The Effect of Financial Liberalization on Various Financial Crises

Abstract

This paper examines the effect of financial liberalization on various financial crises by differentiating developing and developed countries. In the last few decades, countries tended to liberalize their financial system. Commonly, financial liberalization is viewed to promote economic growth because it strengthens financial development. However, in contrast, some studies find that financial liberalization induces excessive risk-taking behavior, increases macroeconomic volatility and leads to more frequent crises.Based on a study of 53 countries from Demirguc-Kunt and Detragiache in 1998, 78% of financial crises occurred in the period of liberalization. The study shows that when a country liberalizes its interest rate, it is more likely that country experiences a banking crisis. This fact motivates the author to closely analyze the relationship between financial liberalization and financial crises. The author also wants to contribute to the literature in this area by not only focusing on banking crisis but also adding some other types of crises such as debt crisis, inflation crisis, currency crisis and stock market crash. Since the countries that experienced these crises consist of both developing and developed countries, the author wants to find out whether the effect is the same for developing and developed countries.The dataset which consist of 35 countries data from 1973-2005 is estimated by the linear probability model combined with fixed effect and IV probit model. The author uses the dummy variable for various crises as dependent variable and the financial liberalization index as the main explanatory variable. The financial liberalization uses seven different dimensions of financial sector policy that affect the financial liberalization process. The following seven dimensions are credit controls and excessively reserve requirements, interest rate controls, entry barriers, state ownership in the banking sector, capital account restrictions, prudential regulations and supervision of the banking sector, and securities market policy.As a result, financial liberalization increases the likelihood of banking crisis and debt crisis in both developing and developed countries. Regarding inflation crisis, financial liberalization increases the likelihood of crisis in developed countries but reduces the likelihood of crisis in developing countries. Financial liberalization decreases the probability of currency crisis in developing countries and increases the probability of stock market crash in developed countries. In the last part, the author provides financial liberalization dimensions that have major contribution in affecting each type of crises.