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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. 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.
  2. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
  3. Patrick Honohan, 1997. "Banking system failures in developing and transition countries: Diagnosis and predictions," BIS Working Papers 39, Bank for International Settlements.
  4. Simon Johnson & Peter Boone & Alasdair Breach & Eric Friedman, 1999. "Corporate Governance in the Asian Financial Crisis," William Davidson Institute Working Papers Series 297, William Davidson Institute at the University of Michigan.
  5. Rafael La Porta & Florencio Lopez-deSilanes & Andrei Shleifer, 2000. "Government Ownership of Banks," Harvard Institute of Economic Research Working Papers 1890, Harvard - Institute of Economic Research.
  6. Eric Santor, 2003. "Banking Crises and Contagion: Empirical Evidence," Working Papers 03-1, Bank of Canada.
  7. 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.
  8. William Easterly & Ross Levine, 2002. "Tropics, Germs, and Crops: How Endowments Influence Economic Development," NBER Working Papers 9106, National Bureau of Economic Research, Inc.
  9. Rafael La Porta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, 1998. "Law and Finance," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1113-1155, December.
  10. Luigi Zingales, 1997. "Corporate Governance," NBER Working Papers 6309, National Bureau of Economic Research, Inc.
  11. Beck, Thorsten & Demirguc-Kunt, Asli & Levine, Ross, 2003. "Law and finance: why does legal origin matter?," Journal of Comparative Economics, Elsevier, vol. 31(4), pages 653-675, December.
  12. 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.
  13. 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.
  14. Kaufmann, Daniel & Kraay, Aart & Zoido-Lobaton, Pablo, 1999. "Governance matters," Policy Research Working Paper Series 2196, The World Bank.
  15. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
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