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Macroeconomic risk and banking crises in emerging market countries: business fluctuations with financial crashes

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  • Pedro Marcelo Oviedo

Abstract

This paper investigates the interaction between aggregate risk, financial fragility, and the macroeconomic performance of emerging market countries when asymmetric information at the level of firms and banks gives rise to agency costs. Two-sided debt contracts are the funding mechanism through which banks borrow from international investors and lend to domestic firms. Banks are risky because their portfolio returns hinge on the strength of the economy which represents a non-diversifiable aggregate risk. Banking crises are sporadic and driven by fundamentals. Macroeconomic risk affects business cycles because all agents suffer the effect of banking failures and incorporate the endogenously determined probability of a crisis into their economic decisions. Model results are consistent with the empirical evidence on banking crises because a slowdown of the economy or an unforeseen interest-rate rise tends to breed banking sector problems. Furthermore, the country-specific interest-rate spread is counter-cyclical because financial crises are less likely during booms.

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Bibliographic Info

Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2004)
Issue (Month): Jun ()
Pages:

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Handle: RePEc:fip:fedfpr:y:2004:i:jun:x:4

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  1. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," MPRA Paper 7125, University Library of Munich, Germany.
  2. Roberto Chang & Andres Velasco, 1998. "Financial Fragility and the Exchange Rate Regime," NBER Working Papers 6469, National Bureau of Economic Research, Inc.
  3. Barry Eichengreen & Andrew K. Rose, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," NBER Working Papers 6370, National Bureau of Economic Research, Inc.
  4. Agenor, Pierre-Richard & McDermott, C John & Prasad, Eswar S, 2000. "Macroeconomic Fluctuations in Developing Countries: Some Stylized Facts," World Bank Economic Review, World Bank Group, vol. 14(2), pages 251-85, May.
  5. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  7. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  8. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  9. Kwanghee Nam & Thomas F. Cooley, 1998. "Asymmetric information, financial intermediation, and business cycles," Economic Theory, Springer, vol. 12(3), pages 599-620.
  10. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  11. Carmen M. Reinhart & Vincent R. Reinhart, 2001. "What Hurts Most? G-3 Exchange Rate or Interest Rate Volatility," NBER Working Papers 8535, National Bureau of Economic Research, Inc.
  12. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  13. Leonardo Leiderman & Carmen Reinhart & Guillermo Calvo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America," IMF Working Papers 92/62, International Monetary Fund.
  14. Fuerst, Timothy S, 1995. "Monetary and Financial Interactions in the Business Cycle," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1321-38, November.
  15. Krasa, Stefan & Villamil, Anne P, 1992. "A Theory of Optimal Bank Size," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 725-49, October.
  16. Mendoza, Enrique G, 1995. "The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(1), pages 101-37, February.
  17. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  18. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
  19. Michael Bordo & Barry Eichengreen & Daniela Klingebiel & Maria Soledad Martinez-Peria, 2001. "Is the crisis problem growing more severe?," Economic Policy, CEPR & CES & MSH, vol. 16(32), pages 51-82, 04.
  20. Timothy S. Fuerst & Charles T. Carlstrom, 1998. "Agency costs and business cycles," Economic Theory, Springer, vol. 12(3), pages 583-597.
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Cited by:
  1. Marco Arena, 2005. "Bank Failures and Bank Fundamentals: A Comparative Analysis of Latin America and East Asia during the Nineties using Bank-Level Data," Working Papers 05-19, Bank of Canada.
  2. Davis, E. Philip & Karim, Dilruba, 2008. "Comparing early warning systems for banking crises," Journal of Financial Stability, Elsevier, vol. 4(2), pages 89-120, June.

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