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Governance and Financial Fragility: Evidence from a Cross-Section of Countries

  • Michael Francis

The author explores the role of governance mechanisms as a means of reducing financial fragility. First, he develops a simple theoretical general-equilibrium model in which instability arises due to an agency problem resulting from a conflict of interest between the borrower and lender. In particular, when governance is weak and transaction costs are high, the share of capital assets that creditors can claim as collateral is highly sensitive to shocks. As a result, there is financial fragility, in that the willingness of agents to finance productive investments is sensitive to shocks. Second, using a data set that contains over 90 industrialized and developing economies, the author tests the hypothesis that governance is important in explaining financial fragility (measured as the likelihood of a banking crisis and investment volatility). His results show that institutions, rules, and laws that govern the financial environment are of first-order importance for the stability of financial systems. The author finds that, while better legal systems are particularly important, so are democratic institutions that limit the power of the executive.

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Paper provided by Bank of Canada in its series Working Papers with number 03-34.

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Length: 58 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:bca:bocawp:03-34
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  1. Rafael La Porta & Florencio Lopezde-Silanes & Andrei Shleifer, 2000. "Government Ownership of Banks," NBER Working Papers 7620, National Bureau of Economic Research, Inc.
  2. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  3. Gary Gorton, 1986. "Banking panics and business cycles," Working Papers 86-9, Federal Reserve Bank of Philadelphia.
  4. Johnson, Simon & Boone, Peter & Breach, Alasdair & Friedman, Eric, 2000. "Corporate governance in the Asian financial crisis," Journal of Financial Economics, Elsevier, vol. 58(1-2), pages 141-186.
  5. Raghuram G. Rajan & Luigi Zingales, 1998. "Which Capitalism? Lessons Form The East Asian Crisis," Journal of Applied Corporate Finance, Morgan Stanley, vol. 11(3), pages 40-48.
  6. Rafael LaPorta & Florencio Lopez de-Silanes & Andrei Shleifer & Robert W. Vishny, 1996. "Law and Finance," Harvard Institute of Economic Research Working Papers 1768, Harvard - Institute of Economic Research.
    • Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1996. "Law and Finance," NBER Working Papers 5661, National Bureau of Economic Research, Inc.
    • La Porta, Rafael & Lopez-de-Silanes, Florencio & Shleifer, Andrei & Vishny, Robert W., 1998. "Law and Finance," Scholarly Articles 3451310, Harvard University Department of Economics.
    • Rafael LaPorta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, . "Law and Finance," Working Paper 19451, Harvard University OpenScholar.
  7. Kaufmann, Daniel & Kraay, Aart & Zoido-Lobaton, Pablo, 1999. "Governance matters," Policy Research Working Paper Series 2196, The World Bank.
  8. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  9. Easterly, William & Levine, Ross, 2003. "Tropics, germs, and crops: how endowments influence economic development," Journal of Monetary Economics, Elsevier, vol. 50(1), pages 3-39, January.
  10. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  11. Luigi Zingales, 1997. "Corporate Governance," NBER Working Papers 6309, National Bureau of Economic Research, Inc.
  12. Patrick Honohan, 1997. "Banking system failures in developing and transition countries: Diagnosis and predictions," BIS Working Papers 39, Bank for International Settlements.
  13. Beck, Thorsten & Demirguc-Kunt, Asli & Levine, Ross, 2002. "Law and finance : why does legal origin matter?," Policy Research Working Paper Series 2904, The World Bank.
  14. Asli Demirgüç-Kunt & Enrica Detragiache, 1998. "The Determinants of Banking Crises in Developing and Developed Countries," IMF Staff Papers, Palgrave Macmillan, vol. 45(1), pages 81-109, March.
  15. Eric Santor, 2003. "Banking Crises and Contagion: Empirical Evidence," Working Papers 03-1, Bank of Canada.
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