Financial Levees:Intermediation, External Imbalances, and Banking Crises

Mark S. CopelovitchDepartment of Political Science &La Follette School of Public AffairsUniversity of Wisconsin – Madison

copelovitch@wisc.edu

David Andrew SingerDepartment of Political Science

MITdasinger@mit.edu

What Caused the “Great Recession”?

External imbalances and capital inflow bonanzas

• Widely seen as proximate or underlying causes (Reinhart and Reinhart 2008, Bernanke 2009, Reinhart and Rogoff 2009, Caballero 2011, Chinn and Frieden 2011)

• Building on earlier work on crises in Latin America and East Asia (Diaz-Alejandro 1985, Calvo 1998, Kaminsky and Reinhart 1999)

The new conventional wisdom?

• Obstfeld and Rogoff (2009): crises and imbalances “intimately related”

• Bini Smaghi (2008): “two sides of the same coin”

• Portes (2009): “global macroeconomic imbalances are the underlying cause of the crisis”

The Global Imbalance Chorus

Portes (2009)• “Global imbalances…brought low interest rates, the search for yield, and

an excessive volume of financial intermediation, which the system could not handle responsibly”

King (2010)• “The massive flows of capital from the new entrants into western financial

markets pushed down interest rates and encouraged risk-taking on an extraordinary scale”

Reinhart and Reinhart (2008)• “Capital inflow bonanza periods are associated with a higher incidence of

banking, currency, and inflation crises in all but the high income countries.”• “Episodes end, more often than not, with an abrupt reversal or “sudden

stop” a la Calvo (1998)”

Problems With the Imbalances View

Empirical anomalies

• Some countries with large current account deficits escaped the crisis (Australia, New Zealand) while others were hit hardest (US, UK, Greece)

• No “sudden stop” in the US, despite collapse of interbank lending

• 2/3 US capital inflows came from Europe, not large surplus countries

• “Financial crises, driven by excessive loan growth, occurred by and large independent of current account imbalances” (Jorda, Schularick, and Taylor 2011)

– 1981-2007: weak correlation between credit booms and both current account deficits (0.01) and bonanzas (0.11)

– Large credit booms in key surplus countries (China 1997-2000; India 2001-4; Brazil 2003-7; Japan in 1980s; US in 1920s)

SOURCE: Borio and Disyatat 2011; Bureau of Economic Analysis

US Balance of Payments (% of GDP)

Our Argument: Consider Financial (Dis)intermediation

Global imbalances are destabilizing only under certain circumstances• Unpacking the “current account”

– Savings minus investment: an intertemporal phenomenon– Deficits are especially problematic when returns on investment are uncertain

• Financial sectors with low levels of securitization are resistant to the destabilizing influences of capital inflows

– Securitization exacerbates the mispricing of risk– Disintermediation distorts the assessment of returns on investment

Traditional banking activity acts as a “financial levee”• Caveat: traditional banking does not prevent all crises!

– Bank credit growth is still a key determinant of financial instability

Empirical Analysis – Variables and Model Specifications

• Dependent variable = 1 if country i experiences a banking crisis in year t– All crisis (Reinhart and Rogoff 2008/9): 375 crises (20.1%), 1981-2007– Systemic crises (Laeven and Valencia 2008): 114 crises (2.4%), 1981-2007

• Key independent variable: Level of securitization of the financial sector– Measured two ways:– 1) Regulatory measure of depth/liberalization (Abiad et. al. 2008)

• Has a country taken measures to develop securities markets (0/3)?• Is a country’s equity market open to foreign investors (0/2)?

– 2) Market/bank ratio: stock market volume / bank lending

• Crisisit = 0 + 1 External imbalance + 2 Securitization + 3 Imbalance*Securitization + 4

Credit growth + 5 Regime type + 6 GDP per capita + 7 GDP growth + 8 Inflation + 9

OECD average growth + 10 Commodity prices + 11 US interest rate + 12 (Last crisis) + 13

(Last crisis)2 + 14 (Last crisis)3 +

SOURCE: World Bank, Database on Financial Development & Market Structure

Interactive Marginal Effects – Banking Crisis (Reinhart-Rogoff)

Interactive Marginal Effects – Banking Crisis (Reinhart-Rogoff)

Conclusions and Next Steps

Conclusions• Market structure conditions the impact of current account deficits on

financial stability– Capital inflows need not be destabilizing: traditional intermediation

serves as a “financial levee”• However: extension of bank credit – independent of the current account

balance – is a key determinant of crises

Next Steps• Consider more directly the role of regulation

– Find (or create) better data on the scope & stringency of regulation, and de jure vs. de facto supervisory independence & mandates

– State ownership• Case study analysis

BACKUP

Interactive Marginal Effects – Banking Crisis (Reinhart-Rogoff)

Countries in SampleCountry Years Country Years

Algeria 1981-1996 Japan 1981-2007

Argentina 1990-2007 Kenya 1981-2007

Australia 1981-2007 Korea 1981-2007

Bolivia 1986-2007 Malaysia 1981-2007

Brazil 1994-2007 Mexico 1981-2007

Canada 1981-2007 Morocco 1981-2007

Chile 1981-2007 New Zealand 1981-2007

Colombia 1981-2007 Nigeria 1981-2007

Costa Rica 1981-2007 Norway 1981-2007

Cote d'Ivoire 1981-2007 Paraguay 1981-2007

Denmark 1981-2007 Peru 1991-2007

Dominican Republic 1981-2007 Philippines 1981-2007

Ecuador 1981-2007 Poland 1991-2007

Egypt 1981-2007 Singapore 1981-2007

El Salvador 1981-2007 South Africa 1981-2007

Finland 1981-2007 Spain 1981-2007

France 1981-2007 Sri Lanka 1981-2007

Ghana 1981-2007 Sweden 1981-2007

Greece 1981-2007 Thailand 1981-2007

Guatemala 1981-2007 Tunisia 1990-2007

Hungary 1991-2007 Turkey 1983-2007

India 1981-2007 United Kingdom 1981-2007

Indonesia 1983-2007 United States 1981-2007

Ireland 1981-2007 Uruguay 1981-2007

Italy 1981-2007    

N = 1247

Predicted Change in Probability of a Banking Crisis, One Standard Deviation Increase in Current Account Deficit, by Market/Bank Ratio

Market/Bank ratio (log), percentile

Current account (% GDP, 5 year moving average): increase from deficit of 1.5% to 5.4%