Financial Distress and Bank Failure: Relevance for Islamic BanksThe role of bank customers (depositors and clients) is also important.
However, being large in number their decisions are not coordinated (except
in situations of panics and mania when actions get coordinated in the form of
a herd behaviour) therefore, for the time being we can abstract away from the
role of bank customers as cause of banking crisis.
- Macroeconomic Situation and the shocks that emerge in the
economy outside the banking sector can be one cause of financial crisis. For
example, a large and persistent current account deficit in a country can give
rise to depreciation of its currency. If most of the liabilities of the banking
sector are in foreign exchange or if the banks cannot adjust their liability—
asset structure as fast as the home currency is depreciating, then the costs of
carrying such portfolio increases eventually putting the banks in financial
distress and can possibly trigger a financial crisis.
Such crisis originating through currency risk are more likely in countries
with fixed or pegged exchange rate regimes if they ever face a sudden flight
of capital. The central bank of such a country would have to support the
home currency by depleting its foreign exchange reserves. Its inability to
support the home currency would call for a sharp devaluation of the home
currency. It can cause financial problems for the banks because they cannot
adjust their portfolios that sharply and quickly.
In third world countries, excessive borrowing by the government creates
an unsustainable financial position of the government. Therefore, sudden
policy shifts take place by the government in its effort to survive or float the
economy. Such sudden shifts change the explicit and implicit (effective)
relative prices creating economic and financial squeeze in various sectors. If
the bank is particularly exposed to one or more such sectors this can result in
financial distress for the bank. Examples of such abrupt policy shifts are a
sudden decision to privatize state owned enterprises in response to meet the
conditionality for financing facilities from IMF.
Changes in macroeconomic conditions can be viewed as change in the
structure and rules of the game. Therefore a portfolio strategy of a bank that
was optimal under one situation no longer remains an equilibrium strategy
after the change in government policies or change in macroeconomic
conditions. Unless the environment changes slowly, the position of banks
become precarious and the set of feasible strategies of the bank may not even
be sufficient to avoid financial distress.
Theories of credit cycles that accompany economic cycles and operate
through pro-cyclic movements in the value of collateral and thus extenuate