Transparency, Liberalization, and Banking Crises

Abstract

We investigate the effect of financial liberalization on the probability of a banking crisis in economies with poor transparency. We construct a model with imperfect information where banks cannot distinguish between aggregate shocks and government's policy on one hand, and firms' quality, on the other. Thus, a sequence of positive shocks or non-transparent policy causes banks to increase their credit above the optimal level given the underlying value of the firms. Once banks discover their large exposure, they are likely to rollover bad loans rather than declare their losses. This delays the crisis, but increases its magnitude. Empirical investigation using data on 56 countries from 1977 to 1997 supports the theoretical model. We find that the probability of a crisis is higher in the period following financial liberalization, significantly so in countries with poor transparency.

Booms and busts in housing markets: Determinants and implications

“…Annex Mehrez and Kaufmann (1999). The dummy variable that indicates the deregulation of mortgage lending takes the value one after the date this measure was applied in each country.…”

How Risky is Financial Liberalization in the Developing Countries?

“…Working with a sample of 53 developed and developing countries, Demirgüç-Kunt and Detragiache (1998b) find a strong effect on bank crises, even if the visible impact is delayed several years. Mehrez and Kaufmann (2000) find a lag of 3 to 5 years. Likewise, looking at 20 countries, Kaminsky and Reinhart (1999) conclude that currency and banking crises are "closely linked in the aftermath of financial liberalization".…”

“…In that case, liberalization can have radically different effects depending on the accompanying measures. Recent work, surveyed by Dooley (1995) and subsequently extended by Demirgüç-Kunt and Detragiache (1998b), Edwards (2000), Mehrez and Kaufmann (2000) and Rossi (1999), shows that the adverse effects of financial liberalization occur mainly, if not only, in countries with poor institutions, characterized by the absence of proper bank regulation and supervision, widespread corruption, and more generally poor "law and order". This important observation suggests that liberalization does not necessarily raise the odds of a crisis; it could be that the danger comes from liberalization combined with other factors: the effects of other policies which were previously obscured and mitigated by financial restrictions, suddenly come into the open.…”

“…Demirgüç-Kunt and Detragiache (1998a) use information on domestic interest rate liberalization to produce an index which records the beginning of the process for 53 developing and developed countries. Mehrez and Kaufmann (2000) use a wider range of indicators, mostly drawn from Demirgüç-Kunt and Detragiache (1998a) and Williamson and Mahar (1998). While interest rate controls indeed constitute the crucial component of most domestic financial restrictions, many countries where interest rates are free still resort to various other important restrictions such as directed credit or lack of entry and competition in the banking sector.…”

Banking Deregulations and Unemployment in South Asia

“…Poor transparency within the banking sector leads to poor performance of the financial sector (Mehrez and Kaufmann 2000), which increases unemployment by providing low quality services.…”