Financial Liberalization and Banking Crises: A Cross-Country Analysis

Abstract

Several studies indicate that financial liberalization contributes to the likelihood of a financial crisis. We focus on banking crises and argue that they are most likely to occur after some degree, but not full, liberalization. Using a recently updated dataset for financial reforms in 48 countries between 1973 and 2005, we find an inverted U-shaped relationship between liberalization and the likelihood of crisis. We ask whether the relationship remains when institutional characteristics of countries and dynamic effects of liberalization are considered. The empirical results indicate that the relationship between liberalization and banking crises depends strongly on the strength of capital regulation and supervision. With very weak regulation and supervision the probability of banking crises is increasing with liberalization but this relationship is reversed as regulation and supervision become stricter. The most important type of liberalization in relation to banking crises seems to be behavioral (a relaxation of interest and credit controls). A policy implication is that positive growth-effects of liberalization can be achieved without increasing the risk of a banking crisis if appropriate institutions are developed.