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

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.