Transparency, Liberalization and Financial Crises

We investigate the effect of financial liberalization on the probability of a banking crises in economies with poor transparency We construct a model with imperfect information where banks cannot distinguish between aggregate shocks on the one hand, and government’s policy and firms’ quality, on the other. Thus, a sequence of positive shocks or non- transparent policy causes banks to increase their credit above the optimal level given the underlying value of the firms. Once banks discover their large exposure, they are likely to roll-over bad loans rather than declare their losses. This delays the crisis, but increasing its magnitude. Empirical investigation using data on 56 countries from 1977 to 1997 supports the theoretical model. We find that the probability of a crisis is higher in the period following financial liberalization, significantly so in countries with poor transparency.