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The effect of financial liberalization on banking sector stability

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  • Mekki Hamdaoui
  • Abir Zouari
  • Samir Maktouf

Abstract

Several studies indicate that financial liberalization increases likelihood of a financial crisis without distinguishing between a normal period, unstable period preceding the onset of banking panics and crisis/post period. We explain in this paper the relationship between financial liberalization and banking sector vulnerability. Then, we argue that banking sector turmoil is most likely to occur after an intermediate degree of liberalization. Using a recently updated dataset for financial reforms, we find an inverted U-shaped relationship between liberalization and the likelihood of banking crisis for a sample of 49 countries between 1980 and 2010. We used a multinomial logit model in order to take into account what is called the ‘post crisis bias’. We ask whether the relationship remains when institutional characteristics of countries and dynamic effects of liberalization are considered. The empirical results indicate that the relationship between liberalization and banking sector stability depends strongly on the strength of capital regulation and supervision. With very weak regulation and supervision, the probability of banking crises is increasing with liberalization but this relationship is reversed as regulation and supervision become significant. The most important type of liberalization in relation to banking crises seems to be operational. A policy implication is that positive growth effects of liberalization can be achieved without increasing the risk of a banking fragility if appropriate institutions are developed.

Suggested Citation

  • Mekki Hamdaoui & Abir Zouari & Samir Maktouf, 2016. "The effect of financial liberalization on banking sector stability," International Review of Applied Economics, Taylor & Francis Journals, vol. 30(5), pages 644-667, September.
  • Handle: RePEc:taf:irapec:v:30:y:2016:i:5:p:644-667
    DOI: 10.1080/02692171.2016.1165654
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    References listed on IDEAS

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    1. Caprio, Gerard Jr. & Summers, Lawrence H., 1993. "Finance and its reform : beyond laissez-faire," Policy Research Working Paper Series 1171, The World Bank.
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    1. Mekki Hamdaoui, 2017. "RETRACTED ARTICLE: Liberalization, Regulatory Delays and Vulnerability to Systemic Banking Crisis," International Economic Journal, Taylor & Francis Journals, vol. 31(4), pages 490-534, October.
    2. Hamdaoui, Mekki & Maktouf, Samir, 2020. "Financial reforms and banking system vulnerability: The role of regulatory frameworks," Structural Change and Economic Dynamics, Elsevier, vol. 52(C), pages 184-205.
    3. Hansen, Daniel, 2020. "The effectiveness of fiscal institutions: International financial flogging or domestic constraint?," European Journal of Political Economy, Elsevier, vol. 63(C).
    4. Mekki Hamdaoui & Samir Maktouf, 2019. "Overall effects of financial liberalization: financial crisis versus economic growth," International Review of Applied Economics, Taylor & Francis Journals, vol. 33(4), pages 568-595, July.

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