipitated a major gold rush, a large increase in immigration, leading to the rapid construction of major gold mining centers in Ballarat and Bendigo. Given the continuing rapid expansion of wool and wheat exports, the country experienced a prolonged major economic boom. Exports helped finance imports of machinery and consumer goods.

Colonial Populations (thousands), 1851-1911

	Australia	NSW	Victoria	Sydney	Melbourne
1851	257	100	46	54	29
1861	669	198	328	96	125
1891	1704	608	598	400	473

 

By the mid-1880s, Australia was estimated to have the highest GDP/capita in the world. But there were clear signs that the boom had created significant downside risks. The mature gold mines faced increasing costs of extraction and squeezed profits. Wheat and wool production had expanded rapidly into marginal lands. Major droughts in the later 1880’s sharply reduced production and profits. Increased supply coming from Canada and the US lead to declines in international commodity prices. Melbourne was a major port for the booming Victorian colony, so as the real economy (SIRS) plateaued and then declined, export returns and profits fell. In turn, this impacted Melbourne wholesale and retail revenue, and real estate prices.

Heavy Victorian government borrowing from London was required to finance a significant expansion of the railroad system. Coupled with the railroad expansion was a Melbourne real estate boom, financed by local banks, who borrowed heavily from London.  There was an influx of new banks and quasi-banks with limited banking experience. As one experienced Australian Banker observed:

“In Melbourne more particularly the spirit of speculation ran mad, and financiers and adventurers of every kind had a regular carnival of dissipation with other people’s money: obtained with too little difficulty from the Melbourne banks many of which, unfortunately for themselves and the country, were driven into advancing on unimproved land, yielding no income, and dead securities of all kinds by the keen competition that existed between them.” (Cork 1893)

By the early 1890s, the Victorian/Melbourne economic boom went into reverse as the underlying SIRS economy declined. Profits and capital values fell and bank credit losses mounted. Several Melbourne banks became insolvent. There was a banking panic as credit losses created contagion. Accusations of fraud and corruption, including political corruption, were commonplace.

Subsequently, the banks were recapitalized with shareholders and creditors taking heavy losses. It took two decades for Victoria to recover from this major economic and financial crisis.

The Texas Banking Crisis of 1980-89

In the early 1970’s the Organization of the Petroleum Exporting Countries (OPEC) reduced output, driving up oil prices. As the following table makes clear, the price of oil rose 12 times in 8 years.

October 1973:   $3   per barrel
January 1974:   $12 per barrel
April 1981:       $37 per barrel

The oil producing Texas economy boomed as oil drilling expanded dramatically in the late 1970’s and early 1980’s.

Active oil rigs in the US early 1970’s:               1,000.
Texas 1981 active oil rigs:                                 4,000.

Drilling expenditure in Texas:

1979:        $16.5 billion
1981:         $38 billion

As the 1980s progressed, there was a rapid expansion in international oil production capacity and output. A consequence was that the OPEC cartel collapsed, with a sustained decline in oil prices. By August 1986, the price of oil had fallen to $10 per barrel, and oil drilling activity declined precipitously.

Given the collapse in the oil industry, Texas housing and commercial real estate construction activity declined, and so did their real estate prices. Texas Banks had lent heavily in the boom to the oil industry and real estate. There had been a sharp increase in numbers of small banks, which lent aggressively on real estate.

Annual number of new Chartered Banks:

1980:         35
1983:       131
1989:           0

The peak was in 1983.

Many bankers were surprised when oil prices fell. Oil drilling and related firms begin to fail and default. Housing construction went into decline, and real estate prices collapsed by 23%. Builders failed and bank credit losses mounted. Commercial real estate had severe credit losses

Texas bank failures:

1983:            3 banks
1988:         175 banks
1989:         134 banks

A Federal Deposit Insurance Corporation study (FDIC (1997)) observed that healthy equity cushions did not save many banks as the credit losses were so severe:

“… although extraordinary events such as the oil price crash in late 1985 and 1986 and the southwestern real estate debacle are difficult if not impossible to predict, nevertheless the euphoric attitude among many southwestern bankers was highly conducive to critical errors in judgment. The simplest lesson that can be learned from the story of the banking collapse in the Southwest is that obvious excesses, in both expectations and competitive behavior, have the potential to cause serious problems, no matter how favorable a situation may seem at the time.”

Conclusion

Most Bank Crises emerge from a real economy boom – bust cycle. Careful analyses of these events reveal that they originated as severe credit events in industries that had SIRS characteristics. Often the insolvent SIRS are regional industries, impacting regional creditors and then spreading via lenders located further afield. We also include credit instruments in our theory so the losses can impact international creditors.

Our theory has important implications for financial sector prudential and regulatory policies. Because the major SIRS credit events occur spasmodically, standard statistical and econometric models can be misleading in not warning of serious downside risks. A more useful tool is to use system-wide stress tests focusing on the worst case plausible downside for SIRS exposures. We develop these arguments in detail in Crean and Milne (2017a and 2017b).