Institutions and financial crises

We examine how institutional quality affects the probability of banking and sovereign debt crises using a panel of 138 countries from 1996 to 2017. Individually, proxies of institutional quality capture different institutional dimensions and suffer from measurement errors. Jointly, we find that their impact is heterogeneous, and multicollinearity slightly biases the estimates: measures more closely related to regulatory quality and corruption mitigation decrease the probability of financial instability, while those oriented toward social capital have perverse effects. This evidence questions the beneficial effect of institutions. On the contrary, when we extract the common component of institutional quality from multiple imprecise measures using a principal component analysis, better institutions unambiguously reduce the probability of financial distress. Such a shielding effect occurs regardless of whether institutions are considered exogenous or endogenous. Financial structure, cultural differences, and international agreements do not affect our findings. Estimates are robust to several econometric exercises.