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World Bank Document __P_S _~I 2 a POLICY RESEARCH WORKING PAPER 1828 Public Disclosure Authorized The Determinants Vulnerabilityto crisesin the banking sector appears Lobe of Banking Crises associated witht t a,_tors: a weaK macroeconomic Public Disclosure Authorized Evidence from Industrial environmentcharacterized by slow GDPqrowth -r-d t-hiqh and Developing Countries infation,vulnerability to Sudden capital outflows. low Asl Demirguc-Kunt liquidityin the banktnasector, Enrica Detragiache a high shareof creditto the private sector, past cre&l, growth, the existence of explicit deposit InsUarn:e, and Public Disclosure Authorized weak institutions. Public Disclosure Authorized The World Bank Development Research Group and International Monetary Fund Research Department September 1997 | POLICYRESEARCH WORKING PAPER 1828 Summary findings In the 1980s and 1990s several countries experienced controlled for, neither the rate of currency depreciation banking crises. Demirgiiu-Kunt and Detragiache try to nor the fiscal deficit are significant. identify features of the economic environment that tend Also associated with a higher probability of crisis are to breed problems in the banking sector. vulnerability to sudden capital outflows, low liquidity in They do so by econometrically estimating the the banking sector, a high share of credit to the private probability of a systemic crisis, applying a multivariate sector, and past credit growth. logit model to data from a large panel of countries, both Another factor significantly (and robustly) associated industrial and developing, for the period 1980-94. with increased vulnerability in the banking sector is the Included in the panei as controls are countries that never presence of explicit deposit insurance, suggesting that experienccd banking problems. moral hazard has piayed a major rote. The authors find that crises tend to occur in a weak Finally, countries with weak institutions (as measured macroeconomic environment characterized by slow GDP by a "law and order" index) are more likely to growth and high inflation. When these effects are experience crises. This paper - a prod:tct of the Development Research Group, World Bank, and the Research Department, International Monetary Fund - is part of a larger effort to understand the causes of banking crises. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagye, room N9-030, telephone 202-473-8526, fax 202-522-1155, Internet address [email protected]. September 1997. (46 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues.An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center The Determinants of Banking Crises Evidence from Industrial and Developing Countries Asli Demirgfii-Kunt Enrica Detragiache Keywords: banking sector, banking crises, deposit insurance. JEL classification: E44, G21 Authors' e-mail addresses: [email protected] [email protected] The authors are indebted to Jerry Caprio, Stijn Claessens, George Clarke, Steve Cosslett, Harry Huizinga, Ed Kane, Ross Levine, Miguel Savastano, Mary Shirley, Dimitri Vittas, and Peter Wickham for helpful comments, and to Anqing Shi for excellent research assistance. 1. INTRODUCTION In the 1980s and early 1990s several developed economies, developing countries, and economies in transition experienced severe banking crises. Such proliferation of large scale banking sector problems has raised widespread concern, as banking crises disrupt the flow of credit to households and enterprises, reducing investment and consumption and possibly forcing viable firms into bankruptcy. Banking crises may also jeopardize the functioning of the payments system and, by undermining confidence in domestic financial institutions, they may cause a decline in domestic savings and/or a large scale capital outflow. Finally, a systemic crisis may force sound banks to close their doors. In most countries, policy makers have responded to banking crises with various interventions, ranging from loose monetary policy to the bail out of insolvent financial institutions with public funds. Even when they are carefully designed, however, rescue operations have several drawbacks: they are often very costly for the budget; they may allow inefficient banks to remain in business; they are likely to create the expectation of future bail- outs thereby reducing incentives for adequate risk management by banks. Rescue operations may also weaken managerial incentives when, as it is often the case, they force healthy banks to bear the losses of ailing institutions. Finally, loose monetary policy to prevent banking sector losses can be inflationary and, in countries with an exchange rate commitment, it may trigger a speculative attack against the currency. 2 Preventing the occurrence of systemic banking problems is undoubtedly a major concern of policy makers, and understanding the mechanisms that are behind the surge in banking crises in the last fifteen years is a first step in this direction. Recently, a number of studies have analyzed various episodes of banking sector distress in an effort to draw useful policy lessons (see Section 3 below).' Most of this work consists of case studies, and econometric analyses are few. Gonzalez-Hermosillo et al. (1997) use an econometric model to predict bank failures using Mexican data for 1991-95. In a paper focused primarily on the connection between banking crises and balance of payments crises, Kaminsky and Reinhart (1996) examine the behavior of a number of macroeconomic variables in the months before and after a crisis in a sample of 20 countries; using a methodology developed for predicting the turning points of business cycles, they attempt to identify variables that act as "early warning signals" for crises.' The best signals appear to be a loss of foreign exchange reserves, high real interest rates, low output growth, and a decline in stock prices. The goal of this study is to further investigate the features of the economic environment that tend to breed banking sector fragility and, ultimately, lead to systemic banking crises. Rather than focusing on the behavior of high frequency time series around the time of the crisis, we study the determinants of the probability of a banking crisis in a multivariate logit specification with annual data using a large panel including all market economies for which data lSome of these studies also discuss at lengththe strategiesadopted to rescuethe bankingsystem, a topic that we do not address in this paper. 2Whilethis approachprovides numerousinteresting insights, it is open to the criticismthat the criteriaused to establishwhich variablesare useful signalsare somewhatarbitrary. 3 were available in the period 1980-943.Many countries in our sample do not experience systemic banking crises in the period under consideration, and therefore serve as controls. The explanatory variables capture many of the factors suggested by the theory and highlighted by case studies, including not only macroeconomic variables but also structural characteristics of the economy in general and of the financial sector in particular. This approach allows us to identify a number of interesting correlations; however, because we estimate a reduced form relationship without deriving it from a specific structural model of the economy, such correlations should be interpreted with caution as they may not necessarily reflect direct causal links. The first issue that we explore is which (if any) elements of the macroeconomic environment are associated with the emergence of banking crises. We find that low GDP growth, excessively high real interest rates, and high inflation significantly increase the likelihood of systemic problems in our sample; thus, crises do not appear to be solely driven by self-fulfilling expectations as in Diamond and Dybvig (1983). This confirms the evidence presented by Gorton (1988) on the determinants of bank runs in the U.S. during the nineteenth century.4 Adverse terms of trade shocks also tend to increase the likelihood of banking sector problems, but here the evidence is weaker. The size of the fiscal deficit and the rate of 3A methodologysimilar to our has beenused to studycurrency crises (see, for instance,Eichengreen et al., 1996) andfactors that leadto Fundfinancial arrangements (Knight and Santaella,1994). Economiesin transitionare excludedfrom our studyeven though they have experienced some of the worstbanking crises. We believe that someof the bankingproblems in theseeconomies are dueto the processof transforminga centrally planned economyinto a marketeconomy, and aretherefore of a distinctivenature. 4 It shouldbe pointedout, however, that withouta theoryof howbeliefs are formedin rationalexpectations models withmultiple equilibria, this evidence cannot rule out that criseshave a self-fulfillingcomponent, since pessimistic, self-fulfillingbeliefs may tend to emergewhen macroeconomic fundamentals are weak. 4 depreciation of the exchange rate,
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