Working Paper

Financial liberalization and banking crises in emerging economies

Abstract: In this paper, we provide a theoretical explanation of why financial liberalization is likely to generate financial crises in emerging market economies. We first show that under financial repression the aggregate capital stock and bank net worth are both likely to be low. This leads a newly liberalized bank to be highly levered, because the marginal product of capitaland thus loan interest ratesare high. The high returns on capital, however, also make default unlikely, and they encourage the bank to retain all of its earnings. As the banks net worth grows, aggregate capital rises, the marginal product of capital falls, and a banking crisis becomes more likely. Although the bank faces conflicting incentives toward risk-taking, as net worth continues to grow the bank will become increasingly cautious. Numerical results suggest that the bank will reduce its risk, by reducing its leverage, before issuing dividends. We also find that government bailouts, which allow defaulting banks to continue running, induce significantly more risk-taking than the liability limits associated with standard bankruptcy.

Keywords: Developing countries; Financial crises;

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Pacific Basin Working Paper Series

Publication Date: 2001

Number: 2001-03