Financial Liberalization and Banking Crises in Emerging Economies

In this paper, we provide a theoretical explanation of why financial liberalization is likely to generate financial crises in emerging market economies. We first show that under financial repression the aggregate capital stock and bank net worth are both likely to be low. This leads a newly liberalized bank to be highly levered, because the marginal product of capital---and thus loan interest rates---are high. The high returns on capital, however, also make default unlikely, and they encourage the bank to retain all of its earnings. As the bank's net worth grows, aggregate capital rises, the marginal product of capital falls and a banking crisis becomes more likely. Although the bank faces conflicting incentives toward risk-taking, as net worth continues to grow the bank will become increasingly cautious. Numerical results suggest that the bank will reduce its risk, by reducing its leverage, before issuing dividends. We also find that government bailouts, which allow defaulting banks to continue running, induce significantly more risk-taking than the liability limits associated with standard bankruptcy.