Banking crises are more likely to occur in liberalized financial systems. Financial liberalization should be approached cautiously—even where macroeconomic stabilization has been achieved—in countries where there is little respect for the rule of law, poor contract enforcement, and a high level of corruption.
Demirgüç-Kunt and Detragiache study the empirical relationship between banking crises and financial liberalization using a panel of data for 53 countries for 1980–95.
They find that banking crises are more likely to occur in liberalized financial systems. But financial liberalization’s impact on a fragile banking sector is weaker where the institutional environment is strong—especially where there is respect for the rule of law, a low level of corruption, and good contract enforcement.
They examine evidence on the behavior of bank franchise values after liberalization. They also examine evidence on the relationship between financial liberalization, banking crises, financial development, and growth.
The results support the view that, even in the presence of macroeconomic stabilization, financial liberalization should be approached cautiously in countries where institutions to ensure legal behavior, contract enforcement, and effective prudential regulation and supervision are not fully developed.
This paper—a joint product of the World Bank’s Development Research Group and the International Monetary Fund’s Research Department—is part of a larger effort to study financial liberalization. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagye, room MC3-422, telephone 202-473-7656, fax 202-522-1155, Internet address psintimaboagye@worldbank.org. The authors may be contacted atademirguckunt@worldbank.org or edetragiache@imf.org. (48 pages)
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