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This paper tests one aspect of whether financial markets can provide strong discipline over domestic macroeconomic policies by looking at the behavior of credit markets following financial crises. While financial markets often fail to give strong warning signals before a crisis, at times they might still provide a secondary form of discipline by helping to force needed economic adjustments once a crisis has broken out, as witnessed by the euro crisis. In this paper we present a test of this hypothesis with respect to the rate of credit growth, a frequent contributor to financial crises. Using a sample 58 banking crisis episodes from 1977 to 2010,we find that after banking crises on average rates of credit expansion fall substantially and financial regulation and supervision is strengthened. However, there is a substantial degree of regional and within-region differences in these discipline effects and for a sizeable minority of cases there is no evidence of discipline effects. We also find that both democracy and the presence of post crisis IMF programs are associated with larger drops in the rate of credit creation from pre to post crisis periods.

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