Explaining Twin Financial Crises

Many international financial crises of the 1980s and 1990s included both a massive devaluation and a collapse of the banking system – a phenomenon labelled ''twin crises''. A new report by Professor Itay Goldstein, published in the Economic Journal, shows how a banking crisis can happen just because creditors believe that a currency crisis is going to happen; and a currency crisis can happen just because speculators believe that a banking crisis is going to happen.
The report presents analysis that explains the twin crises phenomenon. The mechanism relies on two features that characterised emerging markets that experienced twin crises:
• First, governments held fixed exchange rate regimes or narrow exchange rate bands, which were vulnerable to speculative attacks.
• Second, domestic banks had a mismatch between foreign liabilities and domestic assets and were thus exposed to exchange rate risks. This basic set-up yields two effects that generate the twin crises phenomenon:
• First, a currency attack that yields depreciation of the exchange rate reduces the value of banks'' investments relative to the value of their liabilities. Knowing that, foreign creditors expect that banks will have fewer resources to pay their future liabilities, and thus find it more profitable to take their money out immediately – in other words, there is a run on the banks.
• Second, when foreign creditors run on domestic banks and pull their money out of the economy, they indirectly reduce the amount of foreign reserves held by the government. Then, the government faces a higher cost of defending the currency, and abandons the fixed exchange rate regime in most circumstances. This increases the incentive of speculators to attack the currency, as they know that the attack is more likely to succeed. As a result of these two effects, an increase in the probability of one type of crisis generates an increase in the probability of the other type. This yields a vicious cycle between the two types of crisis. The analysis shows that the vicious cycle has two interesting implications:
• First, it destabilises the economy: a banking crisis occurs just because creditors believe that a currency crisis is going to occur, and a currency crisis occurs just because speculators believe that a banking crisis is going to occur. In these cases, neither crisis should have occurred on its own. But both occur as a result of the complementarities between the banking sector and the currency market.
• Second, due to the vicious cycle, both crises become strongly connected to each other, and the result in many cases will be a perfect correlation between them: either both crises occur or neither of them does.

The report shows that twin crises are expected to be more frequent in financially liberalised emerging markets than in industrial economies and in developing economies that are not financially liberalised.

It also shows that in emerging markets, twin crises are expected to be more costly than regular banking and currency crises, but this is not necessarily the case in industrial countries. Finally, the analysis yields some interesting policy implications. In particular, a ''lender of last resort'' regime might not achieve its goal of preventing bank runs. This is because, when the government acts as a lender of last resort, it loses more reserves, and increases the probability of a currency crisis. Then, since a currency crisis increases the probability of a banking crisis, the result of a lender of last resort might be a higher probability of a banking crisis.

As a result, other policy measures that do not affect the reserves of the government, such as an international lender of last resort (the International Monetary Fund) or suspension of convertibility, may be preferable in the presence of spillovers between the banking sector and the currency market.

''Strategic Complementarities and the Twin Crises'' by Itay Goldstein is published in the April 2005 Economic Journal. The author is in the Department of Finance at the University of Pennsylvania.