The Political Economy of Financial Sector Supervision and Banking Crises: A Cross‐Country Analysis

Abstract

This study investigates the relationship between banking crises, financial supervision and institutional veto players in an empirical study consisting of 65 advanced and developing countries from 1976-2005. While the literature relating banking crises and supervision is extensive, discussions of precisely how domestic political institutions influence the design of banking supervision have not been commonplace. We test whether these political institutions which reflect checks and balances affect the probability of a banking crisis, by way of shaping the quality of a country's financial supervisory policies. We find a significant and negative relationship between banking crises probabilities and the strength of financial sector supervision. Our results highlight the important role of financial regulation and supervision in reconciling the benefits of a liberalised financial system (ie enhanced economic growth) with its costs (ie increased financial fragility).In the past three decades, banking crises have stricken countries both rich and poor alike with troubling frequency. From 1970 to 2007, the world witnessed 124 episodes of banking crises (Table 1), with an average output loss totalling 30% of gross domestic product (GDP), 44 of which involved bailouts with an average fiscal cost of 15% of GDP. 1 The recent global financial crisis may be the most severe yet, but it is not an exception.According to International Monetary Fund (IMF) estimates, 2 global economic output in the wake of the contemporary crisis contracted by 1% in 2009, and the forecast for world growth in 2010 is but a modest 3.1%, appreciably lower than the 5.2% recorded in 2007. Given the severity of these losses, how can we formulate appropriate policy and regulatory responses? The question is a propos because the global financial crisis of

Interest Groups, Policy Responses to Global Shocks, and the Relative Likelihood of Currency Crashes Versus Banking Crises

“…Veto Player Theory: One factor that may influence the effectiveness of interest groups in influencing policy is institutional constraints; similar to the idea of "checks and balances" (we operationalize this using the framework of veto player theorya standard approach to analyzing political institutional constraint). Prior work shows that the trade-off between institutional rigidity and flexibility influences how markets and political systems react after global shocks (Meyer, 2018a(Meyer, , 2018bAmri and Kocher, 2012). Formally known as veto players, this theory postulates that more (less) actors in government capable of preventing legislation will make policy change less (more) likely while affecting policy outcomes through influencing the policymaking process (Tsebelis, 2002).…”

When do autonomous banking regulators promote stability?

“…A voluminous literature on banking supervision suggests that banking agencies have the capacity to choose stringent regulatory and supervisory policies as tools to reduce the risk of insolvency among banks (see, e.g., Rossi ; Satyanath ; Amri & Kocher ). While recognising that the policy choices of banking agencies are constrained by law (e.g., countries that adhere to Basel II risk‐prevention guidelines require banks to stick to a capital‐asset ratio of 8 per cent), agencies still have a variety of instruments to promote robustness of the financial system and can dictate the intensity with which they enforce regulations.…”

“…Previous contributions in the literature on banking crises have considered the potential role of veto points, but mostly on policy choice after the onset of banking crises (Keefer ; Haggard & MacIntyre ). See Amri and Kocher () for a revision of the relevant literature.…”

Anatomy of international banking crises at the onset of the Great Recession

“…If they are very weak, the probability of a banking crisis is on the rise with further liberalization but the linkage is reversed as capital regulation and supervision get stricter. Better supervision is closely related to more intense political competition as the latter implies a better design of checks and balances and ultimately fewer rent-seeking opportunities (Amri and Kocher 2012). A higher degree of central bank independence also tends to decrease the probability of banking crises ).…”