The Political Economy of Financial Fragility

Abstract

Financial liberalization under weak regulation is often followed by financial crises. We argue that this may be the deliberate outcome of lobbying interests capturing the reform process. Liberalization may be designed to provide fragile financial access to new entrants by limiting investor protection, resulting in financial deepening rather than broadening access to capital. Interestingly, lobbying may deliberately worsen financial fragility. Poor investor protection limits access to refinance after a shock, forces inefficient default and exit by more leveraged entrepreneurs, thus protecting more established producers. We provide supporting evidence that industry exit rates and profit margins are higher in more corrupt countries during banking crises.