BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
Growth expectations and banking system fragility in developing economies
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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