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Ray Barrell* and E. Philip Davis**1

Abstract: The financial crisis that started in August 2008 reached a climax in the autumn of 2008 with a wave of bank nationalisations across North America and Europe. Although banking crises are not uncommon, this is the largest since 1929–33. This paper discusses the build-up to the crisis, looking at therole of low real interest rates in stimulating an asset price bubble. That bubble was stocked by financial innovation and increases in lending. New financial products were not stress tested and have failed in the downturn. After discussing the bubbles we look at the collapse of the complex asset structure, and then put the crisis in the context of the literature. The paper concludes with adiscussion of policy implications of the crisis, and advocates a significant improvement in the regulatory structure.

Keywords: Financial crises; asset bubbles; securitised assets; financial sector regulation JEL Classifications: E44; G18


National Institute of Economic and Social Research, e-mail **National Institute of Economic and Social Research and Brunel University,e-mail:

Introduction Although financial crises such as that currently underway tend to be seen as surprising and unusual when they occur, in fact they are common events, particularly in the period since 1970. For example, Demirgüc Kunt and Detragiache (2005) use a sample of 77 systemic crises over the period 1980–2002 in their research. Over 1970–2002, Caprio et al.(2005) found 117 episodes of systemic banking crises (with much or all of bank capital being exhausted) in 93 countries. They also found 51 episodes of borderline and non-systemic banking crisis in 45 countries over the same period. As Davis and Karim (2008) detail, seven systemic crises took place between 1980 and 2000 in advanced OECD countries, with minor crises in the US, Portugal and Italy, andlarge-scale systemic crises in the four countries listed in table 1. Other, more moderate crises have also taken place in OECD countries over this period, and are included in some of the lists referred to above. This would suggest that serious banking crises can take place with a probability of about one in fifty in any year in any OECD country, which is approximately 2½ standard deviations awayfrom the mean. They are so common that strong defences should be built against them.

Table 1 Selected banking crises and their effects
direct cost to output loss (% of Date Duration taxpayers* GDP) Japan 1991-2001 10 years 14.0 71.7 Norway 1989-1992 4 years 3.4 27.1 Sweden 1991-1994 4 years 2.1 3.8 Finland 1991-1994 4 years 10.0 44.9 * Per cent of annual GDP at end of episode Source: Barrelland Hurst (2008) and Hoggarth and Saporta (2001)

The Nordic crises were sharp and had a significant effect on output, and they were associated with rapid and poorly designed financial deregulation that led to excessive consumer and commercial real estate borrowing and housing market and commercial property bubbles. The collapse of consumption spending and commercial real estate companies thatcame with the pricking of asset bubbles was a factor behind large-scale losses in the banking sectors, as were exposed positions in foreign exchange dealings. Real house prices fell 30 per cent in Finland between 1991 and 1993, whilst they fell by 25 per cent in Sweden over the same period. In both countries essentially the whole banking system had to be nationalised. Output losses, commonlycalculated as the cumulated drop below trend growth, were large, but there seems to have been little effect on longer-term growth prospects. The Japanese crisis also followed from ill-judged deregulation and an expansion of borrowing but involved fewer failures. The crisis lasted for a significantly longer period and the cumulated output loss appears to have been large. The economy was also trapped in...
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