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Institute for Economies in Transition, Bank of Finland BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland

No 13/2005:
Growth expectations and banking system fragility in developing economies

Eugenio Proto ()

Abstract: The likelihood of a banking crisis appears to be higher in fast-developing countries. An explanation is provided in a Diamond and Dybvig framework, where banks are vehicles of consumption-smoothing, offering insurance against shocks to the consumption path of consumers. The theoretical model shows that the higher consumer growth expectations, the higher the optimal level of illiquidity insurance — even if it implies higher exposure bank runs. Empirical evidence supports this result and suggests that the effect of deposit interest rates on the probability of crisis is stronger after a period of high, uniterrupted growth. Policies of providing bail-outs or deposit insurance are demonstrated to be efficient even when they increase the fragility of the banking system.

32 pages, November 7, 2005

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