**2. The origins of currency and banking crises**

The models to explain the origin of currency and banking crises can be divided into three groups. The first group discusses the rational expectations of investors as the source of crises. According to this model, investors always observe the risk in their investments and act rationally. Thus, a bad macroeconomy fundamental or ineffective policy actions may trigger currency attacks or bank runs [2, 3].

The second group shows that a crisis can still occur at a good time. In this model, a crisis can be triggered by a random panic that influences investors' behaviour to massively convert their assets, thus, the crisis is self-fulfilling [4, 5].

The last group explains that a crisis can also arise in the non-existence of panic at a good time. Following this model, a crisis in other places can spread through the financial market and creates a twin currency and banking crisis [6, 7].

Interestingly, the development of the currency crisis models has gone in the opposite direction to the banking crises development. The first generation model of the crises suggests that a currency crisis stem from rational actions of investor (the speculative attack model) and a banking crisis stem from a panic attack (the random withdrawal model). On the other hand, the second-generation models of the crises argue that a currency crisis is originated from a panic attack (the self-fulfilling prophecy model) and a banking crisis is originated from a ration action (the information-based bank runs).

#### **2.1 The rational acts as the source of currency and banking crises**

The rational acts as the source of currency and banking crises can be divided into two groups. In the currency crises model, the speculative attack model argues that investors always doubt the government's ability to manage a fixed exchange rate when there is a current account deficit. When the foreign reserve is drying up to keep the exchange rate fixed, investors will attack the currency, leading to the breakdown of the fixed exchange rate regime. On the other hand, in the banking crises model, the information-based model shows that negative results in investors' risk assessment of bank portfolios may influence a bank run and create a banking crisis.

#### *2.1.1 Speculative attack on the currency*

The speculative attack model shows that investors undertake an attack if they doubt the government's capacity to keep the exchange rate fixed. Specifically, this condition occurs when the continuation of the current account deficit leads to a decline in foreign exchange reserves. As a result, the speculative attack causes the remaining reserves to move to investors, thus negatively affecting the currency [2, 8, 9].

*Currency and Banking Crises: The Origins and How to Identify Them DOI: http://dx.doi.org/10.5772/intechopen.107245*

The main contribution of the model is the idea that the speculative attack on the currency stems from a rational act rather than from investors' panic. This model succeeded in explaining the currency crisis in Latin America just a few years after it was developed, prompting researchers to examine currency crises as rational events.

The model can be explained as follow. Let us recall the domestic money market equilibrium:

$$m \text{--} p = -a(i), a > 0 \tag{1}$$

Where *m* is the money supply, *p* is the price level, and *i* is the interest rate.

The money supply is calculated based on credit (*d*) and foreign reserves (*r*), therefore:

$$m = d + r \tag{2}$$

Assuming purchasing power parity holds, we can restate the price level (*p*) as a fraction of the foreign price level (*p\**) and the exchange rate (*s*), as follows:

$$p = p^\* + s \tag{3}$$

Imposing uncovered interest rate parity, we can substitute the interest rate (*i*) with the foreign currency interest rate (*i\**) and the change in the exchange rate (*Δs*), as follows:

$$
\dot{a} = \dot{\imath}^\* + \Delta \mathfrak{s} \tag{4}
$$

In a fixed exchange rate regime, where *s* is equal to the future exchange rate (*s e* ), it implies that *Δs* = 0 and *i* = *i\**. By substituting Eqs. (2)–(4) into Eq. (1) with *Δs* = 0, it follows that:

$$r + d \! \! \! \! - p \! \! \! \! \/ \! \! \/ \! \/ \! \/ \! \/ \/ \! \/ \/ \/ \/ \/ \/ \/ \tag{5}$$

Therefore, in a fixed exchange rate regime (assuming foreign currency interest rate and foreign price level are fixed), the credit grows at the same rate as the fall of the foreign reserve (*Δd =* �*Δr*). In the end, the foreign reserve will run out and force central banks to break the fixed exchange rate regime. Thus, the change in exchange rate policy will lead to speculative attacks which in turn lead to a crisis.

#### *2.1.2 Information-based bank run*

The information-based bank run model argues that the bank run is a logical consequence of a rational change of risk in bank portfolios [3].

In the model, there are three periods (T = 0, 1, 2) where agents have one shortterm investment from T = 0 to T = 1 and one long-term investment from T = 0 to T = 2. All agents are identical at T = 0. The model imposes three assumptions: first, agents will adjust their preferences based on information on T = 1. Second, the returns on long-term investments are random. Third, long-term investment yields a zero payoff if liquidated at T = 1. Since there is no information about the returns of longterm investments, agents always observe their investments based on newly available

information. If agents believe that the bank portfolio is at risk based on the latest available information, agents will withdraw their deposit. Consequently, the bank runs are information-based.

Information-based models view banks as providers of a valuable service (by creating non-marketable bank loans) rather than providers of liquidity insurance. However, non-marketable loans in the bank portfolio are difficult to monitor, thus creating asymmetric information between banks and agents.

Furthermore, agents with no interim information cannot observe the real value of a bank, thus they learn about a bank's condition by observing other depositors. However, agents cannot distinguish whether the source of withdrawal is for consumption needs or a run by informed depositors. Therefore, risk-averse agents could assume the worst-case scenario which leads to panic [10]. In addition, a noisy signal and asymmetric information between agents could lead to bank run even when the fundamentals are good enough [11].

A bank run could be efficient since there is risk-sharing between agents. However, the liquidation cost would make a bank run becomes inefficient, so central banks should intervene to control the liquidation cost [12].

Furthermore, as banks are aware that some agents receive interim information and understand the implications of different types of contracts, thus a little change in the contract will discourage agents to conduct a bank run. However, different types of a contract will have different utilities, and banks, on purpose, sometimes would choose a contract that allows a bank run [13]. Furthermore, as the information-based bank runs stem from an asymmetric information, encouraging banks to regularly publish their financial report and a statement from a credible bank supervisor may reduce the risk of bank runs.

#### **2.2 Panics as the source of currency and banking crises**

Panics as the source of currency and banking crises can be divided into two groups. In the currency crises model, the self-fulfilling prophecy model argues that the herd behaviour of investors may cause panic and lead to the withdrawal of assets. As a result, the exchange rate tends to depreciate and translates into a crisis. On the other hand, in the banking crises model, the random withdrawal model shows that depositors can do a bank run due to random events because of the lack of information held by the depositors. When there is a massive bank run, most banks will suffer from liquidity problems since banks heavily invest in long-term illiquid assets which are costly to liquidate.

#### *2.2.1 Self-fulfilling prophecy on the exchange market*

The self-fulfilling prophecy model shows that herd behaviour of investors may cause panic and lead to the withdrawal of assets. As a result, the exchange rate tends to depreciate and translates into a crisis [4].

In this model, investors' actions rely on the sequential observation of other investors' actions. If an investor observes that many other investors sell the currency, then the investor will join the herd despite his own information. Thus, the equilibrium will move from no-attack to attack equilibrium [14].

Furthermore, a lack of information between investors can also lead to an attack and breakdown of the fixed exchange rate even though there is no coordinated action between investors [15]. In this example, investors always observe the state of the

economy and consider other investors' beliefs on the sustainability of a fixed exchange rate. Assuming other investors believe that the fixed exchange rate is unsustainable, investors will launch an attack if the cost of the attack is not too costly.

On the other hand, globalisation creates many investors who have identical decisions in selecting their portfolios. Driven by relative performance to other investors' performances, investors select the same portfolio with other investors to match their performances and create herding behaviour which leads to attack equilibrium [16].

The model can be explained by imposing a conditional shift in domestic credit growth into the speculative attack model [9], where the growth is *G0* if there is no attack, while credit grows faster at *G1* if there is an attack.

**Figure 1** simulates the attack on conditional policy shift. *S0\** and *S1\** represent "shadow exchange rate lines" correlating to the rate of credit growth at *G0* and *G1* respectively. *Sf* is a fixed exchange rate that intersects with shadow exchange rate line *S0\** at point *A* and shadow exchange rate line *S1\** at point *C*.

Assuming "domestic credit" (*G*) is at the left side of point *GB* (*G* ≤ *G<sup>B</sup>* ), "the shadow rate" is at point *B* if there is no attack and jumps to point *C* if there is an attack. In this simulation, the "shadow rates" (*S\**) are always below (or maximum at) the fixed exchange rate (*S\** ≤ *Sf*), thus giving no incentives to speculators to attack the fixed exchange rate.

Multiple equilibria can occur when "domestic credit" is in the range between *G<sup>A</sup>* and *G<sup>B</sup>* . The fixed exchange rate could be maintained if investors believe there is no chance to overcome the government (there is no immediate benefit). On the contrary, the "exchange rate" could shift to the upper "shadow rate line" (*S1\**) if investors believe there will be an attack on the currency which leads to a breakdown of the fixed exchange rate. Consequently, all investors will sell domestic currency, leading to a collapse of the fixed exchange rate. However, there are multiple equilibria in this condition since the attack can only be succeeded if there is a large investor or coordinated action of small investors to launch an attack of sufficient size.

The drawback of the self-fulfilling model is the fact that the model implies the difficulty of predicting currency crises. It implies that policymakers have a limited

**Figure 1.** *Self-fulfilling prophecy with attack equilibrium.*

role in managing the exchange rate since the triggers of currency crises are unclear, thus, they are difficult to forecast. However, as the attack can only succeed within a specific range of fundamentals, therefore, the policy maker can manage currency crises by managing the fundamentals [17].

### *2.2.2 Random withdrawal on the banking system*

The random withdrawal model shows that depositors can do a bank run due to random events because of the lack of information held by the depositors. When there is a massive bank run, most banks will fail since banks heavily invest in loans that are costly to liquidate [5].

Influenced by the first-come-first-served rule, panic could occur when depositors think there will be a bank run, thus agents will try to withdraw their deposit as soon as possible before the bank collapses. Therefore, panic is self-fulfilling. Mervyn King, former Governor of the Bank of England, once said "it may not be rational to start a bank run, but it is rational to participate in one once it had started". However, panic could be avoided if banks do not follow the first-come-first-served rule. Panic will lead to expensive liquidation costs and therefore can only occur when agents are riskaverse [18].

Since the first-come-first-served rule is an essential ingredient for a bank run, eliminating this rule will also eliminate the possibility of a bank run. As an alternative to this rule, suspension of deposit convertibility in the event of a bank run [5] and variation of contracts to accommodate the possibility of a bank run (an allow-bank run contract and a run-proof contract) [18] could be considered.

Furthermore, panic could occur because the institutional structure fails to provide liquidity [19]. To avoid panic, separated-local banks will prevent agents from conducting coordinated withdrawals. Problems in separated-local banks should be addressed by a local reserve bank. Therefore, panic is related to an institutional structure in the banking system when liquidity fails to be provided. However, panic could be avoided if banks can perform an interbank loan market. Furthermore, in order to prevent panic, policymakers should force separated-local banks to hold adequate reserves [20].

In the random withdrawal model, agents use the bank as insurance against risk to cover the uncertainty of consumption needs. To do this, banks provide liquidity and guarantee when agents liquidate their investments before maturity. In doing so, banks can increase welfare but are exposed to risk. Thus, they create the possibility of a selffulfilling bank run.

The model has three periods (T = 0, 1, 2) where agents have one short-term investment from T = 0 to T = 1 and one long-term investment from T = 0 to T = 2. All agents are identical at T = 0 and learn their type at T = 1: being a type 1 agent or being a type 2 agent who cares only about consumption in T = 1 or T = 2, respectively. The salvage value of the long-term investment is equal to the initial investment if it is interrupted at T = 1.

There are two important assumptions in the model which can lead to bank panic: agents cannot claim physical assets in exchange for their deposit, and deposit withdrawals follow the first-come-first-served rule. Based on these assumptions, there will be two equilibriums: good equilibrium occurs when type 1 agents withdraw their deposit at T = 1 and type 2 agents withdraw at T = 2, and bad equilibrium occurs when there is panic. As the liquidation of a bank's long-term assets is costly, thus, a bank will not survive if all deposits are withdrawn at once.

### **2.3 The contagion effects as the source of currency and banking crises**

The contagion effects as the source of currency and banking crises can be divided into two groups. In the first model, the systemic risk model argues that a bank failure can create a systemic failure in the banking system through the money market. In the second model, the twin crisis model discusses how a currency crisis translates into a banking crisis or vice versa.

#### *2.3.1 Systemic risk in banking system*

The systemic risk model focuses on the propagation of a failure in one bank to other banks through financial transactions. Based on this model, interbank lending can overcome the moral hazard problem between the bank owner and depositors due to the supervision of peer banks. However, interbank lending also increases the risk of contagion for banks [6].

An interbank money market has a central role in developing systemic risk. If an interbank money market cannot support one illiquid bank, a systemic bank run may occur since agents may assume that there is not enough liquidity in the banking system. However, a problem in one bank is not sufficient to create panic. It can only be systemic when the problem occurs in a time of economic instability [21]. In addition, even though agents of one specific bank can have interim information; they do not have access to the interim information of other banks. Therefore, they will observe the number of bank failures as a proxy of interim information about macroeconomic conditions and other banks' performance. In this sense, agents may conduct a bank run if they observe there are some bank failures [22].

One strand of study of systemic risk focuses on uncertainty over liquidity demand. Since agents are uncertain about where they want to consume, banks face the risk of withdrawal and the transference of agents' deposits to other areas. To address this problem, banks create an interbank money market, thus there is no need to liquidate their long-term investments to meet agents' cash demands. However, an interbank money market could make contagious bank failures when there is a gridlock in the payment system. Therefore, agents could panic when they fear there is no sufficient reserve among banks [23]. Furthermore, the interbank money market grows because of different liquidity shortages across regions. In this sense, the spread of contagion is influenced by types of claims in the interbank money market [24].

Another view of systemic risk studies the role of the unregulated banking system on systemic risk [25]. The study focuses on claims that bank failures are influenced by safety-net regulations, thus minimal regulatory intervention is required to regain financial stability. While financial market arrangement by a private institution (e.g. clearing house) is more efficient in preventing systemic shocks, a global liquidity shortage that triggers contagious runs may break down the arrangement. Therefore, an unregulated banking system is not immune to systemic risk.

#### *2.3.2 Twin currency and banking crises*

The linkages between the twin currency and banking crises are still ambiguous. It is hard to identify whether it is started by a currency or banking crisis for two reasons: First, banking and currency crises are sometimes driven by common factors [26]. Second, the currency attack and the bank run reinforced each other in a vicious circle [27].

The twin currency and banking crises model shows that the link between a currency and banking crisis lies in a problem for both foreign and domestic currency liquidity [7]. Investors start to attack the currency, either because of economic fundamentals or panic. Currency starts to depreciate and the pressure in the exchange market increases. To fund the attack, investors remove their money from banks and create pressure in the money market that can create a currency and banking crisis.

On the other hand, investors could also attack the bank, either because of random events or information-based. The cash is then used to attack the currency. To avoid sharp depreciation of the currency, the central bank starts intervening by selling foreign reserves and buying domestic currency. The money supply is contracted and pressure in the money market becomes higher. Banks start to have liquidity problems [28].

Investors will observe the central bank's capability to intervene and decide whether to continue the attack. Investors will attack the currency if the central bank indicates its defence of the currency in limited foreign reserve. However, if the central bank decides to allow the currency to depreciate, negative news and fear of depreciation may create panic and a self-fulfilling prophecy.

The central bank's intervention ceases when there is insufficient foreign reserve to sell or there is a lack of domestic currency to be bought, which then leads to a sharp depreciation of the currency. Indeed, the central bank could sterilise the intervention by buying domestic bonds. However, in many cases, the amount of available liquid and high-quality bonds is relatively limited compared to the value of an intervention (**Figure 2**).

**Figure 2.** *Relationship between currency and banking crises.*

#### *Currency and Banking Crises: The Origins and How to Identify Them DOI: http://dx.doi.org/10.5772/intechopen.107245*

Due to the low value of the domestic currency (and the fall of financial asset prices), demand for the domestic currency to buy foreign currency is doubled. There is a liquidity shortage in the money market which leads to a high-interest rate. Some banks will have liquidity problems and become failed banks.

Furthermore, the second-round effect of currency depreciation starts to affect banks that are exposed to foreign liabilities [29]. Some banks have currency mismatches. The third round effect affects the bank's debtors which leads to an increase in domestic and foreign currency non-performance loans (NPL). In addition, banks with foreign debt suffer from the increase in the cost of borrowing. Finally, both banks with and without foreign liabilities suffer from losses and have liquidity and insolvency problems.

The model shows that a successful intervention by the central bank may still lead to a banking crisis through the liquidity shortage channel. Furthermore, a successful attack on currency could lead to a banking crisis in two channels: on the one hand, sharp currency depreciation directly creates a currency mismatch for banks with foreign liquidity exposure. On the other hand, sharp currency depreciation affects the economy and decreases debtors' financial performance which leads to increasing NPL both for domestic and foreign currency loans. In addition, banks with foreign debt also suffer from the increasing cost of borrowing. Therefore, twin currency and banking crises should appear simultaneously.
