Financial reforms and banking system vulnerability: The role of regulatory frameworks

Abstract

This paper aims at bringing new insights concerning the effect of financial reforms on banking system vulnerability. We show that the link between financial liberalization and banking crisis depends on the number of years since last regulatory reforms. Similarly, we show that updating regulations indirectly affect banking crisis according to the financial liberalization level. Then, we show that banking crisis can be largely explained by a gap between financial innovations and regulation update on a sample of 49 developed and developing countries from 1980 to 2010. Our empirical evidence supports that the regulatory environment is more important in developed countries as it reduces banking fragility perhaps because of highly-risky exchanged financial products. The effect of financial liberalization depends largely on the number of years since last reform. However, destabilizing effect of financial liberalization in developing countries cannot be neutralized by updating regulations and gets more obvious as regulations become older.