EFFECT OF BANK CRISES ON FISCAL COST AND ECONOMIC OUTPUT

EFFECT OF BANK CRISES ON FISCAL COST AND ECONOMIC OUTPUT

CHAPTER ONE

INTRODUCTION

Background of the Study

The origins and effects of banking crises are currently, in the light of the U.S. credit and banking crises that started in 2007, often discussed. The public and media search for explanations but even more for scapegoats. However, during these discussions very fundamental aspects seem to be forgotten. The public‘s surprise about the possibility of a banking crisis shows that most have not understood the current financial system and its history. Therefore, I argue that understanding banking crises requires first to understand financial systems, banking and the history of financial crises.
Levine (1997) argues that banks satisfy random liquidity needs of lenders better (at lower risks) than if these lenders would invest their funds directly in the financial markets. However, in order to credibly commit to repay depositors, banks must choose a fragile bank capital structure; argue Diamond and Rajan (2001). Thus, the risk of a banking crisis may be a necessary disciplinary device in an imperfect market.
Liquidity is only provided if expected returns during times of low market liquidity are high in order to compensate providers for their large opportunity cost of holding idle capital for a long time. Low market liquidity however can trigger cash-in-the-market pricing which may lead to fire-sales, contagion and self-fulfilling prophecies of a banking crisis (Kane, 1989; Demirgüc-Kunt and Detragiache, 2002).
Research (e.g. Lindgren et al., 1996; Dooley and Frankel, 2003; and Collyns and Kincaid, 2003) identified various underlying macroeconomic origins of past banking crises such as inflation, cyclical output downturns, term of trade deterioration, exchange rate crashes, and currency as well as asset and real estate devaluations. Additionally, financial liberalization (Demirgüc-Kunt and Detragiache, 1998), flexible exchange rate regimes (Peria, 2003), public bank ownership (Caprio and Levine, 2001), a weak institutional environment (Demirgüç-Kunt and Detragiache, 1998) and an explicit deposit insurance (Demirgüç-Kunt and Detragiache, 2002) were all found to increase the probability of a banking crisis.
Once a banking crisis is ongoing, the credit crunch hypothesis predicts that decreased bank credits to firms decrease investments and expenditure, thus resulting in decreased economic output and demand (Eichengreen and Rose, 1998; Kaminsky and Reinhart, 1999; Demirgüç-Kunt and Detragiache., 2005). While fighting a banking crisis, governments face a trade-off between fiscal and economical costs. Higher fiscal spending on government interventions is expected to decrease the economical cost of crisis (Laeven and Valencia, 2008). However, earlier findings suggest that generous support to the banking system does not reduce the output cost of banking crises (Claessens, Klingebiel and Laeven, 2003).
Therefore, an important question to policy makers and economists is how to decrease the negative effects of a banking crisis most efficiently and effectively as well as how to prevent a banking crisis totally. Also highlighted should be the fact that ―econometric analyses of systemic banking crises are a new field‖ (Demirgüc-Kunt, Detragiache, 2005) and only limited research exists. Hence, more empirical research about banking crises, their origins and relation to economic and fiscal cost is needed.
I contribute to the research on banking crises by providing new insights into the determinants and effects of banking crises with new and larger datasets and time frames as well as better and further developed variables. Specifically, the dataset by Laeven and Valencia (2008) gives the opportunity to research banking crises‘ effects by taking into account government interventions. To my knowledge, earlier studies did not address broad government interventions and policies sufficiently, while researching banking crises‘ effects. Additionally, by taking a larger time frame, I will turn earlier results of Demirgüc-Kunt and Detragiache (1997) about determinants of banking crises around. Therefore, this thesis adds in-depth insight and new results to the research of banking crises‘ determinants and effects.

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Updated: 23rd July 2021 — 3:28 pm