The cause and Interaction between banking crises and the business cycle

This paper analyzed the interplay between banking crises and the business cycle behaviour and its implication for the wider macroeconomy. Firstly, the business cycle of the economies was estimated using Hodrick & Prescott’s (1997) filter as a standard smoothing technique. Next, the turning points were identified, and the cycle was dated using the Harding & Pagan (2003) algorithm, an extension from Bry and Boschan (1971), with the aid of the Philippe Bracke (2011) SBBQ Stata module. Finally, after identifying the peak and trough phases, the distance between the duo was further labelled, and the entire stretch of the economies’ business cycle was classified into six phases, namely recovery, expansion, peak, recession, depression, and trough. The aim is; to ascertain the reactivity between banking crises and the individual business cycle phases and their implications for the aggregate economy. This objective is in addition to; exploring the relationship between banking crises and the cyclical behaviour of the business cycle; ascertaining the probability of banking crises induced by the cyclical behaviour of the business cycle; and establishing the gaps generated by the interactions between banking crises and; the output, the industrial production and the credit gaps. The panel vector autoregressive (pVAR) model was employed. Also, the logistic regression model and the Harding & Pagan (2003) concordance index were applied with diagnostic tests and the adaptive LASSO for robustness checks. The result found three broader categories of banking crises. These are banking crises made possible by; liquidity pressure during economic expansions, excessive leverage(boom and bust) and economic downturns. Banking crises severely contracted the business cycle, via the trough, depression, and recovery phases, with feedback mechanisms lasting about four years. The business cycle caused banking crises in its extreme region- the topmost peak phase, the lowest trough phase, and the recovery phase. The result further confirmed that banking crises naturally occur during the Depression, Recovery, and Trough phases and weakly on the Expansion phases (in that order). Nations slipped from peak to trough during banking crises, but none moved from trough to peak. These results emphasised the importance of macro-financial linkages and their vulnerabilities, suggesting need for policy synergy and considering the business cycle phases in designing and implementing economic policies.