Financial Liberalization and Banking Crises

Choudhry Tanveer Shehzada and Jakob De Haana,b1

a
University of Groningen, The Netherlands
b
CESifo, Munich, Germany

September 2008

Abstract
We examine the impact of financial liberalization on systemic and non-systemic
banking crises, using new financial liberalization measures for a sample of
developing and developed countries for the period 1981 to 2002. In contrast to
conventional wisdom, our multivariate (two stage) probit modeling results
consistently suggest that financial liberalization reduces the likelihood of systemic
crises. In various sensitivity tests, these results turn out to be very robust. However,
there is some evidence that the likelihood of non-systemic crisis increases after
financial liberalization.

JEL Classifications: E44, G21, G28, F36

Keywords: Banking Crises, Financial Liberalization, Financial Fragility

Corresponding author : C.T.Shehzad, Faculty of Economics and Business,

University of Groningen, PO Box 800, 9700 AV Groningen, The Netherlands;
email: c.t.shehzad@rug.nl.

1
We are highly grateful to Abdul De Guia Abiad from the International Monetary Fund for his
generous permission to let us use his data on financial liberalization. We also thank Axel Dreher for
providing us his data on IMF and World Bank programs.
1. Introduction
Financial liberalization is generally believed to improve financial sector
development, which, in turn, will enhance economic growth. However, some
authors argue that liberalization induces risk-taking behavior and may cause
banking crises (Demirgüç-Kunt and Detragiache, 1998, 2000; Mehrez and
Kaufmann, 2000). However, the financial liberalization data used in these studies
was quite limited and rather subjective. Using better data, we argue that financial
liberalization reduces the likelihood of systemic banking crises.
Our indicator of financial liberalization is based on the data set of Abiad et
al. (2007) indicating the extent to which a financial system is liberalized. It is an
extended and updated version of the database as used by Abiad et al. (2005),
covering various dimensions of the financial system. The measures relate to the
presence of (i) credit controls and reserve requirements, (ii) interest rate controls,
(iii) entry barriers, (iv) state ownership in the banking sector, (v) capital account
restrictions, (vi) prudential regulation and supervision of the banking sector, and
(vii) securities market policy. Employing this data set, we analyze the impact of
financial liberalization on systemic and non-systemic banking crises. Our data on
banking crises come from Honahan and Laeven (2005). We analyze systemic and
non-systemic banking crises in 33 countries during the period 1981 to 2002. Our
research questions are: (1) does financial liberalization affect the likelihood of a
banking crisis, and if so, are there differences among the various dimensions of
financial liberalization that we distinguish, and (2) are systemic and non-systemic
crises affected in the same way by financial liberalization?
Our results suggest that liberalization reduce the likelihood of systemic
crises. In various sensitivity tests, these results turn out to be very robust. In
contrast, there is some evidence that the likelihood of non-systemic crisis increases
after financial liberalization.
The rest of the paper is organized as follows. Section 2 provides a
discussion on the determinants of banking crises and their link with financial
liberalization and introduces our measures for financial liberalization and banking
crises. Section 3 describes the empirical specification and explanatory variables
used and section 4 reports the results for systemic and non-systemic crises. Section

2
5 discusses possible endogeneity issues, while section 6 offers some further
robustness checks. Finally, section 7 concludes the paper.

2. Financial Liberalization and Banking Crisis

In their pioneering study, Demirgüç-Kunt and Detragiache (1998) analyze the
empirical relationship between banking crises and financial liberalization using data
from 1980-95 for 53 countries. Their findings suggest that banking crises are more
likely to occur in liberalized financial systems. They also find that the impact of
financial liberalization on a fragile banking sector is weaker where the institutional
environment is strong. However, the indicator of financial liberalization of
Demirgüç-Kunt and Detragiache (1998) can be criticized as they took the first year
in which some interest rates were liberalized as the beginning date of financial
liberalization. Though interest rate liberalization is important, it is quite a narrow
definition of financial liberalization, covering only a minor part of financial sector
reform.
Mehrez and Kaufmann (2000) examine how absence of corruption (i.e.,
‘transparency’) affects the probability of a financial crisis. Using multivariate probit
modeling for 56 countries during 1977-97, they report a higher probability of a
crisis following financial liberalization during the following five years. Moreover,
they also find that crisis probability is higher in countries with poor transparency
than in countries that are transparent. Mehrez and Kaufmann (2000) also show that
the results of Demirgüç-Kunt and Detragiache (1998) are sensitive to sample
selection and the definition of financial liberalization used. They provide their own
dating of financial liberalization and construct their liberalization measure on the
basis of these dates.
Focusing on the link between currency and banking crises, Kaminsky and
Reinhart (1999) analyze 76 currency crises and 26 banking crises for 20 countries
during 1970 to mid-1995. One of their main findings is that financial liberalization
often precedes banking crises. Their proxy for financial liberalization is two-year
lagged domestic credit growth. However, Demirgüç-Kunt and Detragiache (2000)
show that a multivariate logit model of banking crises probabilities results in lower
type-I and type-II errors than the Kaminsky and Reinhart (1999) approach.

3
 On the basis of a panel analysis, Caprio and Martinez (2000) find that
government ownership of banks increases the likelihood of banking crisis.
However, Barth et al. (2004) using cross-country analysis, do not find that
government ownership is significantly associated with increases in bank fragility
once they control for the regulatory and supervisory environment.
There are also some papers that do not explicitly include financial
liberalization as a potential determinant of banking crises. A good example is the
recent study by Beck et al. (2006) who examine the impact of national bank
concentration, bank regulations, and national institutions on the likelihood of a
country suffering systemic banking crises. They use data from 1980 to 1997 for 69
countries and report that crises are less likely in economies with more concentrated
banking systems. Moreover, they find that regulatory policies and institutions that
discourage competition are associated with greater banking system fragility.
The studies discussed above use different indicators of banking crises. Our
indicator of banking crises is based on the Honohan and Laeven (2005) dataset that
updates the work by Caprio and Klingebiel (1999), distinguishing between systemic
and non-systemic banking crises that have occurred since the late 1970s.2 This
database is one of the most comprehensive banking crises databases. In our analysis
of the relationship between (systemic and non-systemic) banking crises and
financial liberalization we use a sample of 33 countries during 1981 to 2002. This
selection is primarily dictated by the availability of the financial liberalization
index, to be discussed hereunder, and the availability of control variables.3 Table A-
1 in the Appendix identifies the years in which the countries in our sample had a
crisis.
Our data on financial liberalization come from Abiad et al. (2007) who
distinguish seven dimensions of the extent to which the financial sector has been
liberalized that are graded on scale from 3 (fully liberalized) to 0 (not liberalized).
Apart from distinguishing between different dimensions of financial liberalization,
the database has the advantage that it allows for policy reversals. The first
dimension of liberalization refers to credit controls and excessively high reserve

2
Caprio and Klingebiel (1999) define a systemic banking crisis as a crisis in which much or all bank
capital been exhausted. Honohan and Laeven (2005) use the same definition.
3
Abiad et al. (2007) provide data from 1973 to 2002 for 42 countries. However, various data series
in the World Banks’ World Development Indicators and the International Monetary Funds’
International Financial Statistics Database are only available from 1981 onwards and not for all
countries, restricting our dataset to 33 countries.

4
requirements (referred to as credit controls henceforth) focusing on the presence of
specific credit ceilings or floors and level for reserve requirements. The second
dimension is about interest rate controls examining whether they are administered
by government and whether there are floors, ceilings or bands present. The third
dimension is entry barriers, which is based on licensing requirements and
restrictions on geographical outreach activities. The fourth dimension covers state
ownership in the banking sector, i.e., the share of the assets of the banking sector
controlled by state-owned banks. The fifth dimension refers to capital account
restrictions and other restrictions on international capital flows. The sixth dimension
captures prudential regulations and supervision of the banking sector, including
compliance with the Basel standards, and executive influence on the banking
supervisory agency. The final dimension refers to securities market policy covering
the auctioning of government securities, debt and equity market development, and
openness to foreign investors.
Table 1 shows the averages of these measures over the period of our
analysis, i.e., 1981-2002, while Table 2 shows the correlation coefficients. Table 2
makes clear that the various dimensions of the extent to which a financial system
has been liberalized clearly differ from one another. Overall financial liberalization
has also been taken from Abiad et al. (2007) and consists of the sum of the scores
of the various liberalization dimensions. In our empirical analysis we take the
change of the various measures as our indicators of financial liberalization.

5
 TABLE 1. LIBERALIZATION MEASURES (MEANS), 1976-2002
Interest
Credit Rate Entry State Capital Securities
YEAR Liberalization Restrictions Control Barriers Supervision Ownership Flows Policy
1976 4.33 0.48 0.58 0.27 0.03 1.15 1.09 0.73
1977 4.76 0.58 0.67 0.33 0.03 1.15 1.27 0.73
1978 5.00 0.64 0.76 0.42 0.03 1.12 1.30 0.73
1979 5.30 0.70 0.76 0.45 0.03 1.12 1.45 0.79
1980 5.79 0.82 1.06 0.48 0.03 1.12 1.45 0.82
1981 5.91 0.82 1.03 0.61 0.06 1.15 1.42 0.82
1982 5.67 0.88 0.94 0.73 0.09 0.97 1.21 0.85
1983 5.79 0.97 0.91 0.76 0.09 0.91 1.27 0.88
1984 6.24 1.06 1.03 0.76 0.12 0.91 1.36 1.00
1985 6.61 1.15 1.24 0.91 0.12 0.88 1.30 1.00
1986 6.94 1.24 1.27 0.94 0.24 0.88 1.30 1.06
1987 7.58 1.39 1.61 0.91 0.30 0.94 1.24 1.18
1988 7.91 1.39 1.61 1.03 0.33 0.94 1.36 1.24
1989 8.73 1.39 1.88 1.06 0.39 1.09 1.48 1.42
1990 9.55 1.58 2.09 1.15 0.42 1.09 1.61 1.61
1991 11.03 1.79 2.48 1.27 0.48 1.30 1.85 1.85
1992 12.09 2.00 2.64 1.42 0.67 1.45 2.00 1.91
1993 12.91 2.09 2.61 1.82 0.79 1.52 2.12 1.97
1994 13.42 2.18 2.61 2.09 0.85 1.58 2.12 2.00
1995 14.03 2.33 2.67 2.09 1.00 1.64 2.21 2.09
1996 14.70 2.33 2.85 2.18 1.09 1.79 2.33 2.12
1997 14.97 2.42 2.85 2.24 1.15 1.76 2.36 2.18
1998 15.33 2.52 2.85 2.36 1.33 1.61 2.45 2.21
1999 15.67 2.52 2.88 2.48 1.36 1.70 2.48 2.24
2000 15.94 2.52 2.91 2.58 1.42 1.76 2.48 2.27
2001 15.91 2.47 2.88 2.56 1.47 1.78 2.53 2.25
2002 16.00 2.42 2.88 2.58 1.64 1.76 2.42 2.30

TABLE 2. CORRELATION COEFFICIENTS

Interest
Entry Capital Credit Rate State Securities
Liberalization Barriers Flows Restrictions Control Ownership Supervision Policy
Liberalization 1.00
Entry
Barriers 0.80 1.00
Capital Flows 0.80 0.54 1.00
Credit
Restrictions 0.84 0.63 0.59 1.00
Interest Rate
Control 0.78 0.61 0.52 0.61 1.00
State
Ownership 0.67 0.36 0.54 0.46 0.37 1.00
Supervision 0.75 0.61 0.50 0.60 0.51 0.45 1.00
Securities
Policy 0.86 0.67 0.69 0.68 0.59 0.52 0.62 1.00

6
3. Model Specification

To analyze the impact of financial liberalization on systemic and non-systemic

banking crises, we employ a panel data probit model as given in equation (1). On
the LHS of the model are dummy variables representing systemic and non-systemic
banking crises, respectively. The dependent variable P(i,t) takes a value of 1, if
there is a crisis and zero if there is no crisis. We assume that the probability that a
crisis will occur at a time t for country i is a function of a vector of n variables
denoted by X(i,t), that includes our financial liberalization variables and various
control variables. β is a vector of unknown coefficients and F(β’X(i,t)) is the
cumulative probability distribution function. The log-likelihood function of the
model can be written as:

Ln L = Σ t=1…T Σi=1…n [P(i,t) ln {F(β’X(i,t))} + (1- P(i,t)) ln {1-F(β’X(i,t))}] (1)

Using this model, the likelihood function is calculated by adaptive Gauss-Hermite

quadrature. The coefficients reported indicate the expected change in the log odds4
when there is a one unit change in the predictor variable with all of the other
variables in the model held constant.
In our empirical analysis, we take the change of liberalization as we are
interested in how liberalization reforms affect the probability of crises. In our
analysis, we examine the effect of any kind of liberalization reform in the previous
five years on the probability of the occurrence of a crisis. However, in our
sensitivity analysis, we also check for the effect of liberalization reforms over the
preceding three years. Moreover, as we mentioned before, Abiad et al. (2007)
contains seven dimensions of liberalization. Out of these seven dimensions, one is
about the supervision and prudential regulation. The authors themselves
acknowledge that this measure is different from the other dimensions. A higher
score in this case means better (more) regulation. So in our empirical analysis, we
do not treat this as a dimension of liberalization and also exclude it in calculating
the overall liberalization score. However, we include supervision as a control
variable because it may affect the probability of a crisis.
We include various other control variables following previous studies like
Beck et al. (2006) and Demirgüç-Kunt and Detragiache (2002). These variables

4
The relationship between odds ratio and coefficient can be captured by the formula as odds ratio =
exp(coefficient).

7
include real GDP growth, the change in the terms of trade, the rate of inflation5
(change in CPI Index), the real interest rate, the depreciation of the exchange rate,
and the ratio of M2 to foreign exchange reserves. Moreover, the two-year lagged
domestic credit growth rate is taken up (Kaminsky and Reinhart, 1999). Finally, we
include real GDP per capita (in US$ corresponding to 1981) to control for the level
of economic development. Table 3 summarizes the control variables and Table 4
shows their sources and expected signs.

Table 3. Summary Statistics

Standard
Variable Mean Deviation Maximum Minimum Observations

Liberalization (total) 9.37 6.39 21.00 0.00 1260

Supervision 0.59 0.88 3.00 0.00 1260
Credit Controls 1.43 1.25 3.00 0.00 1260
Interest Rate
Controls 1.76 1.33 3.00 0.00 1260
Barriers to Entry 1.27 1.12 3.00 0.00 1260
Privatization 1.17 1.16 3.00 0.00 1260
Capital Controls 1.69 1.15 3.00 0.00 1260
Security Market
Policy 1.46 1.10 3.00 0.00 1260
Terms of Trade -0.01 0.10 0.40 -0.87 898
Real GDP growth 0.03 0.04 0.15 -0.16 1393
Depreciation -2.22 56.64 1.00 -1848.73 1393
Inflation (Adjusted) 0.13 0.16 0.99 -0.08 1371
Real Interest Rate 6.84 13.69 88.11 -97.81 977
M2/Reserve 12320.47 252087.30 6181205.00 0.00 1263
Credit to Private
Sector 51.65 403.23 11729.57 -49.35 1229

Table A-2 in the Appendix shows the correlation matrix of the control
variables and our indicators of banking crises. The table shows that the controls
have low correlation so that multicollinearity does not seem to be an issue.

Table 4. Control variables included

Variable: Expected Sign: Source:
1 Real GDP Growth - WDI
2 Real GDP/capita Level - WDI
3 Terms of Trade +/- WDI
4 Real Interest Rate + WDI
5 Depreciation +/- WDI
6 Inflation + WDI
7 Lagged Credit Growth + WDI
8 M2 to Reserve Ratio + WDI

5
The inflation rate (p) is transformed by the formula (p/100)/(1+(p/100)) to reduce the influence of
extreme observations.

8
4. Financial liberalization and systemic banking crisis: Empirical Findings
Table 5 shows our results using the panel data probit model and occurrence of
systemic crises as the dependent variable. In model I, we regress systemic banking
crises on control variables only, without using any liberalization measure. Our
findings are in line with those of previous studies and the estimated coefficients in
accordance with the expected signs as shown in Table 4. However, only three
variables (GDP growth, GDP/capita, and depreciation) turn out to be significant at
the 5% level of significance.
In model II, we introduce our indicator of overall liberalization reforms,
while in the remaining columns of Table 5 we include the various dimensions of
financial reform. As suggested by Mehrez and Kaufmann (2000), we examine the
impact of liberalization steps taken in the preceding five years. It turns out that
overall financial liberalization has a negative impact on the likelihood of systemic
crises. Next, we introduce our six liberalization measures separately into the
regressions for systemic crises one by one. We observe that reforms come up
significant except for barriers to entry and securities market reforms. Moreover, all
liberalization measures have negative signs. All these results suggest that
liberalization reduces the likelihood of systemic crises. The Wald chi-square tests
and Likelihood ratio tests indicate joint significance of our models at the 1% level
of significance.
In the next step, we use non-systemic crises as our dependent variable.
There are 14 episodes of non-systemic crises in our sample of 33 countries.
Modeling non-systemic crises is a difficult task for two reasons. First, there are
many factors that can cause non-systemic crises, and secondly, it is not necessary
that these crises occur because of changes in macroeconomic or overall financial
system variables. However, financial liberalization can be one of the causes for
these crises. Table 6 presents our multivariate probit regression results for non-
systemic crises. The results indicate that the impact of liberalization is not as strong
as for systemic crises. The Likelihood Ratio test is significant for all the
specification at 1% level of significance, but the Wald tests are not significant even
at 10% level of significance. This indicates the limited ability of a macroeconomic
model to explain non-systemic crises.

9
 According to the results, financial liberalization increases the likelihood of a
non-systemic crisis, a result primarily driven by reform aimed at reducing entry
barriers and credit control reforms. Interestingly, this result is opposite to our
findings for systemic crises. Moreover, we also observe that real GDP growth and
Real GDP per capita, which reduce the likelihood of systemic crises, appear
insignificant here.

5. Endogeneity
The results presented in the previous section can be subject to endogeneity because
it is possible that supervisors liberalize or repress their financial systems in the
wake of crises. To test for this problem of endogeneity, we use a two-step probit
model with endogenous repressors.6
For systemic crises, we use two instrument variables. The first one is from
the economic freedom index dataset from the Fraser institute (Gwartney and
Lawson, 2008). The economic freedom index data is available from 1970 onwards
and has several dimensions of economic freedom like size of government
(expenditure, taxes and enterprises), legal structure and security of property rights,
access to sound money, freedom to trade internationally and regulation of credit,
labor and business. We drop those dimensions of the economic freedom index that
are very similar to our financial liberalization measures. The basic intuition for
using this proxy is that financial sector reforms are often part of a broader economic
reform program. Secondly, we use the openness of the economy (computed as the
sum of exports and imports as a percentage of real GDP) as an instrument. We
average both instruments over five years.

6
We implement the two-step probit model with endogenous regressors by IVPROBIT module of
STATA and use robust standard errors for the clustering over countries.

10
 Table 5. Systemic Crisis: Panel Data Probit Model
1 2 3 4 5 6 7 8

Real GDP
CF
Growth (t-1) -7.848*** -7.025*** -7.870*** -7.113*** -7.827*** -6.798*** -7.816*** -7.649***
SE 1.96 2.106 1.98 2.152 1.96 2.056 2.016 1.973
Real GDP Level CF -0.092** -0.109** -0.093** -0.115** -0.092** -0.101** -0.103** -0.092**
SE 0.039 0.045 0.04 0.05 0.039 0.041 0.042 0.039
Real Interest
CF
Rate 0.007 0.012** 0.008* 0.010* 0.007 0.010** 0.010** 0.008*
SE 0.005 0.005 0.005 0.005 0.005 0.005 0.005 0.005
Inflation CF -0.692 -0.255 -0.555 -0.012 -0.667 -0.543 -0.503 -0.644
SE 0.988 1.053 1.001 1.073 0.99 1.027 1.005 0.985
M2/Reserves CF 0.000 -0.001* -0.000* -0.001** 0.000 0.000 -0.000* -0.000*
SE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Terms of Trade
CF
(t-1) 0.181 0.456 0.283 0.651 0.181 0.367 0.312 0.129
SE 0.689 0.717 0.697 0.763 0.691 0.717 0.693 0.686
Credit to Private
CF
Sector (t-2) 0.000 0.000 0.000 0.001 0.000 0.000 0.000 0.000
SE 0 0.001 0.000 0.001 0.000 0.000 0.000 0.000
Depreciation CF 1.791** 0.96 1.624** 1.581** 1.825** 1.348* 1.437* 1.596**
SE 0.741 0.781 0.75 0.795 0.745 0.765 0.757 0.747
Supervision CF 0.067 0.021 0.054 0.001 0.064 0.067 0.079 0.025
SE 0.126 0.134 0.128 0.139 0.126 0.128 0.13 0.128
Liberalization
CF
Reforms -0.181***
SE 0.035
Credit Control
CF
Reforms -0.210**
SE 0.083
Interest Rate
CF
Control Reforms -0.657***
SE 0.11
Barrier to Entry
CF
Relaxation 0.045
SE 0.093
Privatization CF -0.508***
SE 0.111
Capital Control
CF
Relaxation -0.292***
SE 0.093
Securities
CF
Market Reforms -0.236
SE 0.145
Constant CF -0.536* -0.165 -0.445 -0.344 -0.565* -0.486 -0.457 -0.425
SE 0.298 0.336 0.303 0.361 0.304 0.311 0.312 0.304

Number of
577 577 577 577 577 577 577 577
Observation
Wald Chi-
Square 37.110*** 55.762*** 41.760*** 61.489*** 37.301*** 53.024*** 43.533*** 39.683***
LR-Ratio Test 71.61*** 83.93*** 72.28*** 93.49*** 70.64*** 78.91*** 74.65*** 70.89***
CF stands for coefficient value and SE for Standard Errors
*** indicates significance at 1% level whereas ** indicates significance at 5% and * indicates significance at 10% level

11
 Table 6. Non-systemic Crisis: Panel Data Probit Model
1 2 3 4 5 6 7 8
Real GDP
Growth (t-1) CF 1.253 1.077 1.744 1.224 1.623 1.869 1.283 1.436
SE 3.352 3.427 3.554 3.392 3.46 3.462 3.362 3.468
Real GDP Level CF 0.110* 0.100* 0.104* 0.102* 0.111* 0.111* 0.111* 0.109*
SE 0.06 0.059 0.061 0.06 0.061 0.061 0.061 0.06
Real Interest
Rate CF -0.016 -0.023 -0.017 -0.018 -0.02 -0.013 -0.015 -0.022
SE 0.016 0.017 0.017 0.017 0.017 0.016 0.017 0.018
Inflation CF -1.968 -3.182 -2.802 -2.505 -3.017 -1.815 -1.908 -2.671
SE 2.056 2.259 2.136 2.16 2.2 2.046 2.099 2.17
- - -
M2/Reserves CF 0.056*** -0.047** -0.048** -0.050** -0.054*** 0.056*** 0.056*** -0.051**
SE 0.021 0.021 0.021 0.021 0.021 0.021 0.022 0.021
Terms of Trade
(t-1) CF -0.305 -0.347 -0.531 -0.298 -0.378 -0.289 -0.309 -0.286
SE 0.702 0.705 0.733 0.702 0.711 0.704 0.703 0.709
Credit to Private 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Sector (t-2) CF
SE 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Depreciation CF -0.17 -0.16 -0.134 -0.155 -0.178 -0.147 -0.17 -0.149
SE 0.123 0.123 0.124 0.124 0.123 0.126 0.124 0.125
Supervision CF -1.216 -0.869 -0.57 -1.09 -1.005 -1.292 -1.227 -1.126
SE 1.083 1.121 1.136 1.097 1.112 1.086 1.086 1.11
Liberalization
Reforms CF 0.062*
SE 0.035
Credit Control
Reforms CF 0.307***
SE 0.115
Interest Rate
Control
Reforms CF 0.1
SE 0.095
Barrier to Entry
Relaxation CF 0.279**
SE 0.132
Privatization CF -0.16
SE 0.155
Capital Control
Relaxation CF -0.013
SE 0.099
Securities
Market Reforms CF 0.349*
SE 0.201
- - - - - - -
Constant CF 1.835*** 1.834*** 2.060*** 1.815*** -1.923*** 1.894*** 1.843*** 1.906***
SE 0.614 0.601 0.637 0.604 0.622 0.621 0.618 0.613

Number of
Observation 577 577 577 577 577 577 577 577
Wald Chi-
Square 11.263 14.229 17.724* 12.425 14.986 12.151 11.256 13.681
LR-Ratio Test 98.01*** 92.59*** 96.44*** 94.68*** 100.08*** 99.02*** 96.99*** 96.57***
CF stands for coefficient value and SE for Standard Errors
*** indicates significance at 1% level whereas ** indicates significance at 5% and * indicates significance at 10%
level

12
We check the validity of our instruments by the Amemiya-Lee-Newey minimum
chi-square test under the null hypothesis that the used group of instruments is valid,
i.e., they are uncorrelated with the error term in the structural equation. As shown in
the bottom panel of Table 7, we cannot reject the null hypothesis. Next we apply the
Wald test of exogeneity under the null hypothesis that the instrumented variable is
exogenous. The results as shown in Table 7 suggest that only reforms aimed at
reducing barriers to entry in banking system appear endogenous. Using instruments
to deal with this endogeneity makes its coefficient negative and significant. The
results for the other dimensions of liberalization remain similar to those reported
earlier.
Similarly, we also instrument liberalization measures for non-systemic
crises by our economic freedom index. In this case, openness to trade turns out to be
an invalid instrument as indicated by the Amemiya-Lee-Newey minimum chi-
square test. As an alternative, we use the participation in an IMF or World Bank
adjustment programs during the preceding five years as instrument for liberalization
reforms for non-systemic crises.7 We check the validity of instruments again by
Amemiya-Lee-Newey minimum chi-square test and endogeneity by the Wald test.
The results as shown in Table 8 indicate that the two instruments are valid.
Interestingly, the results show that most of the reform measures used here are
endogenous to non-systemic crises. It shows that often liberalization measures are
taken as a consequence of non-systemic crises. Here the models are jointly
significant as shown by the Wald chi-square and likelihood ratio tests. Still, our
macroeconomic variables remain insignificant. Our liberalization measures are the
only significant variables and all come up with positive signs, which is clearly in
contrast to our results for systemic crises. We therefore conclude that the effect of
liberalization on systemic and non-systemic crises is fundamentally different.

7
The data comes from Dreher, who has used them in various publications; see, for instance, Dreher
(2004).

13
Table 7. Systemic Crisis Results with Two-Step Probit Model with Endogenous Regressors
1 2 3 4 5 6 7 8
Real GDP Growth
(t-1) CF -7.848*** -6.677*** -6.437*** -6.225*** -5.575*** -4.543 -5.906*** -4.603*
SE 2.859 1.916 2.192 2.132 2.03 3.591 2.046 2.655
Real GDP Level CF -0.092 -0.03 -0.024 -0.026 -0.022 -0.032 -0.029 -0.03
SE 0.105 0.04 0.031 0.044 0.032 0.036 0.034 0.033
Real Interest
Rate CF 0.007 0.006 0.005 0.003 0.005 0.006 0.009 0.005
SE 0.015 0.006 0.004 0.005 0.005 0.008 0.005 0.006
Inflation CF -0.692 -1.235 -0.604 -0.92 -1.427 -0.776 -1.127 -0.852
SE 2.192 1.47 1.303 1.717 1.114 1.658 1.352 1.437
M2/Reserves CF 0.000 -0.001*** -0.001** -0.001*** -0.001* -0.001** -0.001** -0.001**
SE 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Terms of Trade
(t-1) CF 0.181 0.323 0.522 0.367 0.134 0.221 0.189 -0.036
SE 0.799 0.424 0.429 0.433 0.331 0.367 0.464 0.426
Credit to Private
Sector (t-2) CF 0.00 0.00 0.000* 0.00 0.00 0.00 0.00 0.00
SE 0.005 0.001 0.000 0.001 0.000 0.000 0.000 0.000
Depreciation CF 1.791** 1.039 0.678 1.362 0.622 0.763 0.804 0.678
SE 0.784 1.006 1.045 1.005 1.004 1.191 1.034 1.061
Supervision CF 0.067 -0.228 -0.229* -0.289* -0.084 -0.064 -0.175 -0.264**
SE 0.238 0.152 0.122 0.157 0.125 0.185 0.146 0.125
Liberalization
Reforms CF -0.175*
SE 0.103
Credit Control
Reforms CF -0.722**
SE 0.343
Interest Rate
Control Reforms CF -0.676*
SE 0.392
Barrier to Entry
Relaxation CF -0.945***
SE 0.275
Privatization CF -0.989*
SE 0.554
Capital Control
Relaxation CF -0.759**
SE 0.33
Securities Market
Reforms CF -1.309**
SE 0.53
Constant CF -0.536 0.095 0.138 0.003 0.364 -0.205 -0.044 0.257
SE 0.437 0.385 0.364 0.335 0.339 0.257 0.309 0.358

Wald Chi-Square 9.429*** 58.4*** 56.28*** 81.08*** 101.38*** 68.68*** 143.19*** 84.84***
Wald Test of
Exogeneity 0.3 1.6 0.51 4.32 0.81 1.96 2.28
P(Wald test of
Exogeniety) 0.59 0.21 0.48 0.04 0.37 0.16 0.13
Amemiya-Lee-
Newey Test 0.52 0.55 0.78 0.027 1.49 0.53 0.014
P(Amemiya-Lee-
Newey Test) 0.47 0.46 0.38 0.87 0.22 0.47 0.91
CF stands for coefficient value and SE for Standard Errors
*** indicates significance at 1% level whereas ** indicates significance at 5% and * indicates significance at 10% level

14
Table 8. Non-systemic Crisis Results with Two-Step Probit Model with Endogenous Regressors
1 2 3 4 5 6 7 8
Real GDP Growth
(t-1) CF 1.253 -3.594** -1.972 -3.588** -0.834 -3.547** -2.814* -3.954***
SE 4.153 1.612 1.994 1.584 2.24 1.653 1.463 1.452
Real GDP Level CF 0.11 0.001 -0.003 -0.005 0.005 0.01 0.005 0.007
SE 0.082 0.044 0.035 0.04 0.034 0.029 0.036 0.038
Real Interest Rate CF -0.016 -0.024*** -0.019** -0.016* -0.018** -0.016* -0.022*** -0.020**
SE 0.038 0.008 0.009 0.01 0.008 0.009 0.007 0.008
Inflation CF -1.968 -2.350** -1.996 -2.231** -0.901 -1.762 -1.235 -1.741
SE 4.175 1.147 1.249 0.944 1.298 1.225 1.183 1.136
M2/Reserves CF -0.056 -0.004 -0.003 -0.004 -0.005 -0.003 -0.005 -0.004
SE 0.039 0.018 0.014 0.016 0.014 0.012 0.015 0.015
Terms of Trade (t-
1) CF -0.305 -0.615 -0.834** -0.586 -0.337 -0.355 -0.368 -0.15
SE 0.956 0.46 0.413 0.444 0.429 0.301 0.557 0.595
Credit to Private
Sector (t-2) CF 0.00 -0.003 -0.002 -0.002 -0.002 -0.001 -0.002 -0.002
SE 0.007 0.004 0.003 0.003 0.003 0.002 0.003 0.003
Depreciation CF -1.216 0.42 0.421 0.119 0.372 0.542 0.033 0.323
SE 0.782 0.696 0.849 0.614 0.662 0.716 0.703 0.629
Supervision CF -0.17 0.02 0.076 0.094 -0.052 -0.129 0.001 0.099
SE 0.327 0.252 0.208 0.238 0.195 0.159 0.205 0.212
Liberalization
Reforms CF 0.201**
SE 0.088
Credit Control
Reforms CF 0.919***
SE 0.243
Interest Rate
Control Reforms CF 0.734***
SE 0.242
Barrier to Entry
Relaxation CF 1.074***
SE 0.352
Privatization CF 1.105***
SE 0.28
Capital Control
Relaxation CF 0.766**
SE 0.32
Securities Market
Reforms CF 1.453***
SE 0.391
Constant CF -1.835 -1.013*** -0.945*** -0.844*** -1.041*** -0.424* -0.700** -1.043***
SE 1.788 0.368 0.293 0.3 0.273 0.256 0.336 0.303
Wald Chi-Square 67.62*** 69.51*** 167.2*** 105.98*** 82.61*** 64.99*** 157.29***

Wald Test of
Exogeneity 2.07 2.9 3.45 2.26 4.72 3.2 3.7
P(Wald test of
Exogeniety) 0.15 0.09 0.06 0.13 0.03 0.07 0.05
Amemiya-Lee-Newey
Test 0.01 0.03 0.06 0.48 0.024 0.19 0.09
P(Amemiya-Lee-
Newey Test) 0.92 0.86 0.81 0.48 0.88 0.66 0.75
CF stands for coefficient value and SE for Standard Errors
*** indicates significance at 1% level whereas ** indicates significance at 5% and * indicates significance at 10% level

6. Robustness
We examine the robustness of our results for systemic and non-systemic crises
results in a number of ways. These tests indicate that our results are not sensitive to

15
changes in estimation methodology, sample composition, and modification of
certain variables.
First, we have used a conditional logit model. While this does not affect our
results, the number of observations drops from 577 to 397. Arellano and Hahn
(2007) and Green (2004) show that the probit estimator is not well behaved in the
presence of fixed effects. However, when we check for the impact of fixed effects
in our logit model it turns out that our main results do not differ in both random and
fixed effects models.8 Moreover, we have also generated bootstrapped standard
errors. Despite some changes in the significance level it goes without affecting our
main conclusions.
Secondly, we have restricted our sample to only non-OECD countries. It
reduces our number of observations from 577 to 443. The effect of liberalization is
significant and negative for systemic crises (except for barriers to entry) and
positive for non-systemic crises, but significant only for credit market liberalization
for non-systemic crises. The results for systemic crises are provided in Table A-3 in
the Appendix.
Thirdly, we modify our liberalization variables and average them over three
(instead of five) years. The results (available on request) are qualitatively very
similar to our previous findings.
As part of our sensitivity analysis, we also use two other variables that have
been suggested to affect banking crises, namely transparency (as suggested by
Mehrez and Kaufmann, 2000) and concentration (as suggested by Beck et al.,
2006). Transparency (i.e., lack of corruption) has been taken from the International
Country Risk Guide (ICRG) database; the variable takes a higher value if there is
less corruption in the country concerned. As this variable is only available from
1984 onwards, our analysis is restricted by this limitation. Concentration has been
taken from the World Bank’s Financial Structure Database. However, this series is
also not available for our full sample period, reducing the number of observations
by 50%. Both of these modifications do not change our basic results. All the
liberalization variables retain their sign and significance for both systemic and non-
systemic crises. Inclusion of concentration does not affect our main results again
except for a minor anomaly for entry to barrier reforms which comes out with a

8
For this we build comparable regression models, by excluding GDP/capita from the random effects
model and then apply conditional fixed effect logit model.

16
positive sign for systemic crises but as mentioned before this is the only variable
which was shown as endogenous. All other liberalization measures come out with a
negative sign. Inclusion of transparency does not change our conclusions although
transparency comes up significantly with a positive sign for non-systemic crises; for
systemic crises it turns out be insignificant. (Results are available on request).

7. Conclusions
In this paper, we examine the effect of six dimensions of financial liberalization on
the likelihood of systemic and non-systemic banking crises. We find that
liberalization reduces the likelihood of systemic crises, which is against the
commonly held view that liberalization increases the likelihood of a banking crisis.
Our results also hold after controlling for a possible endogeneity problem.
Moreover, we also find that systemic and non-systemic crises behave differently. If
anything, liberalization has a positive impact on the likelihood of a non-systemic
crisis.

References

− Abiad, Abdul and Ashoka Mody (2005), “Financial Reform: What Shakes It?
What Shapes It?”, American Economic Review, 95 (1), pp 66-88.
− Abiad, Abdul, Enrica Detragiche, and Thierry Tressel (2007), “A New Database
of Financial Reforms”, unpublished, Washington: International Monetary Fund.
− Arellano, M. and J. Hahn (2007), “Understanding Bias in Nonlinear Panel
Models: Some Recent Developments.” In: R. Blundell, W. Newey, and T.
Persson (eds.), Advances in Economics and Econometrics, Ninth World
Congress, Cambridge University Press
− Barth, James R., Gerard Caprio Jr., and Ross Levine (2004), “Bank Regulation
and Supervision: what works best?”, Journal of Financial Intermediation, 13,
205-248.
− Beck, Thorsten, Asli Demirguc-Kunt, and Ross Levine, Ross (2006), “Bank
Concentration, Competition, and Crises: First results”, Journal of Banking and
Finance, 30, 1581-1603.
− Caprio, G. and D. Klingebiel (1999), “Episodes of Systemic and Borderline
Financial Crises”, Mimeo, The World Bank.
− Caprio Jr., Gerard and E.A. Martinez, (2000), “Avoiding Disaster: Policies to
Reduce the Risk of Banking Crises”. Egyptian Centre for Economic Studies
Working Paper No. 47.
− Demirguc-Kunt, Asli and Enria Detragiache, Enrica (1998), “Financial
Liberalization and Financial Fragility”, World Bank Policy Research Working
Paper No 1917.
− Demirguc-Kunt, Asli and Enrica Detragiache (2000), “Monitoring Banking
Sector Fragility: A Multivariate Logit Approach”, World Bank Economic
Review, 14(2), 287-307.

17
− Demirguc-Kunt, Asli and Enrica Detragiachea (2002), “Does Deposit Insurance
Increase Banking System Stability? An Empirical Investigation”, Journal of
Monetary Economics, 49, 1373-1406.
− Dreher, A. (2004), The Influence of IMF Programs on the Re-election of Debtor
Governments, Economics and Politics, 16(1), 53-75.
− Green, William (2004), “The Behaviour of the Maximum Likelihood Estimator
of Limited Dependent Variable Models in the Presence of Fixed Effects”,
Econometrics Journal, 7(1), 98-119.
− Gwartney, James and Robert Lawson with Seth Norton (2008). Economic
Freedom of the World, 2008 Annual Report. The Fraser Institute. Data retrieved
from www.freetheworld.com.
− Honahan, P. and L. Laeven (2005), Systemic Financial Distress: Containment
and Resolution, Cambridge (UK): Cambridge University Press.
− Kaminsky, Graciela L. (1999), “Currency and Banking Crises: The Early
Warnings of Distress”, IMF Working Paper No. 99/178.
− Mehrez, Gil and Daniel Kaufman (2000), “Transparency, Liberalization and
Banking Crises”, World Bank Policy Research Working Paper No. 2286.

18
Appendix

TABLE A1: Systemic and Non-systemic Crises

Non-systemic
Country Systemic Crises Crises

Argentina 1980-82, 1989-90, 1995, 2001

Australia 1989-92

Bangladesh 1988 -1996

Bolivia 1986-88, 1994
Brazil 1990, 1994-99
Canada 1983-85
Chile 1981-83
Colombia 1982-87
Costa Rica 1994-96

Ecuador 1980-84, 1996-97, 1998-2001

Egypt 1980-84
Ghana 1982-89 1997
Guatemala 1990s

1982-83,
Hong Kong 1983-86, 1998
India 1993
Indonesia 1997-2002 1994
Israel 1977-83
Japan 1992-
Korea, PR 1997-2002
Malaysia 1997-2001 1985-88
Mexico 1981-91, 1994-2000
Morocco 1982-84

New Zealand 1987-90

Peru 1983-90
Philippines 1983-87, 1998
Singapore 1982

South Africa 1989

Sri Lanka 1989-93
Thailand 1983-87, 1997-2002

United States 1988-91

Uruguay 1981-84, 2002
Venezuela 1994-95 1976-89
Zimbabwe 1995-96

Source: Honohan and Laeven (2005)

19
Table A2 Correlation of controls

Terms
Credit Non- Real of M2 to
GDP GDP Growth Systemic systemic Interest Trade Reserve
Growth level Inflation Lag Crises Crises Depreciation Rate Changes Ratio
GDP
Growth 1.00
GDP level -0.13 1.00
-
Inflation -0.18 0.29 1.00
Credit -
Growth Lag -0.06 0.05 0.33 1.00
Systemic -
Crises -0.21 0.04 0.02 -0.05 1.00
Non-
systemic -
Crises 0.02 0.19 -0.04 -0.03 -0.20 1.00
-
Depreciation -0.38 0.14 0.64 0.28 0.11 -0.06 1.00
Real
Interest -
Rate -0.07 0.17 0.05 0.29 0.10 -0.08 0.17 1.00
Terms of
Trade
Changes 0.03 0.00 0.04 0.06 0.02 -0.05 -0.02 -0.08 1.00
M2 to
Reserve -
Ratio -0.16 0.07 0.36 0.00 -0.04 -0.03 0.01 -0.25 -0.02 1.00

20
 Table A3 : Systemic Crisis Results with Panel Data Probit Model (For Non-OECD Countries)
1 2 3 4 5 6 7 8
Real GDP
Growth (t-1) CF -6.846*** -5.929*** -6.901*** -6.092*** -6.842*** -5.976*** -6.701*** -6.501***
SE 2.002 2.147 2.023 2.19 2.002 2.076 2.067 2.027
Real GDP
Level CF -0.158*** -0.195*** -0.160*** -0.200*** -0.158*** -0.181*** -0.186*** -0.149**
SE 0.059 0.069 0.06 0.074 0.059 0.064 0.064 0.06
Real Interest
Rate CF 0.008* 0.013** 0.008* 0.010** 0.008* 0.010** 0.011** 0.009*
SE 0.005 0.005 0.005 0.005 0.005 0.005 0.005 0.005
Inflation CF -0.702 -0.012 -0.513 -0.041 -0.696 -0.369 -0.288 -0.647
SE 1.003 1.078 1.021 1.09 1.003 1.04 1.03 1.007
M2/Reserves CF -0.000* -0.000* -0.000* -0.000* -0.000* -0.000* -0.000* -0.000*
SE 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Terms of Trade
(t-1) CF 0.472 0.685 0.565 0.814 0.472 0.563 0.604 0.425
SE 0.68 0.712 0.688 0.75 0.681 0.703 0.69 0.68
Credit to
Private Sector
(t-2) CF 0.00 0.00 0.00 0.001 0.00 0.00 0.00 0.00
SE 0.00 0.001 0.00 0.001 0.00 0.00 0.00 0.00
Depreciation CF 1.699** 0.769 1.488* 1.552* 1.714** 1.276 1.193 1.401*
SE 0.784 0.838 0.797 0.829 0.789 0.809 0.813 0.792
Supervision CF -0.093 -0.112 -0.094 -0.142 -0.094 -0.069 -0.069 -0.181
SE 0.142 0.152 0.144 0.157 0.143 0.145 0.147 0.15
Liberalization
Reforms CF -0.171***
SE 0.036
Credit Control
Reforms CF -0.208**
SE 0.085
Interest Rate
Control
Reforms CF -0.585***
SE 0.115
Barrier to Entry
Relaxation CF 0.017
SE 0.098
Privatization CF -0.401***
SE 0.119
Capital Control
Relaxation CF -0.31***
SE 0.095
Securities
Market
Reforms CF -0.388**
SE 0.157
Constant CF -0.334 0.01 -0.251 -0.139 -0.344 -0.298 -0.259 -0.16
SE 0.251 0.286 0.256 0.303 0.257 0.261 0.26 0.264

Number of
Observation 443 443 443 443 443 443 443 443
Wald Chi-
Square 33.592*** 47.997*** 37.668*** 49.560*** 33.603*** 41.120*** 40.493*** 38.649***
LR-Ratio Test 22.04*** 27.8*** 22.88*** 32.64*** 21.8*** 25.43*** 21.44*** 23.03***
CF stands for coefficient value and SE for Standard Errors
*** indicates significance at 1% level whereas ** indicates significance at 5% and * indicates significance at 10% level

21