Cross-Country Empirical Studies of Systemic Bank Distress: A Survey

Article excerpt

A rapidly growing empirical literature is studying the causes and consequences of bank fragility in contemporary economies. The paper reviews the two basic methodologies adopted in cross-country empirical studies, the signals approach and the multivariate probability model, and their application to study the determinants of banking crises. The use of these models to provide early warnings for crises is also reviewed, as are studies of the economic effects of banking crises and of the policies to forestall them. The paper concludes by identifying directions for future research.

Keywords: Banking crises; financial fragility.

JEL classification: E44, G21

I. Introduction

Until recently, research on banking crises was inspired mostly by the experiences of the 19th and early 20th century. In particular, the field was dominated by studies of the Great Depression, when numerous and catastrophic bank failures occurred around the world. (1) Beginning in the 1990s, a resurgence of banking crises provided new impetus and new materials to researchers, and a rapidly growing literature is studying the causes and consequences of bank fragility in contemporary economies. This paper surveys this work and tries to highlight directions for future research.

The paper is organised as follows: the next section reviews the basic facts about the recent wave of financial crises. Section 3 presents the two basic methodologies adopted in cross-country empirical studies of the determinants of banking crises, and Section 4 discusses how these models have been used for crisis prediction. Section 5 reviews the literature and evidence on how various factors contribute to bank fragility. Section 6 surveys work on the economic effects of banking crises. Section 7 concludes by pointing to some of the issues that further research could usefully focus on.

2. The resurgence of financial instability in the 1990s

Following the financial disasters of the 1920s and '30s, the postwar years marked a return to economic and financial stability, and banking crises were rare and isolated events. A calm macroeconomic environment, favourable economic growth, low inflation, and pervasive controls on international capital flows contributed to financial stability. Also, in many countries, including the more free-market oriented ones, bankers' freedom of action remained severely restricted by watchful central banks, wielding a wide array of regulatory powers to control the quantity and price of credit.

Following the breakdown of the Bretton Woods system and the first oil shock, macroeconomic stability became elusive. But even during the turbulent 1970s the banking sector remained sound in most countries, perhaps thanks to the low (indeed negative) real interest rates and the persistent regulatory straightjacket.

Once lax monetary policy was abandoned, real interest skyrocketed, and credit markets began to be liberalised in the early 1980s, several financial crises broke out in Latin America and other developing countries, often accompanied by widespread bank distress. Most explanations for these crises, however, focused on fiscal profligacy, external shocks, and exchange rate policy as the main culprits, while bank fragility continued to garner little attention. An important exception was Diaz-Alejandro's (1985) masterful account of the Chilean crisis. As the title unambiguously indicates (Goodbye financial repression, hello financial crash), this paper traced the roots of the Chilean crisis directly to the banking system and its botched privatisation in the late 1970s.

If bankers might have been innocent by-standers during the LDC debt crises of the 1980s, this was certainly not the case in the US Savings and Loans debacle which unfolded during the same period. This episode demonstrated how the erosion of bank capital following financial liberalisation, generous deposit insurance, and ineffective regulation could conspire to make gambling and looting an optimal business strategy for scores of bank managers (Kane, 1989; Akerlof and Romer, 1993). …