Abstract

There have been four waves of banking crises since the early 1980s with each wave involving three, four or more countries. Each country that has experienced a banking crisis had previously experienced an economic boom, and an increase in cross-border investment inflow, which led to increases in the price of its currency and an increase in the price of securities. The pace of the investment inflow was too rapid to be sustained; when the inflow slowed, the price of the country’s currency and the price of securities declined, which triggered the banking crisis.

Banking crises occur when currencies are floating and when they are pegged; countries that are members of a monetary union have also had banking crises. The response to a surge in investment inflows when a currency is floating differs sharply from the response when a currency is pegged because adjustments must ensure that there is an induced increase in the country’s current account deficit that corresponds with the autonomous increase in its capital account surplus. The increase in the prices of securities and household wealth is an integral part of the adjustment process.

The booms initiated by the cross-border inflows lead to increases in the anticipated rates of return on investment, which leads to an acceleration of inflows – until the lenders suddenly realized that the borrowers’ are too extensively indebted.