Description
While the literature studying the effect of banking crises on real output growth rates has
found short-lived effects, recent work has focused on the level effects showing that banking crises can
reduce output below its trend for several years. This paper aims to investigate the effect of banking
crises on investment finding a prolonged negative effect
Journal of Financial Economic Policy
The persistent effect of banking crises on investment and the role of financial markets
Felix Rioja Fernando Rios-Avila Neven Valev
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To cite this document:
Felix Rioja Fernando Rios-Avila Neven Valev , (2014),"The persistent effect of banking crises on investment
and the role of financial markets", J ournal of Financial Economic Policy, Vol. 6 Iss 1 pp. 64 - 77
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The persistent effect of banking
crises on investment and the role
of ?nancial markets
Felix Rioja, Fernando Rios-Avila and Neven Valev
Department of Economics, Andrew Young School of Policy Studies,
Georgia State University, Atlanta, Georgia, USA
Abstract
Purpose – While the literature studying the effect of banking crises on real output growth rates has
found short-lived effects, recent work has focused on the level effects showing that banking crises can
reduce output below its trend for several years. This paper aims to investigate the effect of banking
crises on investment ?nding a prolonged negative effect.
Design/methodology/approach – The authors test to see whether investment declines after a
banking crisis and, if it does, for how long and by how much. The paper uses data for 148 countries
from 1963 to 2007. Econometrically, the authors test how banking crises episodes affect investment in
future years after controlling for other potential determinants.
Findings – The authors ?nd that the investment to GDP ratio is on average about 1.7 percent lower for
about eight years following a banking crisis. These results are robust after controlling for credit
availability, institutional characteristics, and a host of other factors. Furthermore, the authors ?nd that
the size and duration of this adverse effect on investment varies according to the level of ?nancial
development of a country. The largest and longer-lasting decrease in investment is found in countries in
a middle region of ?nancial development, where ?nance plays its most important role according to
theory.
Originality/value – The authors contribute by ?nding that banking crisis can have long-term
effects on investment of up to nine years. Further, the authors contribute by ?nding that the level of
development of the country’s ?nancial markets affects the duration of this decrease in investment.
Keywords Investment, Banking crises, Financial development
Paper type Research paper
I. Introduction
A large body of research has established that banking crises lead to a steep decline in
output, investment, and employment. This literature ?nds that economic growth
resumes in one to three years after the onset of the crisis, which is the amount of time that
it typically takes to resolve the major problems in the ?nancial sector (Kaminsky and
Reinhart, 1998; Eichengreen and Rose, 1998; Dell’Ariccia et al., 2008). However, although
economic growth resumes, some recent studies ?nd that there may be a long-term
decline in output whichremains belowits pre-crisis trend. Speci?cally, Cerra and Saxena
(2008) ?nd that, even ten years after a banking crisis, output remains about 7 percent
below its pre-crisis trend. Hence, banking crises may have persistent effects on
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G01, E22
The authorswouldlike tothankLawrenceBall, BarryBosworth, Daniel Leigh, ElizabethSearing,
and Henry Thompson for valuable comments. Useful comments from seminar participants at the
Brookings Institution and Auburn University are gratefully acknowledged.
Journal of Financial Economic Policy
Vol. 6 No. 1, 2014
pp. 64-77
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-08-2013-0035
JFEP
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the economy. The IMF’s WorldEconomic Outlook (2009) further ?nds that the persistent
fall in output in the mediumtermarises fromreductions in both employment and capital.
We explore the origins of the persistent effect by focusing on investment in capital,
a key component of output, which typically accounts for a large part of the variations in
output during crises. We investigate whether investment declines after a banking crisis
and, if it does, for howlong and by howmuch. The paper uses data for 148 countries from
1963 to 2007, including the well-known Reinhart and Rogoff (2008) event data on banking
crises episodes. Our results con?rmthat banking crises have long-termconsequences. We
?nd that crises reduce investment even after controlling for feedback effects fromgrowth
to investment, the magnitude of the crisis, institutions, level of development, anda number
of other factors. In fact, the investment to GDP ratio is on average about 1.7 percentage
points lower during each of the seven to nine years following a banking crisis.
We follow the work of Cerra and Saxena (2008) who study the long-term impacts of
banking crises (and other shocks) on output, but we focus on investment, funding for
which may critically depend on the banking sector. Further, whereas Cerra and Saxena
(2008) use a time series approach, we use panel methods that allow us to control for a
host of other factors that may contribute to the decline in investment. We are also
cautious about potential reverse causality as a banking crisis could be the outcome of a
deteriorating economic environment and reduced investment. Although we cannot
entirely rule out the potential of reverse causality, we confront this issue to the degree
that we can using a lagged structure in our empirical models.
Perhaps, the closest paper to our work is Joyce and Nabar’s (2009). They study the
effects of “sudden stops” (sudden declines in capital in?ows) and banking crises
on investment in 26 emerging market economies. They ?nd that banking crises can
affect investment negatively but that sudden stops do not have an independent effect on
investment. We extend Joyce and Nabar (2009) making the following contributions.
First, we test how long the adverse effects of banking crises last and measure the size of
the effect over a number of years. Second, we consider a larger sample of countries, 148,
than Joyce and Nabar (2009) which studies 26 countries.
Third, we investigate how investment is affected in countries with different levels of
?nancial development. We are motivated by an earlier literature that shows a
non-monotonic effect of ?nancial development (typically proxied by credit issued to the
private sector) on GDP per capita growth. According to this literature, credit may have
only a small effect on economic growth at low levels of ?nancial development
(“low region”) for the following reasons. Banks may be too small to fund large,
high-productivity investments (Acemoglu andZilibotti, 1997); banks maynot effectively
pool and diversify risk (Saint-Paul, 1992; Bencivenga and Smith, 1991); and banks may
still be gaining experience allocating credit (Lee, 1996). Only after the ?nancial system
attains a critical size (entering a “middle region”) the above issues are overcome, and it
starts to have a strong positive effect on economic growth. However, once the banking
system grows large past another threshold and enters the “high region”, its positive
effects decline. This may be due to the following reasons: diminishing returns set in
(Greenwood and Jovanovic, 1990); market-based ?nancing becomes increasingly
important as a substitute for credit (Levine and Zervos, 1998, De Gregorio and Guidotti,
1995); or because a larger fraction of credit is allocated to households for consumption
(Beck et al., 2012). The ?ndings in Rioja and Valev (2004) con?rm the non-monotonic
effect of the ?nancial system on economic growth described above. Another related
Persistent effect
of banking crises
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paper to this research is Rioja et al. (2012). However, that paper studies the role of serial
crises in the persistent effect of banking crises on investment.
Following this literature on the non-monotonic effect of the ?nancial system, we
investigate whether the effects of banking crises vary with different levels of ?nancial
development. We show that the adverse effect of banking crises on investment is most
pronounced in countries where credit has the strongest positive impact – in the
“middle region”. Investment interestingly rebounds more rapidly in countries with a
low level of ?nancial development.
The rest of the paper is structured as follows: Section II describes the data and
methodology; Section III discusses the results; and Section IV concludes.
II. Data and methodology
Reinhart and Rogoff (2008) identify episodes of banking crises as:
[. . .] periods when bank runs lead to the closure, merging or takeover of ?nancial institutions
or, if there are no runs, the closure, merging, takeover or large program assistance from the
public sector to an important ?nancial institution [which] led to similar distress in other
?nancial institutions.
Using this de?nition, Reinhart and Rogoff (2008) identify 156 banking crises in
110 countries from 1963 to 2007. We construct a dummy variable denoted crisis that takes
the value 1 for the year when a banking crisis started, andzero otherwise. The frequency of
bankingcrises has varied over time but seems to have trended upwards. For instance, only
three banking crisis in our dataset occurred between 1960 and 1975, whereas about
35 percent of all crises occurredinthe 1980s and45percent inthe ?rst half of the 1990s. This
trend declined in the latter years of the sample as only 16 percent of the crises happened
after 1995. Of course, this does not include the latest crises of 2008-2009 as our sample only
goes up to 2007. Appendix 1 presents summary data on the number of banking crises in
different country-income groups and in different regions of ?nancial development.
Countries in the middle region of ?nancial development experienced the most number of
banking crises and also have ?ve countries that have experienced three or more crises.
We are interested in the effect of banking crises on capital formation. We de?ne
Investment as real gross capital formation as share of GDP. The investment data come
from the Penn World Tables (Heston et al., 2011). As the summary statistics in Table I
show, investment is on average 17 percent of GDP in our sample of countries. Since we
are interested in how a banking crisis may affect investment, we de?ne our dependent
variable as the deviation of investment from its trend. Presumably a banking crisis will
result in a decrease in investment below its trend. We are interested in how large this
effect may be and how long investment remains below its trend. We compute a simple
quadratic trend for investment country by country and denote it Trend
i,t
. Then we
compute the deviation of actual investment in the country from its trend, so Investment
Deviation
i,t
¼ Investment
i,t
2 Trend
i,t
. Our basic empirical speci?cation is:
Investment Deviation
i;t
¼ a þ
X
10
k¼1
u
k
crisis
i;t2k
þ gX
i;t
þ e
i;t
ð1Þ
We construct lagged values of the crisis variable for eachcountryinthe sample andenter
up to ten lags. This speci?cation allows us to estimate the effect of a crisis on investment
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up to ten years after the onset of the crisis[1]. We are interested in the magnitude and
statistical signi?cance of the estimated parameters u at different lags. For example,
^
u
6
, 0 would indicate that a banking crisis reduces investment in the sixthyear after the
crisis began[2]. We estimate equation (1) using the entire sample and then for three
separate subsamples of countries based on their level of ?nancial development.
Equation(1) also includes a set of control variables that mayaffect investment, X. The
set of control variables is drawn from the literature. One key determinant of investment
is the amount of funding or credit issued to the private sector. A measure of credit that
has been widely used in the ?nance and growth literature (Levine, 2005) is Private Credit,
which we de?ne as the amount of credit issued by banks to the private sector as a share
of GDP[3]. Credit booms may be related to expansions of investment and credit crunches
may be related to decreases in investment. Since our dependent variable is investment’s
deviation fromtrend, it seems also appropriate to control for the deviation of credit from
trend. We followthe same procedure describedabove to compute the deviation of Private
Credit from trend and denote this variable Credit Deviation.
Another key determinant of the ?uctuations in investment may be the well-known
“accelerator effect”. When output in an economy has been growing fast, business pro?ts
and cash ?ows increase, which leads ?rms to increase investment. Hence, we use the
average GDP growth over the previous ?ve years to control for this “investment
accelerator” effect. The other variables that comprise our baseline control set are
standard controls for investment: GDP per capita, in?ation, government spending (as a
share of GDP), trade openness (as a share of GDP), and capital account openness. GDP
per capita controls for the stage of development of the country. In?ation maybe expected
to have a negative effect as it affects potential future returns (Aizenman and Marion,
1999). Openness of the economy to trade is likely to have a positive effect on investment
(Aizenman and Noy, 2006). The degree of capital (?nancial) account openness may also
affect investment. We use the well-known Chinn and Ito (2006, 2008) index of capital
account openness. Another control variable, the government spending share of GDP is
typically found to have a negative effect on economic growth; hence, a negative effect
on investment would be expected. In some regressions, we also control for stock
market activity which can be an alternative source of funds for investment. We use value
Variable Mean SD Min. Max.
Investment ratio 16.55 9.20 0.15 55.14
Investment deviation 20.50 3.75 217.57 24.60
Crisis 0.03 0.18 0 1
Main controls
GDP per capita 10,686 9,804 365 76,228
Avg. GDP growth 1.63 2.94 211.71 13.83
In?ation 27.63 322.37 211.69 11,749.64
Gov. spending 19.79 7.97 3.30 61.43
Private Credit 42.68 38.13 0.41 269.76
Credit Deviation 0.00 0.13 20.78 1.63
Value Traded 28.14 51.08 0 427.85
Openness 77.86 53.30 10.53 456.56
Capital account openness 0.40 1.57 21.83 2.50
Law and Order 3.82 1.47 0 6
Table I.
Summary statistics
Persistent effect
of banking crises
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traded which measures the value of the traded shares in the domestic stock market as a
share of GDP. It measures howactive or liquid the country’s stock market is. Finally, we
use the index of Law and Order published by the International Country Risk Guide
(ICRG) as measures of institutional development. Adding institutions to the equation is
important as banking crises might be a symptom of underdeveloped institutions and,
therefore, the effect of crises on investment that we detect could be a proxy for the role of
institutions. Appendix 2 shows the de?nitions and the sources of the data, while Table I
presents the summary statistics and Table II presents correlations.
Investment
ratio
Investment
deviation Crisis
Multiple
crisis
GDP per
capita
Avg. GDP
growth In?ation
Investment
ratio 1
Investment
deviation 0.4914 1
Crisis 20.0477 20.0016 1
Multiple
crisis 20.1151 0.0286 0.1781 1
GDP per
capita 0.5868 0.1466 20.0682 20.108 1
Avg. GDP
growth 0.3037 0.2217 20.0117 20.1198 0.1143 1
In?ation 20.058 20.0332 0.044 0.0726 20.0664 20.0906 1
Gov.
spending 20.2801 20.1831 0.0105 20.107 20.2964 20.0402 20.0001
Private
Credit 0.5701 0.1537 20.0249 20.0812 0.6645 0.1196 20.0824
Credit
Deviation 0.1291 0.1294 0.0979 0.0022 0.061 0.0396 20.0164
Value
Traded 0.3853 0.1569 20.0353 20.018 0.5577 0.0612 20.0411
Openness 0.2952 0.0676 20.0751 20.1731 0.2499 0.1583 20.0796
Capital acct.
openness 0.4139 0.1365 20.0461 0.0186 0.5945 0.097 20.1188
Law and
Order 0.4568 0.0126 20.0312 20.1675 0.6928 0.1332 20.104
Gov.
spending
Private
Credit
Credit
Deviation
Value
Traded Openness
Capital
account
openness
Law and
Order
Gov.
spending 1
Private
Credit 20.2246 1
Credit
Deviation 20.0476 0.4084 1
Value
Traded 20.2637 0.5154 0.0353 1
Openness 20.0792 0.3128 0.0113 0.2157 1
Capital acct.
openness 20.1819 0.4656 0.0538 0.3111 0.2485 1
Law and
Order 20.0801 0.5427 0.079 0.3238 0.1947 0.4489 1
Table II.
Correlations
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III. Results
The effects of banking crises on investment
We ?rst estimate equation (1) regressing the deviation of investment from its trend on
lags of the banking crisis dummy and our baseline control set. Both ?xed effects and
random effects regressions were initially estimated with the Hausman test indicating
that country ?xed effects is the more appropriate approach. All the estimations
presented in the paper henceforth are ?xed effects regressions.
The results in Table III show that investment can be adversely affected by banking
crises which decrease investment below its trend for as long as seven to nine years. For
example, regression (1) shows that the effect of a crisis reduces investment for up to
nine years. The size of the coef?cient estimates for the crises dummies measure the
percent of GDP by which investment falls. Therefore, the adverse effect of banking
crises is economically signi?cant as investment is on average about 1.7 percent of GDP
below trend for nine years (ranging from 1.16 to 2.23 percent of GDP). The largest
impact occurs three years after the crisis when investment is 2.23 percent of GDP
below trend. Regressions (2), (3), and (4) add other control variables; the persistent
effect of banking crisis is con?rmed in these regressions.
It is useful to compare our results to Joyce and Nabar’s (2009). Their estimated
effect of banking crisis on contemporaneous investment is about 21.28 percent of
GDP. According to our Table III, the effect one year after the crisis is about 22 percent
of GDP. As explained in footnote [2], we also estimated our model with a
contemporaneous crisis term. The estimated coef?cient (unreported) is about
21.0 percent of GDP, similar to Joyce and Nabar’s estimate. Hence, while our
contemporaneous impact is about the same as Joyce and Nabar’s (2009), we estimate
the effects in subsequent years which are larger. A second comparison can be made
with Joyce and Nabar’s (2009, p. 318) estimate of a long-run decrease in investment of
3.75 percent of GDP. In comparison, we ?nd that investment falls by about 1.8 percent
for each of the seven to nine years after the onset of the banking crisis. Hence, the
cumulative investment losses are about 14 percent of GDP over the period of seven to
nine years.
Regarding the control variables, Credit Deviation is statistically signi?cant in all
regressions. The interpretation is that when credit is below trend, investment is also
below trend and vice versa. Since it is possible that the reduction in investment
decreases the demand for credit, we do not claim a causal effect of credit on investment,
but can only say that they are positively related. Other control variables like the
“investment accelerator”, GDP per capita, government spending, and the openness of
the economy are statistically signi?cant in several regressions and have the expected
signs. In contrast, the institutional measure (Law and Order) and the measure of stock
markets (Value Traded) are not statistically signi?cant at standard con?dence levels.
The effects of banking crises, however, remain signi?cant and of roughly the same size
across speci?cations. In sum, the key ?nding in Table III is the sizable and persistent
negative effect of banking crises on investment after accounting for a host of
other factors.
Financial development and the effects of banking crises
We next investigate whether investment is affected in the same way in countries with
different levels of ?nancial development. To create three groups of countries with high,
Persistent effect
of banking crises
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Variables (1) (2) (3) (4)
L1.crisis 22.036
* * *
21.966
* * *
22.046
* * *
22.418
* * *
(0.352) (0.368) (0.385) (0.469)
L2.crisis 22.199
* * *
22.136
* * *
22.222
* * *
22.506
* * *
(0.378) (0.385) (0.398) (0.621)
L3.crisis 22.233
* * *
22.213
* * *
22.347
* * *
22.341
* * *
(0.393) (0.403) (0.417) (0.594)
L4.crisis 22.024
* * *
21.960
* * *
22.013
* * *
22.026
* * *
(0.370) (0.376) (0.399) (0.552)
L5.crisis 21.776
* * *
21.712
* * *
21.636
* * *
21.469
* * *
(0.373) (0.368) (0.394) (0.553)
L6.crisis 21.991
* * *
21.985
* * *
21.989
* * *
21.363
* *
(0.352) (0.349) (0.366) (0.549)
L7.crisis 22.022
* * *
21.939
* * *
21.939
* * *
21.159
* *
(0.372) (0.360) (0.366) (0.491)
L8.crisis 21.647
* * *
21.600
* * *
21.663
* * *
20.909
*
(0.397) (0.378) (0.381) (0.464)
L9.crisis 21.165
* *
21.165
* *
21.280
* * *
20.679
(0.476) (0.464) (0.449) (0.484)
L10.crisis 20.575 20.597 20.649 0.0514
(0.448) (0.459) (0.438) (0.402)
Credit Deviation 5.730
* * *
5.831
* * *
6.037
* * *
2.465
* *
(1.490) (1.467) (1.600) (1.119)
GDP per cap. 0.795
* *
0.344 20.868 3.301
* *
(0.364) (0.421) (0.609) (1.635)
In?ation 0.0571 0.191 20.105
(0.333) (0.289) (0.265)
Gov. spending 20.111
* *
20.133
* *
20.353
* * *
(0.0438) (0.0520) (0.0753)
Openness 0.0301
* * *
20.00332
(0.00985) (0.0108)
Avg. ?ve year GDP growth 0.111
*
0.197
* *
(0.0590) (0.0942)
Capital acct. openness 0.0680 0.0769
(0.130) (0.193)
Law and Order 0.0472
(0.205)
Value Traded 20.459
(0.533)
Constant 26.313
* *
20.0601 8.266 223.69
(3.123) (4.164) (5.461) (14.75)
Observations 4,157 4,105 3,780 1,406
Number of countries 148 148 141 90
R
2
overall 0.06 0.08 0.12 0.32
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation of
investment as a share of GDP from its trend; results shown are from robust ?xed effects regressions;
Lj.Crisis is a dummy variable for a banking crisis that occurred j years ago; GDP per cap. is log of GDP
per capita; robust standard errors are in parenthesis
Table III.
The effect of banking
crisis on investment
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middle or low ?nancial development, we rank order the countries in terms of each
country’s average value for Private Credit over the entire sample period. Using an
average over the entire sample period eliminates temporary ?uctuations in credit
activity and provides a long-term indicator of the size of the credit market in each
country. We separate the sample into three roughly equal groups of countries with low,
middle, and high level of ?nancial development[4]. Appendix 3 lists the countries
within each region.
Table IV shows the results from estimating equation (1) for each of the three groups
separately[5]. The results show that banking crises have a relatively short-lived impact
on investment in countries with low ?nancial development where the investment
decline is only statistically signi?cant for two years. Conversely, in countries in the
middle region of ?nancial development, the impact is long: ten years. In countries with
a high level of ?nancial development, the impact lasts for about seven years. Thus,
the countries in the middle region are affected most adversely.
Low Middle High
Variables (1) (2) (3) (4) (5) (6)
L1.crisis 21.476
* *
21.420
* *
22.557
* * *
22.539
* * *
21.659
*
21.231
(0.574) (0.577) (0.392) (0.384) (0.838) (0.956)
L2.crisis 21.405
* * *
21.366
* * *
22.156
* * *
22.130
* * *
22.724
* * *
22.328
* *
(0.485) (0.484) (0.455) (0.453) (0.958) (0.998)
L3.crisis 20.884 20.942 22.462
* * *
22.424
* * *
22.928
* * *
22.520
* * *
(0.828) (0.845) (0.484) (0.474) (0.782) (0.816)
L4.crisis 21.260
*
21.183 22.021
* * *
22.012
* * *
22.603
* * *
22.215
* * *
(0.736) (0.769) (0.501) (0.494) (0.738) (0.793)
L5.crisis 21.082 21.020 21.908
* * *
21.934
* * *
22.071
* * *
21.757
* *
(0.733) (0.732) (0.593) (0.593) (0.609) (0.658)
L6.crisis 20.938 20.864 22.350
* * *
22.382
* * *
22.296
* * *
22.113
* * *
(0.651) (0.665) (0.600) (0.597) (0.474) (0.487)
L7.crisis 21.301 21.014 22.401
* * *
22.423
* * *
21.915
* * *
21.937
* * *
(0.778) (0.741) (0.617) (0.617) (0.489) (0.528)
L8.crisis 20.549 20.287 22.489
* * *
22.509
* * *
21.119
*
21.192
*
(0.796) (0.734) (0.656) (0.659) (0.643) (0.639)
L9.crisis 0.467 0.735 22.524
* * *
22.539
* * *
20.680 20.537
(1.024) (0.962) (0.723) (0.735) (0.686) (0.704)
L10.crisis 0.937 1.087 21.598
* *
21.647
* *
20.406 20.367
(1.093) (1.069) (0.612) (0.623) (0.652) (0.578)
Observations 1,151 1,136 1,426 1,416 1,580 1,553
No. of countries 48 48 49 49 51 51
R
2
overall 0.06 0.05 0.11 0.11 0.05 0.15
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation of
investment as a share of GDP from its trend; results shown are from robust ?xed effects regressions;
regressions for countries in the low, middle, and high regions according to their levels of Private Credit;
the ?rst regression for each group also include Credit Deviation and GDP per cap. as controls
(unreported); the second regression includes Credit Deviation, GDPper cap., In?ation and Gov. Spending
as controls (unreported); Lj.Crisis is a dummy variable for a banking crisis that occurred j years ago;
GDP pc is log of GDP per capita; robust standard errors are in parenthesis
Table IV.
Banking crisis effects and
?nancial development
(Private Credit)
Persistent effect
of banking crises
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These results appear to be consistent with the theoretical literature described in the
introduction. Several theories predict a small effect of ?nancial development on the
economy in countries with low?nancial development, e.g. Acemoglu and Zilibotti (1997)
and Bencivenga and Smith (1991). In these countries, bank credit disruptions may
have relatively small effects on the economy. Our results show that indeed a banking
crisis may reduce investment for only two years in countries in the low region. Once the
?nancial market attains a critical size and reaches the middle region, however, bank
credit plays a larger role in ?nancing investment. Hence, a disruption in ?nancing
investment that likely comes with a banking crisis may account for the observed
long-term effect of ten years[6].
We tried to ascertain that the differences in recovery times are because of different
levels of ?nancial development and not just due to different income levels or
institutional quality. Hence, we ran robustness regressions separating countries into
three groups by:
.
income per capita; and
.
by institutional development (using the Law and Order variable).
However, we did not ?nd much difference in the effect of banking crisis in the three
groups of countries[7]. In other words, the results in Table IV are not a proxy for
differences in income levels or institutional quality. The effect of banking crises on
investment appears to depend on the importance of the banking system for investment
identi?ed in the three regions of ?nancial development.
One more robustness test was conducted. Instead of separating countries into three
?nancial development groups according to Private Credit, we separated them by Liquid
Liabilities. The variable Liquid Liabilities is an alternative measure of the depth of the
?nancial systemthat has been used in the literature (Levine, 2005). It measures currency
plus demand and interest-bearing liabilities of banks and other ?nancial intermediaries
as percent of GDP. The results presented in Table V con?rmour earlier ?ndings as they
are very similar to Table IV’s. The longest adverse effect on investment is in countries in
the middle region.
IV. Conclusions
How do we evaluate the adverse effects of a banking crisis on the economy? Typically
the literature has measured the value of the ?scal cost or the output lost within a
narrow time frame. Our paper ?nds an additional dimension to the adverse effect of
banking crisis: the prolonged decrease in investment in capital. Banking crises can
depress investment by a sizable amount and for a long time. We ?nd that banking
crises can persistently reduce investment below its trend for up to seven to nine years.
This effect is robust across empirical speci?cations that control for a range of economic
and ?nancial variables.
Moreover, we ?nd that the decrease in investment depends on the level of ?nancial
development of the country. Speci?cally, banking crises have a longer and deeper
impact on investment in countries where the ?nancial system, in principle, has a
stronger positive effect on the economy during good times. These are the countries in
the middle region of ?nancial development. Since many emerging countries are in this
region, banking crisis can be particularly debilitating for them.
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The long-term impacts of banking crises on investment and the economy in general
merits further research attention. A next logical step is to use disaggregated data on
credit and investment to investigate the origins for the prolonged effect of banking
crises. Are all sectors of the economy affected in the same way? Is there relocation of
investment across sectors during the recovery? The speed of adjustment of investment
across the various sectors is likely to pay a role in the speed of recovery of aggregate
investment.
Notes
1. Joyce and Nabar’s (2009) speci?cation is in levels (they do not use deviations from trend);
rather they include lagged investment to account for its persistence.
2. Cerra and Saxena (2008) report results using: (i) only lagged values of crisis (as we do)
and (ii) using the contemporaneous crisis dummy along with its lagged values. They ?nd the
Low Middle High
Variables (1) (2) (3) (4) (5) (6)
L1.crisis 22.083
* * *
22.054
* * *
22.510
* * *
22.513
* * *
21.353
*
21.207
(0.492) (0.486) (0.569) (0.569) (0.753) (0.859)
L2.crisis 21.486
* * *
21.455
* * *
22.578
* * *
22.566
* * *
22.357
* *
22.370
* *
(0.526) (0.526) (0.379) (0.389) (1.040) (1.076)
L3.crisis 21.427
*
21.478
*
22.818
* * *
22.811
* * *
22.346
* *
22.309
* *
(0.733) (0.743) (0.369) (0.366) (0.904) (0.914)
L4.crisis 21.474
* *
21.428
* *
21.998
* * *
22.030
* * *
22.475
* * *
22.355
* * *
(0.623) (0.645) (0.555) (0.539) (0.757) (0.784)
L5.crisis 20.939 20.895 22.135
* * *
22.206
* * *
22.097
* * *
22.058
* * *
(0.621) (0.619) (0.645) (0.638) (0.622) (0.649)
L6.crisis 20.964
*
20.915
*
22.496
* * *
22.573
* * *
22.349
* * *
22.403
* * *
(0.537) (0.538) (0.637) (0.645) (0.573) (0.579)
L7.crisis 21.188
*
20.985
*
22.341
* * *
22.403
* * *
22.287
* * *
22.497
* * *
(0.600) (0.563) (0.647) (0.649) (0.631) (0.662)
L8.crisis 20.847 20.655 21.840
* *
21.911
* * *
21.995
* * *
22.298
* * *
(0.600) (0.550) (0.709) (0.702) (0.734) (0.772)
L9.crisis 0.352 0.545 22.195
* * *
22.260
* * *
21.476
*
21.443
(0.792) (0.756) (0.782) (0.777) (0.810) (0.878)
L10.crisis 0.445 0.553 20.763 20.878 21.293 21.355
(0.865) (0.860) (0.610) (0.606) (0.846) (0.867)
Observations 1,285 1,272 1,350 1,333 1,522 1,500
No. of
countries 50 50 48 48 50 50
R
2
overall 0.06 0.06 0.11 0.12 0.04 0.13
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation
of investment as a share of GDP from its trend; results shown are from robust ?xed effects
regressions; regressions for countries in the low, middle, and high regions according to their
levels of Liquid Liabilities; the ?rst regression for each group also include Credit Deviation and GDP
per cap. as controls (unreported); the second regression includes Credit Deviation, GDP per cap.,
In?ation and Gov. Spending as controls (unreported); Lj.Crisis is a dummy variable for a banking
crisis that occurred j years ago; GDP pc is log of GDP per capita; robust standard errors are
in parenthesis
Table V.
Banking crisis effects and
?nancial development
(Liquid Liabilities)
Persistent effect
of banking crises
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results are robust to both speci?cations. We follow a similar approach. As a baseline, we
choose the speci?cation with lags only in order to partially address the potential endogeneity
issue. In robustness tests, we also include the contemporaneous crisis variable ?nding the
results are unaffected by such inclusion.
3. Most of the literature refers to Private Credit as the credit issued by banks and other ?nancial
intermediaries to the private sector. We focus on bank credit only as we are particularly
interested in the effect of banking crisis.
4. Countries are classi?ed as follows. Low region if Private Credit # 0.17. Middle region if
0.17 , Private Credit , 0.369. High region if Private Credit $ 0.369.
5. There are two regression results reported for each region. The ?rst column includes Credit
Deviation and GDP per capita as controls. The second regression includes Credit Deviation,
GDP per capita, In?ation and Government Spending as controls. The coef?cients for the
control variables are unreported for conciseness.
6. We extended the lag structure past ten years in unreported regressions but there were no
statistically signi?cant effects beyond ten years.
7. The results are available on request.
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Appendix 1
Number of countries with
No crisis One crisis Two crises Three or more crises
Income group
High income OECD 8 14 0 1
High income non OECD 10 5 0 0
Upper middle income 16 9 5 3
Low middle income 24 18 10 2
Low income 20 30 7 1
Financial development
Low region 17 23 7 1
Middle region 13 22 9 5
High region 24 22 4 1
Table AI.
Banking crises by income
group and ?nancial
development
Persistent effect
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Sources of information
JFEP
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Appendix 3
Corresponding author
Felix Rioja can be contacted at: [email protected]
Low region Middle region High region
Albania Madagascar Algeria Mauritania Australia Kuwait
Angola Malawi Bangladesh Mauritius Austria Luxembourg
Argentina Mali Belgium Mexico Bahamas Macao
Armenia Moldova Bolivia Nicaragua Bahrain Malaysia
Benin Mongolia Brazil Oman Barbados Malta
Botswana Mozambique Bulgaria Pakistan Belize The Netherlands
Burkina Faso Nepal Cape Verde Papua New
Guinea
Brunei The Netherlands
Antilles
Burundi Niger Costa Rica Paraguay Canada New Zealand
Cambodia Nigeria Cote
d’Ivoire
Philippines Chile Norway
Cameroon Peru Ecuador Poland Croatia Panama
Central African
Republic
Romania Egypt Qatar Cyprus Portugal
Chad Russia El Salvador Samoa Czech
Republic
Singapore
Colombia Rwanda Estonia Saudi Arabia Denmark Slovak Republic
Congo Seychelles Fiji Senegal Dominica South Africa
Dominican
Republic
Sierra Leone Greece Slovenia Finland Spain
Ethiopia Solomon
Islands
Honduras Sri Lanka France St Kitts and Nevis
Gabon Syria Hungary Swaziland Germany St Lucia
Gambia Tanzania India Togo Guyana St Vincent and
Grenadine
Georgia Turkey Indonesia Tonga Hong Kong Sweden
Guatemala Uganda Iran Trinidad and
Tobago
Iceland Switzerland
Guinea-Bissau Yemen Jamaica Uruguay Ireland Thailand
Haiti Zimbabwe Kazakhstan Vanuatu Israel Tunisia
Kyrgyzstan Kenya Venezuela Italy UK
Laos Latvia Japan USA
Lesotho Lithuania Jordan Vietnam
Libya Macedonia Korea
Table AIII.
Country list and groups
according to ?nancial
development (Private
Credit)
Persistent effect
of banking crises
77
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This article has been cited by:
1. Felix Rioja, Fernando Rios-Avila, Neven Valev. 2014. Serial Banking Crises and Capital Investment.
Emerging Markets Finance and Trade 50, 193-208. [CrossRef]
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doc_718332197.pdf
While the literature studying the effect of banking crises on real output growth rates has
found short-lived effects, recent work has focused on the level effects showing that banking crises can
reduce output below its trend for several years. This paper aims to investigate the effect of banking
crises on investment finding a prolonged negative effect
Journal of Financial Economic Policy
The persistent effect of banking crises on investment and the role of financial markets
Felix Rioja Fernando Rios-Avila Neven Valev
Article information:
To cite this document:
Felix Rioja Fernando Rios-Avila Neven Valev , (2014),"The persistent effect of banking crises on investment
and the role of financial markets", J ournal of Financial Economic Policy, Vol. 6 Iss 1 pp. 64 - 77
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The persistent effect of banking
crises on investment and the role
of ?nancial markets
Felix Rioja, Fernando Rios-Avila and Neven Valev
Department of Economics, Andrew Young School of Policy Studies,
Georgia State University, Atlanta, Georgia, USA
Abstract
Purpose – While the literature studying the effect of banking crises on real output growth rates has
found short-lived effects, recent work has focused on the level effects showing that banking crises can
reduce output below its trend for several years. This paper aims to investigate the effect of banking
crises on investment ?nding a prolonged negative effect.
Design/methodology/approach – The authors test to see whether investment declines after a
banking crisis and, if it does, for how long and by how much. The paper uses data for 148 countries
from 1963 to 2007. Econometrically, the authors test how banking crises episodes affect investment in
future years after controlling for other potential determinants.
Findings – The authors ?nd that the investment to GDP ratio is on average about 1.7 percent lower for
about eight years following a banking crisis. These results are robust after controlling for credit
availability, institutional characteristics, and a host of other factors. Furthermore, the authors ?nd that
the size and duration of this adverse effect on investment varies according to the level of ?nancial
development of a country. The largest and longer-lasting decrease in investment is found in countries in
a middle region of ?nancial development, where ?nance plays its most important role according to
theory.
Originality/value – The authors contribute by ?nding that banking crisis can have long-term
effects on investment of up to nine years. Further, the authors contribute by ?nding that the level of
development of the country’s ?nancial markets affects the duration of this decrease in investment.
Keywords Investment, Banking crises, Financial development
Paper type Research paper
I. Introduction
A large body of research has established that banking crises lead to a steep decline in
output, investment, and employment. This literature ?nds that economic growth
resumes in one to three years after the onset of the crisis, which is the amount of time that
it typically takes to resolve the major problems in the ?nancial sector (Kaminsky and
Reinhart, 1998; Eichengreen and Rose, 1998; Dell’Ariccia et al., 2008). However, although
economic growth resumes, some recent studies ?nd that there may be a long-term
decline in output whichremains belowits pre-crisis trend. Speci?cally, Cerra and Saxena
(2008) ?nd that, even ten years after a banking crisis, output remains about 7 percent
below its pre-crisis trend. Hence, banking crises may have persistent effects on
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G01, E22
The authorswouldlike tothankLawrenceBall, BarryBosworth, Daniel Leigh, ElizabethSearing,
and Henry Thompson for valuable comments. Useful comments from seminar participants at the
Brookings Institution and Auburn University are gratefully acknowledged.
Journal of Financial Economic Policy
Vol. 6 No. 1, 2014
pp. 64-77
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-08-2013-0035
JFEP
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the economy. The IMF’s WorldEconomic Outlook (2009) further ?nds that the persistent
fall in output in the mediumtermarises fromreductions in both employment and capital.
We explore the origins of the persistent effect by focusing on investment in capital,
a key component of output, which typically accounts for a large part of the variations in
output during crises. We investigate whether investment declines after a banking crisis
and, if it does, for howlong and by howmuch. The paper uses data for 148 countries from
1963 to 2007, including the well-known Reinhart and Rogoff (2008) event data on banking
crises episodes. Our results con?rmthat banking crises have long-termconsequences. We
?nd that crises reduce investment even after controlling for feedback effects fromgrowth
to investment, the magnitude of the crisis, institutions, level of development, anda number
of other factors. In fact, the investment to GDP ratio is on average about 1.7 percentage
points lower during each of the seven to nine years following a banking crisis.
We follow the work of Cerra and Saxena (2008) who study the long-term impacts of
banking crises (and other shocks) on output, but we focus on investment, funding for
which may critically depend on the banking sector. Further, whereas Cerra and Saxena
(2008) use a time series approach, we use panel methods that allow us to control for a
host of other factors that may contribute to the decline in investment. We are also
cautious about potential reverse causality as a banking crisis could be the outcome of a
deteriorating economic environment and reduced investment. Although we cannot
entirely rule out the potential of reverse causality, we confront this issue to the degree
that we can using a lagged structure in our empirical models.
Perhaps, the closest paper to our work is Joyce and Nabar’s (2009). They study the
effects of “sudden stops” (sudden declines in capital in?ows) and banking crises
on investment in 26 emerging market economies. They ?nd that banking crises can
affect investment negatively but that sudden stops do not have an independent effect on
investment. We extend Joyce and Nabar (2009) making the following contributions.
First, we test how long the adverse effects of banking crises last and measure the size of
the effect over a number of years. Second, we consider a larger sample of countries, 148,
than Joyce and Nabar (2009) which studies 26 countries.
Third, we investigate how investment is affected in countries with different levels of
?nancial development. We are motivated by an earlier literature that shows a
non-monotonic effect of ?nancial development (typically proxied by credit issued to the
private sector) on GDP per capita growth. According to this literature, credit may have
only a small effect on economic growth at low levels of ?nancial development
(“low region”) for the following reasons. Banks may be too small to fund large,
high-productivity investments (Acemoglu andZilibotti, 1997); banks maynot effectively
pool and diversify risk (Saint-Paul, 1992; Bencivenga and Smith, 1991); and banks may
still be gaining experience allocating credit (Lee, 1996). Only after the ?nancial system
attains a critical size (entering a “middle region”) the above issues are overcome, and it
starts to have a strong positive effect on economic growth. However, once the banking
system grows large past another threshold and enters the “high region”, its positive
effects decline. This may be due to the following reasons: diminishing returns set in
(Greenwood and Jovanovic, 1990); market-based ?nancing becomes increasingly
important as a substitute for credit (Levine and Zervos, 1998, De Gregorio and Guidotti,
1995); or because a larger fraction of credit is allocated to households for consumption
(Beck et al., 2012). The ?ndings in Rioja and Valev (2004) con?rm the non-monotonic
effect of the ?nancial system on economic growth described above. Another related
Persistent effect
of banking crises
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paper to this research is Rioja et al. (2012). However, that paper studies the role of serial
crises in the persistent effect of banking crises on investment.
Following this literature on the non-monotonic effect of the ?nancial system, we
investigate whether the effects of banking crises vary with different levels of ?nancial
development. We show that the adverse effect of banking crises on investment is most
pronounced in countries where credit has the strongest positive impact – in the
“middle region”. Investment interestingly rebounds more rapidly in countries with a
low level of ?nancial development.
The rest of the paper is structured as follows: Section II describes the data and
methodology; Section III discusses the results; and Section IV concludes.
II. Data and methodology
Reinhart and Rogoff (2008) identify episodes of banking crises as:
[. . .] periods when bank runs lead to the closure, merging or takeover of ?nancial institutions
or, if there are no runs, the closure, merging, takeover or large program assistance from the
public sector to an important ?nancial institution [which] led to similar distress in other
?nancial institutions.
Using this de?nition, Reinhart and Rogoff (2008) identify 156 banking crises in
110 countries from 1963 to 2007. We construct a dummy variable denoted crisis that takes
the value 1 for the year when a banking crisis started, andzero otherwise. The frequency of
bankingcrises has varied over time but seems to have trended upwards. For instance, only
three banking crisis in our dataset occurred between 1960 and 1975, whereas about
35 percent of all crises occurredinthe 1980s and45percent inthe ?rst half of the 1990s. This
trend declined in the latter years of the sample as only 16 percent of the crises happened
after 1995. Of course, this does not include the latest crises of 2008-2009 as our sample only
goes up to 2007. Appendix 1 presents summary data on the number of banking crises in
different country-income groups and in different regions of ?nancial development.
Countries in the middle region of ?nancial development experienced the most number of
banking crises and also have ?ve countries that have experienced three or more crises.
We are interested in the effect of banking crises on capital formation. We de?ne
Investment as real gross capital formation as share of GDP. The investment data come
from the Penn World Tables (Heston et al., 2011). As the summary statistics in Table I
show, investment is on average 17 percent of GDP in our sample of countries. Since we
are interested in how a banking crisis may affect investment, we de?ne our dependent
variable as the deviation of investment from its trend. Presumably a banking crisis will
result in a decrease in investment below its trend. We are interested in how large this
effect may be and how long investment remains below its trend. We compute a simple
quadratic trend for investment country by country and denote it Trend
i,t
. Then we
compute the deviation of actual investment in the country from its trend, so Investment
Deviation
i,t
¼ Investment
i,t
2 Trend
i,t
. Our basic empirical speci?cation is:
Investment Deviation
i;t
¼ a þ
X
10
k¼1
u
k
crisis
i;t2k
þ gX
i;t
þ e
i;t
ð1Þ
We construct lagged values of the crisis variable for eachcountryinthe sample andenter
up to ten lags. This speci?cation allows us to estimate the effect of a crisis on investment
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up to ten years after the onset of the crisis[1]. We are interested in the magnitude and
statistical signi?cance of the estimated parameters u at different lags. For example,
^
u
6
, 0 would indicate that a banking crisis reduces investment in the sixthyear after the
crisis began[2]. We estimate equation (1) using the entire sample and then for three
separate subsamples of countries based on their level of ?nancial development.
Equation(1) also includes a set of control variables that mayaffect investment, X. The
set of control variables is drawn from the literature. One key determinant of investment
is the amount of funding or credit issued to the private sector. A measure of credit that
has been widely used in the ?nance and growth literature (Levine, 2005) is Private Credit,
which we de?ne as the amount of credit issued by banks to the private sector as a share
of GDP[3]. Credit booms may be related to expansions of investment and credit crunches
may be related to decreases in investment. Since our dependent variable is investment’s
deviation fromtrend, it seems also appropriate to control for the deviation of credit from
trend. We followthe same procedure describedabove to compute the deviation of Private
Credit from trend and denote this variable Credit Deviation.
Another key determinant of the ?uctuations in investment may be the well-known
“accelerator effect”. When output in an economy has been growing fast, business pro?ts
and cash ?ows increase, which leads ?rms to increase investment. Hence, we use the
average GDP growth over the previous ?ve years to control for this “investment
accelerator” effect. The other variables that comprise our baseline control set are
standard controls for investment: GDP per capita, in?ation, government spending (as a
share of GDP), trade openness (as a share of GDP), and capital account openness. GDP
per capita controls for the stage of development of the country. In?ation maybe expected
to have a negative effect as it affects potential future returns (Aizenman and Marion,
1999). Openness of the economy to trade is likely to have a positive effect on investment
(Aizenman and Noy, 2006). The degree of capital (?nancial) account openness may also
affect investment. We use the well-known Chinn and Ito (2006, 2008) index of capital
account openness. Another control variable, the government spending share of GDP is
typically found to have a negative effect on economic growth; hence, a negative effect
on investment would be expected. In some regressions, we also control for stock
market activity which can be an alternative source of funds for investment. We use value
Variable Mean SD Min. Max.
Investment ratio 16.55 9.20 0.15 55.14
Investment deviation 20.50 3.75 217.57 24.60
Crisis 0.03 0.18 0 1
Main controls
GDP per capita 10,686 9,804 365 76,228
Avg. GDP growth 1.63 2.94 211.71 13.83
In?ation 27.63 322.37 211.69 11,749.64
Gov. spending 19.79 7.97 3.30 61.43
Private Credit 42.68 38.13 0.41 269.76
Credit Deviation 0.00 0.13 20.78 1.63
Value Traded 28.14 51.08 0 427.85
Openness 77.86 53.30 10.53 456.56
Capital account openness 0.40 1.57 21.83 2.50
Law and Order 3.82 1.47 0 6
Table I.
Summary statistics
Persistent effect
of banking crises
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traded which measures the value of the traded shares in the domestic stock market as a
share of GDP. It measures howactive or liquid the country’s stock market is. Finally, we
use the index of Law and Order published by the International Country Risk Guide
(ICRG) as measures of institutional development. Adding institutions to the equation is
important as banking crises might be a symptom of underdeveloped institutions and,
therefore, the effect of crises on investment that we detect could be a proxy for the role of
institutions. Appendix 2 shows the de?nitions and the sources of the data, while Table I
presents the summary statistics and Table II presents correlations.
Investment
ratio
Investment
deviation Crisis
Multiple
crisis
GDP per
capita
Avg. GDP
growth In?ation
Investment
ratio 1
Investment
deviation 0.4914 1
Crisis 20.0477 20.0016 1
Multiple
crisis 20.1151 0.0286 0.1781 1
GDP per
capita 0.5868 0.1466 20.0682 20.108 1
Avg. GDP
growth 0.3037 0.2217 20.0117 20.1198 0.1143 1
In?ation 20.058 20.0332 0.044 0.0726 20.0664 20.0906 1
Gov.
spending 20.2801 20.1831 0.0105 20.107 20.2964 20.0402 20.0001
Private
Credit 0.5701 0.1537 20.0249 20.0812 0.6645 0.1196 20.0824
Credit
Deviation 0.1291 0.1294 0.0979 0.0022 0.061 0.0396 20.0164
Value
Traded 0.3853 0.1569 20.0353 20.018 0.5577 0.0612 20.0411
Openness 0.2952 0.0676 20.0751 20.1731 0.2499 0.1583 20.0796
Capital acct.
openness 0.4139 0.1365 20.0461 0.0186 0.5945 0.097 20.1188
Law and
Order 0.4568 0.0126 20.0312 20.1675 0.6928 0.1332 20.104
Gov.
spending
Private
Credit
Credit
Deviation
Value
Traded Openness
Capital
account
openness
Law and
Order
Gov.
spending 1
Private
Credit 20.2246 1
Credit
Deviation 20.0476 0.4084 1
Value
Traded 20.2637 0.5154 0.0353 1
Openness 20.0792 0.3128 0.0113 0.2157 1
Capital acct.
openness 20.1819 0.4656 0.0538 0.3111 0.2485 1
Law and
Order 20.0801 0.5427 0.079 0.3238 0.1947 0.4489 1
Table II.
Correlations
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III. Results
The effects of banking crises on investment
We ?rst estimate equation (1) regressing the deviation of investment from its trend on
lags of the banking crisis dummy and our baseline control set. Both ?xed effects and
random effects regressions were initially estimated with the Hausman test indicating
that country ?xed effects is the more appropriate approach. All the estimations
presented in the paper henceforth are ?xed effects regressions.
The results in Table III show that investment can be adversely affected by banking
crises which decrease investment below its trend for as long as seven to nine years. For
example, regression (1) shows that the effect of a crisis reduces investment for up to
nine years. The size of the coef?cient estimates for the crises dummies measure the
percent of GDP by which investment falls. Therefore, the adverse effect of banking
crises is economically signi?cant as investment is on average about 1.7 percent of GDP
below trend for nine years (ranging from 1.16 to 2.23 percent of GDP). The largest
impact occurs three years after the crisis when investment is 2.23 percent of GDP
below trend. Regressions (2), (3), and (4) add other control variables; the persistent
effect of banking crisis is con?rmed in these regressions.
It is useful to compare our results to Joyce and Nabar’s (2009). Their estimated
effect of banking crisis on contemporaneous investment is about 21.28 percent of
GDP. According to our Table III, the effect one year after the crisis is about 22 percent
of GDP. As explained in footnote [2], we also estimated our model with a
contemporaneous crisis term. The estimated coef?cient (unreported) is about
21.0 percent of GDP, similar to Joyce and Nabar’s estimate. Hence, while our
contemporaneous impact is about the same as Joyce and Nabar’s (2009), we estimate
the effects in subsequent years which are larger. A second comparison can be made
with Joyce and Nabar’s (2009, p. 318) estimate of a long-run decrease in investment of
3.75 percent of GDP. In comparison, we ?nd that investment falls by about 1.8 percent
for each of the seven to nine years after the onset of the banking crisis. Hence, the
cumulative investment losses are about 14 percent of GDP over the period of seven to
nine years.
Regarding the control variables, Credit Deviation is statistically signi?cant in all
regressions. The interpretation is that when credit is below trend, investment is also
below trend and vice versa. Since it is possible that the reduction in investment
decreases the demand for credit, we do not claim a causal effect of credit on investment,
but can only say that they are positively related. Other control variables like the
“investment accelerator”, GDP per capita, government spending, and the openness of
the economy are statistically signi?cant in several regressions and have the expected
signs. In contrast, the institutional measure (Law and Order) and the measure of stock
markets (Value Traded) are not statistically signi?cant at standard con?dence levels.
The effects of banking crises, however, remain signi?cant and of roughly the same size
across speci?cations. In sum, the key ?nding in Table III is the sizable and persistent
negative effect of banking crises on investment after accounting for a host of
other factors.
Financial development and the effects of banking crises
We next investigate whether investment is affected in the same way in countries with
different levels of ?nancial development. To create three groups of countries with high,
Persistent effect
of banking crises
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Variables (1) (2) (3) (4)
L1.crisis 22.036
* * *
21.966
* * *
22.046
* * *
22.418
* * *
(0.352) (0.368) (0.385) (0.469)
L2.crisis 22.199
* * *
22.136
* * *
22.222
* * *
22.506
* * *
(0.378) (0.385) (0.398) (0.621)
L3.crisis 22.233
* * *
22.213
* * *
22.347
* * *
22.341
* * *
(0.393) (0.403) (0.417) (0.594)
L4.crisis 22.024
* * *
21.960
* * *
22.013
* * *
22.026
* * *
(0.370) (0.376) (0.399) (0.552)
L5.crisis 21.776
* * *
21.712
* * *
21.636
* * *
21.469
* * *
(0.373) (0.368) (0.394) (0.553)
L6.crisis 21.991
* * *
21.985
* * *
21.989
* * *
21.363
* *
(0.352) (0.349) (0.366) (0.549)
L7.crisis 22.022
* * *
21.939
* * *
21.939
* * *
21.159
* *
(0.372) (0.360) (0.366) (0.491)
L8.crisis 21.647
* * *
21.600
* * *
21.663
* * *
20.909
*
(0.397) (0.378) (0.381) (0.464)
L9.crisis 21.165
* *
21.165
* *
21.280
* * *
20.679
(0.476) (0.464) (0.449) (0.484)
L10.crisis 20.575 20.597 20.649 0.0514
(0.448) (0.459) (0.438) (0.402)
Credit Deviation 5.730
* * *
5.831
* * *
6.037
* * *
2.465
* *
(1.490) (1.467) (1.600) (1.119)
GDP per cap. 0.795
* *
0.344 20.868 3.301
* *
(0.364) (0.421) (0.609) (1.635)
In?ation 0.0571 0.191 20.105
(0.333) (0.289) (0.265)
Gov. spending 20.111
* *
20.133
* *
20.353
* * *
(0.0438) (0.0520) (0.0753)
Openness 0.0301
* * *
20.00332
(0.00985) (0.0108)
Avg. ?ve year GDP growth 0.111
*
0.197
* *
(0.0590) (0.0942)
Capital acct. openness 0.0680 0.0769
(0.130) (0.193)
Law and Order 0.0472
(0.205)
Value Traded 20.459
(0.533)
Constant 26.313
* *
20.0601 8.266 223.69
(3.123) (4.164) (5.461) (14.75)
Observations 4,157 4,105 3,780 1,406
Number of countries 148 148 141 90
R
2
overall 0.06 0.08 0.12 0.32
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation of
investment as a share of GDP from its trend; results shown are from robust ?xed effects regressions;
Lj.Crisis is a dummy variable for a banking crisis that occurred j years ago; GDP per cap. is log of GDP
per capita; robust standard errors are in parenthesis
Table III.
The effect of banking
crisis on investment
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middle or low ?nancial development, we rank order the countries in terms of each
country’s average value for Private Credit over the entire sample period. Using an
average over the entire sample period eliminates temporary ?uctuations in credit
activity and provides a long-term indicator of the size of the credit market in each
country. We separate the sample into three roughly equal groups of countries with low,
middle, and high level of ?nancial development[4]. Appendix 3 lists the countries
within each region.
Table IV shows the results from estimating equation (1) for each of the three groups
separately[5]. The results show that banking crises have a relatively short-lived impact
on investment in countries with low ?nancial development where the investment
decline is only statistically signi?cant for two years. Conversely, in countries in the
middle region of ?nancial development, the impact is long: ten years. In countries with
a high level of ?nancial development, the impact lasts for about seven years. Thus,
the countries in the middle region are affected most adversely.
Low Middle High
Variables (1) (2) (3) (4) (5) (6)
L1.crisis 21.476
* *
21.420
* *
22.557
* * *
22.539
* * *
21.659
*
21.231
(0.574) (0.577) (0.392) (0.384) (0.838) (0.956)
L2.crisis 21.405
* * *
21.366
* * *
22.156
* * *
22.130
* * *
22.724
* * *
22.328
* *
(0.485) (0.484) (0.455) (0.453) (0.958) (0.998)
L3.crisis 20.884 20.942 22.462
* * *
22.424
* * *
22.928
* * *
22.520
* * *
(0.828) (0.845) (0.484) (0.474) (0.782) (0.816)
L4.crisis 21.260
*
21.183 22.021
* * *
22.012
* * *
22.603
* * *
22.215
* * *
(0.736) (0.769) (0.501) (0.494) (0.738) (0.793)
L5.crisis 21.082 21.020 21.908
* * *
21.934
* * *
22.071
* * *
21.757
* *
(0.733) (0.732) (0.593) (0.593) (0.609) (0.658)
L6.crisis 20.938 20.864 22.350
* * *
22.382
* * *
22.296
* * *
22.113
* * *
(0.651) (0.665) (0.600) (0.597) (0.474) (0.487)
L7.crisis 21.301 21.014 22.401
* * *
22.423
* * *
21.915
* * *
21.937
* * *
(0.778) (0.741) (0.617) (0.617) (0.489) (0.528)
L8.crisis 20.549 20.287 22.489
* * *
22.509
* * *
21.119
*
21.192
*
(0.796) (0.734) (0.656) (0.659) (0.643) (0.639)
L9.crisis 0.467 0.735 22.524
* * *
22.539
* * *
20.680 20.537
(1.024) (0.962) (0.723) (0.735) (0.686) (0.704)
L10.crisis 0.937 1.087 21.598
* *
21.647
* *
20.406 20.367
(1.093) (1.069) (0.612) (0.623) (0.652) (0.578)
Observations 1,151 1,136 1,426 1,416 1,580 1,553
No. of countries 48 48 49 49 51 51
R
2
overall 0.06 0.05 0.11 0.11 0.05 0.15
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation of
investment as a share of GDP from its trend; results shown are from robust ?xed effects regressions;
regressions for countries in the low, middle, and high regions according to their levels of Private Credit;
the ?rst regression for each group also include Credit Deviation and GDP per cap. as controls
(unreported); the second regression includes Credit Deviation, GDPper cap., In?ation and Gov. Spending
as controls (unreported); Lj.Crisis is a dummy variable for a banking crisis that occurred j years ago;
GDP pc is log of GDP per capita; robust standard errors are in parenthesis
Table IV.
Banking crisis effects and
?nancial development
(Private Credit)
Persistent effect
of banking crises
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These results appear to be consistent with the theoretical literature described in the
introduction. Several theories predict a small effect of ?nancial development on the
economy in countries with low?nancial development, e.g. Acemoglu and Zilibotti (1997)
and Bencivenga and Smith (1991). In these countries, bank credit disruptions may
have relatively small effects on the economy. Our results show that indeed a banking
crisis may reduce investment for only two years in countries in the low region. Once the
?nancial market attains a critical size and reaches the middle region, however, bank
credit plays a larger role in ?nancing investment. Hence, a disruption in ?nancing
investment that likely comes with a banking crisis may account for the observed
long-term effect of ten years[6].
We tried to ascertain that the differences in recovery times are because of different
levels of ?nancial development and not just due to different income levels or
institutional quality. Hence, we ran robustness regressions separating countries into
three groups by:
.
income per capita; and
.
by institutional development (using the Law and Order variable).
However, we did not ?nd much difference in the effect of banking crisis in the three
groups of countries[7]. In other words, the results in Table IV are not a proxy for
differences in income levels or institutional quality. The effect of banking crises on
investment appears to depend on the importance of the banking system for investment
identi?ed in the three regions of ?nancial development.
One more robustness test was conducted. Instead of separating countries into three
?nancial development groups according to Private Credit, we separated them by Liquid
Liabilities. The variable Liquid Liabilities is an alternative measure of the depth of the
?nancial systemthat has been used in the literature (Levine, 2005). It measures currency
plus demand and interest-bearing liabilities of banks and other ?nancial intermediaries
as percent of GDP. The results presented in Table V con?rmour earlier ?ndings as they
are very similar to Table IV’s. The longest adverse effect on investment is in countries in
the middle region.
IV. Conclusions
How do we evaluate the adverse effects of a banking crisis on the economy? Typically
the literature has measured the value of the ?scal cost or the output lost within a
narrow time frame. Our paper ?nds an additional dimension to the adverse effect of
banking crisis: the prolonged decrease in investment in capital. Banking crises can
depress investment by a sizable amount and for a long time. We ?nd that banking
crises can persistently reduce investment below its trend for up to seven to nine years.
This effect is robust across empirical speci?cations that control for a range of economic
and ?nancial variables.
Moreover, we ?nd that the decrease in investment depends on the level of ?nancial
development of the country. Speci?cally, banking crises have a longer and deeper
impact on investment in countries where the ?nancial system, in principle, has a
stronger positive effect on the economy during good times. These are the countries in
the middle region of ?nancial development. Since many emerging countries are in this
region, banking crisis can be particularly debilitating for them.
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The long-term impacts of banking crises on investment and the economy in general
merits further research attention. A next logical step is to use disaggregated data on
credit and investment to investigate the origins for the prolonged effect of banking
crises. Are all sectors of the economy affected in the same way? Is there relocation of
investment across sectors during the recovery? The speed of adjustment of investment
across the various sectors is likely to pay a role in the speed of recovery of aggregate
investment.
Notes
1. Joyce and Nabar’s (2009) speci?cation is in levels (they do not use deviations from trend);
rather they include lagged investment to account for its persistence.
2. Cerra and Saxena (2008) report results using: (i) only lagged values of crisis (as we do)
and (ii) using the contemporaneous crisis dummy along with its lagged values. They ?nd the
Low Middle High
Variables (1) (2) (3) (4) (5) (6)
L1.crisis 22.083
* * *
22.054
* * *
22.510
* * *
22.513
* * *
21.353
*
21.207
(0.492) (0.486) (0.569) (0.569) (0.753) (0.859)
L2.crisis 21.486
* * *
21.455
* * *
22.578
* * *
22.566
* * *
22.357
* *
22.370
* *
(0.526) (0.526) (0.379) (0.389) (1.040) (1.076)
L3.crisis 21.427
*
21.478
*
22.818
* * *
22.811
* * *
22.346
* *
22.309
* *
(0.733) (0.743) (0.369) (0.366) (0.904) (0.914)
L4.crisis 21.474
* *
21.428
* *
21.998
* * *
22.030
* * *
22.475
* * *
22.355
* * *
(0.623) (0.645) (0.555) (0.539) (0.757) (0.784)
L5.crisis 20.939 20.895 22.135
* * *
22.206
* * *
22.097
* * *
22.058
* * *
(0.621) (0.619) (0.645) (0.638) (0.622) (0.649)
L6.crisis 20.964
*
20.915
*
22.496
* * *
22.573
* * *
22.349
* * *
22.403
* * *
(0.537) (0.538) (0.637) (0.645) (0.573) (0.579)
L7.crisis 21.188
*
20.985
*
22.341
* * *
22.403
* * *
22.287
* * *
22.497
* * *
(0.600) (0.563) (0.647) (0.649) (0.631) (0.662)
L8.crisis 20.847 20.655 21.840
* *
21.911
* * *
21.995
* * *
22.298
* * *
(0.600) (0.550) (0.709) (0.702) (0.734) (0.772)
L9.crisis 0.352 0.545 22.195
* * *
22.260
* * *
21.476
*
21.443
(0.792) (0.756) (0.782) (0.777) (0.810) (0.878)
L10.crisis 0.445 0.553 20.763 20.878 21.293 21.355
(0.865) (0.860) (0.610) (0.606) (0.846) (0.867)
Observations 1,285 1,272 1,350 1,333 1,522 1,500
No. of
countries 50 50 48 48 50 50
R
2
overall 0.06 0.06 0.11 0.12 0.04 0.13
Notes: Signi?cant at:
*
10,
* *
5 and
* * *
1 percent levels; the dependent variable is the deviation
of investment as a share of GDP from its trend; results shown are from robust ?xed effects
regressions; regressions for countries in the low, middle, and high regions according to their
levels of Liquid Liabilities; the ?rst regression for each group also include Credit Deviation and GDP
per cap. as controls (unreported); the second regression includes Credit Deviation, GDP per cap.,
In?ation and Gov. Spending as controls (unreported); Lj.Crisis is a dummy variable for a banking
crisis that occurred j years ago; GDP pc is log of GDP per capita; robust standard errors are
in parenthesis
Table V.
Banking crisis effects and
?nancial development
(Liquid Liabilities)
Persistent effect
of banking crises
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results are robust to both speci?cations. We follow a similar approach. As a baseline, we
choose the speci?cation with lags only in order to partially address the potential endogeneity
issue. In robustness tests, we also include the contemporaneous crisis variable ?nding the
results are unaffected by such inclusion.
3. Most of the literature refers to Private Credit as the credit issued by banks and other ?nancial
intermediaries to the private sector. We focus on bank credit only as we are particularly
interested in the effect of banking crisis.
4. Countries are classi?ed as follows. Low region if Private Credit # 0.17. Middle region if
0.17 , Private Credit , 0.369. High region if Private Credit $ 0.369.
5. There are two regression results reported for each region. The ?rst column includes Credit
Deviation and GDP per capita as controls. The second regression includes Credit Deviation,
GDP per capita, In?ation and Government Spending as controls. The coef?cients for the
control variables are unreported for conciseness.
6. We extended the lag structure past ten years in unreported regressions but there were no
statistically signi?cant effects beyond ten years.
7. The results are available on request.
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Appendix 1
Number of countries with
No crisis One crisis Two crises Three or more crises
Income group
High income OECD 8 14 0 1
High income non OECD 10 5 0 0
Upper middle income 16 9 5 3
Low middle income 24 18 10 2
Low income 20 30 7 1
Financial development
Low region 17 23 7 1
Middle region 13 22 9 5
High region 24 22 4 1
Table AI.
Banking crises by income
group and ?nancial
development
Persistent effect
of banking crises
75
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Sources of information
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Appendix 3
Corresponding author
Felix Rioja can be contacted at: [email protected]
Low region Middle region High region
Albania Madagascar Algeria Mauritania Australia Kuwait
Angola Malawi Bangladesh Mauritius Austria Luxembourg
Argentina Mali Belgium Mexico Bahamas Macao
Armenia Moldova Bolivia Nicaragua Bahrain Malaysia
Benin Mongolia Brazil Oman Barbados Malta
Botswana Mozambique Bulgaria Pakistan Belize The Netherlands
Burkina Faso Nepal Cape Verde Papua New
Guinea
Brunei The Netherlands
Antilles
Burundi Niger Costa Rica Paraguay Canada New Zealand
Cambodia Nigeria Cote
d’Ivoire
Philippines Chile Norway
Cameroon Peru Ecuador Poland Croatia Panama
Central African
Republic
Romania Egypt Qatar Cyprus Portugal
Chad Russia El Salvador Samoa Czech
Republic
Singapore
Colombia Rwanda Estonia Saudi Arabia Denmark Slovak Republic
Congo Seychelles Fiji Senegal Dominica South Africa
Dominican
Republic
Sierra Leone Greece Slovenia Finland Spain
Ethiopia Solomon
Islands
Honduras Sri Lanka France St Kitts and Nevis
Gabon Syria Hungary Swaziland Germany St Lucia
Gambia Tanzania India Togo Guyana St Vincent and
Grenadine
Georgia Turkey Indonesia Tonga Hong Kong Sweden
Guatemala Uganda Iran Trinidad and
Tobago
Iceland Switzerland
Guinea-Bissau Yemen Jamaica Uruguay Ireland Thailand
Haiti Zimbabwe Kazakhstan Vanuatu Israel Tunisia
Kyrgyzstan Kenya Venezuela Italy UK
Laos Latvia Japan USA
Lesotho Lithuania Jordan Vietnam
Libya Macedonia Korea
Table AIII.
Country list and groups
according to ?nancial
development (Private
Credit)
Persistent effect
of banking crises
77
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This article has been cited by:
1. Felix Rioja, Fernando Rios-Avila, Neven Valev. 2014. Serial Banking Crises and Capital Investment.
Emerging Markets Finance and Trade 50, 193-208. [CrossRef]
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