Financial Levees: Regulation, External Imbalances, and Banking Crises Around the World

Abstract

An emerging consensus among scholars and policymakers identifies “global imbalances” and capital flow “bonanzas” as the primary determinants of banking crises in developed and emerging market countries. We question the rush to embrace this conventional wisdom and argue that the stringency of banking regulation is a key variable omitted in the existing literature. Using a dataset of banking crises covering up to 50 countries from 1981 to 2007, we find that more stringent regulation and supervision substantially reduces the probability of a crisis. Moreover, we find that neither large current account deficits nor capital inflow bonanzas are significant determinants of banking crises once we control for the level of banking regulation. Our results suggest that robust banking regulation acts as a “fnancial levee” insulating countries from the potentially destabilizing impact of global imbalances and international capital flows on the national banking system. From a policy perspective, our findings lend credibility to argument of those, such as Borio and Disyatat (2011), who claim that an exclusive focus on unwinding global imbalances and improving fiscal policy – without also focusing on the regulatory and financial intermediation problems at the root of the Great Recession – is unlikely to prevent future crises.

Keywords: Banking crises, financial crises, global imbalances, capital flow bonanzas, financial regulation, banking regulation, prudential regulation, banking supervision, credit booms, Great Recession