The Bright and the Dark Side of Cross-Border Banking Linkages

When a country’s banking system becomes more linked to the global banking network, does that system get more or less prone to a banking crisis? Using simulations and econometric estimates based on a world-wide dataset, we find an M-shaped relationship between the stability and the interconnectedness of a country’s banking sector. For banking sectors that are not very connected to the global banking network, increases in interconnectedness are associated with a reduced probability of a banking crisis, but once the interconnectedness reaches a certain value, further increases in interconnectedness can increase the crisis probability. Interestingly, it matters whether the linkages are primarily in terms of the banks’ assets or liabilities, with the relationship between interconnectedness and crisis probability being stronger for liabilities. Our findings suggest that it may be beneficial for policies to support greater interlinkages for less connected banking systems, but only up to a point.