Does Financial Liberalization Increase the Likelihood of a Systemic Banking Crisis? Evidence from the Past Three Decades and the Great Depression

Abstract:     
Over the past three decades, leading industrial nations and many developing countries have deregulated their financial markets. Financial liberalization has produced major benefits, including more efficient intermediation of financial resources, more rapid economic development and faster growth in trade. At the same time, however, many banking crises have occurred in countries that previously adopted programs of financial deregulation. This essay provides a brief overview of banking crises in international markets since 1973, together with more detailed discussions of Japan's financial crisis that began in 1990, the U.S. banking crises of 1929-33 and 1980-92, and the challenges confronting major U.S. and European banks during 2000-02.

This historical evidence indicates that financial liberalization encourages banks to increase their lending commitments and equity investments in the real estate and securities markets. A rapid growth of credit and investment in those markets typically produces an economic "boom," which is fueled by positive feedback between rising asset prices and the willingness of creditors and investors to provide additional financing in the belief that asset values will continue to increase. Under such conditions, asset prices tend to "overshoot" and reach levels that cannot be justified by economic "fundamentals" (e.g., the actual cash flow generated by real estate projects and business ventures). When investors and creditors realize that market prices have diverged significantly from economic fundamentals, they are likely to pursue a rapid liquidation of investments and loans and thereby trigger a "bust." A severe asset bust often gives rise to a systemic banking crisis, because it exposes banks to crippling losses from defaulted loans and depreciated loan collateral and equity investments. Governments have typically responded to such crises by spending massive amounts to protect depositors and recapitalize banks.

This apparent correlation between deregulation and banking crises suggests that financial liberalization has a "dark side," because it tends to create a banking system that is more vulnerable to systemic risk. Bank regulators should therefore give greater attention to the potential lending and investment risks created by financial liberalization efforts.

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