What Makes High Credit Growth Harmful? Evidence from Banking Crises
43 Pages Posted: 9 Dec 2012
Date Written: December 5, 2012
Rapid credit growth seems to precede many episodes of banking crises in both advanced and emerging market economies including the recent global financial crisis of 2007-09. All episodes of high credit growth are not followed by crisis, however. We argue that credit growth is more likely to lead to a banking crisis if the financial system is characterized by fragility caused by distortions or imbalances in the system. The indicators of potential fragility we point to in this paper are high leverage, financial liberalization, a high rate of capital inflows (e.g. bank loans) from abroad, surges in asset prices, the existence of explicit or implicit protection of banks’ creditors, and weak supervision of banks’ risk-taking. We test the hypotheses that these factors interact with high credit growth to increase the likelihood of a banking crisis. The empirical work is based on data for 77 countries for the period 1973-2009. The results show that in advanced economies relatively high credit growth over several years increases the likelihood of a banking crisis and that this effect is strengthened by high leverage, weak capital regulation and supervision, and cumulative asset price inflation. These results are robust with respect to inclusion of the recent crisis period. The other financial fragility indicators have independent effects on the likelihood of banking crisis but the significance of effects vary across specifications, types of countries and time period.
Keywords: Banking Crises, Credit Growth, Leverage, Financial Liberalization, Capital Regulation and Supervision
JEL Classification: E51, G01, G21, G28
Suggested Citation: Suggested Citation