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Journal of Financial Stability

journal homepage: www.elsevier.com/locate/jfstabil

Role of financial regulation and innovation in the financial crisis

Teakdong Kim a , Bonwoo Koo b , Minsoo Park c,∗
a
Korea Deposit Insurance Corporation, 30 Cheonggyechun-no, Jung-gu, Seoul, Republic of Korea
b
Department of Management Sciences, University of Waterloo, 200 University Avenue West, Waterloo, ON, Canada N2L 3G1
c
Department of Economics, Sungkyunkwan University, 25-2 Sungkyunkwan-Ro, Jongnogu, Seoul, Republic of Korea

a r t i c l e i n f o a b s t r a c t

Article history: Using the financial and macroeconomic dataset of 132 countries, this study empirically analyzes the effects
Received 1 November 2011 of financial regulations and innovations on the global financial crisis. It shows that regulatory measures
Received in revised form 8 July 2012 such as restrictions on bank activities and entry requirements have decreased the likelihood of a banking
Accepted 19 July 2012
crisis, while capital regulation and government ownership of banks have increased the likelihood of a
Available online xxx
currency crisis. Financial innovation has contributed to the banking crisis but contained the currency
crisis. This study also shows that judicious implementation of regulatory measures is critical to financial
JEL classification:
stability because some regulations, if implemented simultaneously, can further aggravate or alleviate a
G38
G21
crisis.
E51 © 2012 Elsevier B.V. All rights reserved.

Keywords:
Financial regulation
Innovation
Government supervision

1. Introduction
The global financial crisis, starting with the housing bubble and
credit boom in 2007 and peaking with the housing bust and col-
lapse of Lehman Brothers in September 2008, has led to a global
recession and a loss of confidence in the financial system. In spite
of a few positive signs in key economic indicators, the world econ-
omy in 2012 remains fragile and uncertain. Recent financial crises
have been characterized by their global scale in which a downward
economic spiral in one country quickly spreads to other countries.
The recent sovereign debt crisis in Greece has had severe conta-
gious effects on other countries in Europe and beyond. The extent
and impact of these crises vary by country, which raises an impor-
tant research question of examining the determinants that affect
the degree and frequency of financial crises.
Several studies show that deregulation and hyperactive finan-
cial innovations in the financial sector have caused various types of
financial crises during the past few decades (Morris and Shin, 1998;
Reinhart and Rogoff, 2008). Regulatory and supervisory agencies
in many countries have failed to keep abreast of the rapidly evolv-
ing development of the financial industry and its myriad products
and practices. Risky lending and investment practices by financial
∗ Corresponding author. Tel.: +82 02 760 0427; fax: +82 02 760 0946.
E-mail address: minsoopark@skku.edu (M. Park).
institutions in the recent crisis might have stemmed from lax regu-
lations on the financial sector. While Eichengreen and Portes (1987)
argue that strong regulations and sound institutional frameworks
help stabilize financial markets by reducing the moral hazard prob-
lems associated with asymmetric information, Barth et al. (2004)
show that restrictions on bank activities may contribute to financial
crises because banks are not able to diversify into other financial
activities to reduce risks.
In addition, recent financial crises might also have been caused
by excessive reliance on financial innovations such as mortgage-
backed securities (MBS), collateralized debt obligations (CDO) and
credit default swaps (CDS). Securitizations such as MBS and CDO
led to the credit boom and asset bubble because the risks associ-
ated with the underlying assets are transferred to investors (Keys
et al., 2010). Derivatives such as CDS are used as protection against
defaults on bonds or loans but have exposed the financial sec-
tor to systemic risks through excessive leveraging and speculative
investments (Dodd, 2002).
The objective of this study is to empirically analyze how
(de)regulatory measures and financial innovation have contributed
to the recent global financial crisis, using the financial and
macroeconomic data of 132 countries. This study examines the fun-
damental role of regulations to explain the causes of the recent
global crisis and discusses long-term structural reforms in the
financial sector. This study is close to those of Barth et al. (2004) and
Beck et al. (2006), which use cross-country data to examine the role

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of regulation in financial crises. However, those studies might have
the reverse causality problem in which the financial crises data
were collected for the 1980s and 1990s, while the regulatory data
were from 1999. With the dataset of more recent financial crises
for 132 countries that reflect a variety of preceding regulatory sys-
tems, this study systematically examines the effects of regulations
on the global financial crises. This study also analyzes the relation
between financial innovation and the recent global financial cri-
sis using an aggregate index for assessing the extent of financial
innovation in a country.
By examining the roles of several types of regulatory measures
and financial innovations, this study provides the following main
results. First, in terms of individual regulatory measures, this study
shows that countries with strong restrictions on bank activities
and entry requirements are less likely to experience a banking
crisis. Second, various regulatory measures, if implemented simul-
taneously, can have aggravating or alleviating effects on a crisis,
suggesting that partial analysis of the effect of individual measures
may lead to misleading policy implications. This study illustrates
the complex mechanisms of regulations in influencing the banking
sector and foreign exchange market. Third, while financial innova-
tion increased the chance of the banking crisis, it alleviated the risk
of the currency crisis.
This study is organized as follows. Section 2 reviews the litera-
ture on the various types of financial crises and their relationships
with financial regulations and innovations, followed by several
testable hypotheses drawn from the literature. Section 3 describes
the sources of data and explains each variable used in the empiri-
cal model. After presenting the estimation methodology, Section 4
uses several regression models to analyze the effects of each vari-
able on the financial crises. Section 5 provides the conclusion and
a few policy implications.
2. Financial crises and their determinants
2.1. Types of financial crises
A financial crisis is broadly defined as a situation when a large
number of financial contracts are broken in a short period of time
and the financial sector undergoes a wide range of turmoil, such
as a significant decrease in asset values, bankruptcy of financial
institutions, and disruption in foreign exchange markets (Allen and
Snyder, 2009). The turmoil in a country’s financial sector has major
repercussions on the real economy and often leads to a widespread
recession with low investment rates and high unemployment rates.
Financial crises can be classified into three broad types: banking cri-
sis, currency crisis, and debt crisis.1 However, this classification is
not necessarily exclusive since some crises are “twin crises” when
currency depreciation exacerbates the banking sector problems
through banks’ exposure to foreign currency (Laeven and Valencia,
2008).
A banking crisis occurs when banks and financial institutions
face difficulties in repaying contracts on time and experience a
large number of defaults. A banking crisis is often accompanied by
1
A debt crisis occurs when a country defaults on its sovereign debts, and it can be
caused by a sharp increase in the proportion of short-term debt, a sudden decrease
in foreign exchange reserves, an exchange rate policy that affects a country’s finan-
cial openness, and other political factors (Georgievska et al., 2008). A debt crisis is
identified by the presence of a debt rescheduling agreement or negotiation, arrears
(amount past due and unpaid) on principal repayments or interest payments, and
an International Monetary Fund (IMF) debt rescheduling loan agreement (Lestano
et al., 2003). While a debt crisis is important in its impact, it is not included in our
empirical analysis due to the infrequent occurrences (only 7 occurrences in the 132
country samples).
Please cite this article in press as: Kim, T., et al., Role of financial regulation and innovation in the financial crisis. J. Financial Stability (2012),
http://dx.doi.org/10.1016/j.jfs.2012.07.002
bubbles in credit and assets, sharp increases in debt, current
account deficits and financial liberalization (Reinhart and Rogoff,
2008). A banking crisis is identified by specific events such as bank
runs, mergers, takeovers and government interventions (Kaminsky
and Reinhart, 1999), or by quantitative thresholds such as the ratio
of nonperforming assets to total assets exceeding 10% or the cost
of rescue operations being more than 2% of GDP (Demirgüç-Kunt
and Detragiache, 1997).
A currency crisis occurs when the value of a country’s currency
depreciates substantially in a short period of time. The poten-
tial causes of a currency crisis include a weak banking sector, a
bank run, and asymmetric information about financial fundamen-
tals (Obstfeld, 1995). Defining an appropriate index that captures
a currency crisis has been a focus of several studies; some studies
emphasize the magnitude of currency depreciation (Frankel and
Rose, 1996), while others include speculative pressure and gov-
ernment interventions (Eichengreen et al., 1995).
Several anecdotal studies of the 2008 financial crisis have found
that the crisis was preceded by low real interest rates, a credit boom
and a rise in asset prices (Taylor, 2009; World Bank, 2009). Low
interest rates and loose mortgage lending practices in the early
2000s accelerated investments in the housing market. As housing
prices began to drop in 2006 due to tightening credit and negative
housing price expectations, defaults on mortgage loans increased
and the subprime mortgage industry experienced large losses. Bad
loans and assets caused a number of bank failures and the collapse
of several financial institutions such as Lehman Brothers. Those
events triggered a global financial crisis that negatively affected
the real economy. To rebuild confidence in the financial system and
to avert a severe global recession, several governments intervened
by nationalizing banks and implementing temporary guarantees of
money market funds and various other monetary and fiscal mea-
sures.
2.2. Determinants of financial crises
Among the several factors that might have contributed the
global financial crisis of 2008, both regulatory measures and
financial innovations are most widely discussed in the literature.
Financial liberalization and deregulation could play a large role in
creating financial crises because regulators often fail to control the
high leverage or detect its risks. For example, “shadow banking
system” activities by non-bank financial institutions such as invest-
ment banks, hedge funds, and venture capital and private equity
are not subject to the same (strict) regulations as depository banks.
Consequently, they tend to have high levels of leverage and might
have exacerbated the recent crisis (World Bank, 2009). Financial
innovations such as securitization and derivatives can accelerate
asset booms and lead to sharp increases in leverage.
2.2.1. Regulation
Consumers have limited capacity to effectively monitor com-
plex financial products, so prudent financial regulations are critical
to maintaining the stability of the financial sector. Diverse views
about the role of financial regulations exist; some support stringent
financial regulations and supervision (Skott, 1995), while others
support lax oversight (Gordy and Howells, 2006). Several types of
regulatory measures are implemented in different economies, and
the definition of each measure varies by country.
Among the various regulatory measures, three pillars of
the Basel II Accord – capital regulation on the minimum
required amount, the extent of a government’s supervisory power,
and private-sector monitoring of banks – are most commonly
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discussed.2 Barth et al. (2004) further extend the category into
seven regulatory measures by adding four more indices: restric-
tions on bank activities, restrictions on entry into the banking
sector, guidelines on the diversification of assets and liabilities,
and government ownership of banks. This study tests the following
hypotheses to examine the effects of each of the seven regulatory
measures.
Hypothesis 1a. Restrictions on bank activities contain a financial
crisis.
Due to the complexity of financial instruments for risk trans-
fer, banks are more vulnerable to small shocks, which can rapidly
spread across sectors and countries. Prudent regulatory restric-
tions on bank activities have become more critical in stabilizing
the banking sector (Allen and Carletti, 2006).
Hypothesis 1b. Entry requirements contain a financial crisis.
Keeley (1990) argues that strong entry requirements for a bank-
ing system increase the soundness of the banking industry by
preventing the excessive risk-taking often observed in competitive
banking environments.
Hypothesis 1c. Diversification leads to a financial crisis.
Stigum and Crescenzi (2007) argue that stringent diversifica-
tion guidelines limit the use of diverse portfolio strategies and can
exacerbate a financial crisis.
Hypothesis 1d. Capital regulation leads to a financial crisis.
Some studies claim that tightened capital regulation cannot
maintain bank stability (Allen and Gale, 2003; Barth et al., 2004),
and the existing Basel Capital Accord has been criticized for not
capturing foreign exchange risk.
Hypothesis 1e. Private monitoring contains a financial crisis.
Private monitoring is considered to be more important than gov-
ernment regulations since politicians can be affected by big-bank
conglomerates (Shleifer and Vishny, 1998).
Hypothesis 1f. Government ownership of banks leads to a finan-
cial crisis.
Government ownership of banks can lead to a weak banking
sector because government officials without expertise often make
banks less competitive and innovative. A weak banking sector often
makes it difficult for a country to defend its currency when faced
with turmoil in foreign exchange markets.
Hypothesis 1g. Official supervisory power contains a financial
crisis.
If supervisory authority has the power to monitor and disci-
pline banks, it can take corrective action against banks that violate
regulations or engage in imprudent behavior.
Most regulatory measures discussed above are implemented
simultaneously, and the effect of one regulatory measure may
depend on other measures and institutional environments
(Claessens et al., 2005). Thus, it is important to assess the coun-
tervailing or amplifying effects of the various combinations of
regulatory measures. Barth et al. (2004) examined the effects of
several combinations of regulatory measures (restrictions on bank
activities, entry requirements, and capital regulations), but found
2
The Basel II Accord, published in 2004 and implemented in 2007, is an interna-
tional agreement that sets guidelines for bank regulation and supervision. The first
accord, Basel I Accord, was implemented in 1988, and an updated Basel III will be
implemented in 2013.
Please cite this article in press as: Kim, T., et al., Role of financial regulation and innovation in the financial crisis. J. Financial Stability (2012),
http://dx.doi.org/10.1016/j.jfs.2012.07.002
3
no significance in any combinations. With updated data, we test
the effects of the following combinatory regulations on financial
crises.
Hypothesis 2a. Tighter restrictions on bank activities with strong
official supervisory power have a countervailing effect on a finan-
cial crisis.
Restrictions on bank activities are considered to contain a finan-
cial crisis. However, in strong institutional environments where
the supervisory authority possesses the power to take corrective
action, tighter restriction on bank activities can weaken the banking
sector.
Hypothesis 2b. Stringent entry requirements with greater diver-
sification have a countervailing effect on a financial crisis.
Entry requirements as a regulatory measure are believed to
contain a financial crisis. However, under rigid regulation of diver-
sification, several firms in the financial industry are likely to follow
the herd behavior in borrowing and lending, making the fragile
financial system vulnerable to small shocks.
Hypothesis 2c. Tighter capital regulation with weak official
supervisory power has a countervailing effect on a financial crisis.
Capital regulation alone is considered to lead to a financial crisis.
However, this regulatory measure may play a critical role in con-
taining a financial crisis in countries with weak official supervisory
power.
2.2.2. Financial innovation
Financial innovation is defined as the act of creating and imple-
menting new financial instruments, technologies, institutions, and
markets (Tufano, 2003). Financial innovations were believed to sta-
bilize the financial system by transferring risks to investors, but
they are now blamed as one of the main causes of the recent cri-
sis (Brunnermeier, 2009; Keys et al., 2010). This study tests the
following hypothesis about the effect of financial innovation.
Hypothesis 3. Financial innovation leads to a financial crisis.
3. Sources of data and variables
3.1. Measures of financial crises
The recent financial crisis affected many countries, but its
impacts varied across countries. Rather than using a binary variable
to confirm/indicate the existence of a crisis, this study measures
the frequency of shocks related to the banking or currency crisis
from January 2007 to October 2009, using the monthly data to ana-
lyze the extent of the crisis (Kaminsky and Reinhart, 1999; Lestano
et al., 2003). Alternatively, we can also define the crisis by count-
ing consecutive shock months as a single event of crisis. However,
counting each shock month as separate crises reflects the intensity
of the shocks, and we focus on the former approach.3
3.1.1. Banking crisis
A country is considered to have a banking crisis if its banks
have had bank runs during the sample period, or if its banks have
implemented deposit freezes, given blanket guarantees, received
emergency liquidity support or government bank interventions
(Laeven and Valencia, 2008). A bank run is observed when the
3
For example, while Greece experienced 17 banking crises in the counting of
each month, it had only one shock if we consider consecutive months of shocks as
a single crisis.
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monthly percentage decline in total bank deposits is greater than
5%. A deposit freeze is identified when the monetary authority
imposes a freeze on deposits, and a blanket guarantee is observed
when the government guarantees all bank liabilities. Emergency
liquidity support is observed when the monthly ratio of claims
from monetary authorities on deposit-holding institutions to the
total deposits is greater than 5% and is at least double the ratio of
the previous year. Large-scale government interventions include
large bank nationalizations, closures, mergers, sales and recapital-
izations. In addition to these measures, this study also includes
the receipt of stand-by arrangement (SBA) loans from the IMF,
which are designed to help banks cope with short-term balance-
of-payments problems and restore solvency.
This study considers both quantitative thresholds (bank runs
and emergency liquidity support) and chronology of events
(deposit freezes, blanket guarantees, bank interventions, and SBA
loans) to identify shocks related to banking crises. The total num-
ber of bank runs and incidents of emergency liquidity support in
each country are tallied using monthly data of the total deposits
and claims on deposit-holding banks from the IMF’s International
Financial Statistics (IFS). The other measures – deposit freezes,
blanket guarantees, and SBA loans – occurred at most once in each
country during the sample period. The count measure of the bank-
ing crisis for each country is the sum of the occurrences of each
shock; a total of 375 shocks related to the banking crisis occurred
in 80 countries in our sample.
3.1.2. Currency crisis
Facing pressure to depreciate a currency, a country can (i) allow
the exchange rate to depreciate, (ii) use foreign reserves to defend
the exchange rate, (iii) raise the interest rate, or (iv) use a com-
bination of all or some of the above (Dominguez et al., 2011).
Eichengreen et al. (1995) identify a currency crisis as exceeding a
certain threshold level of the exchange rate market pressure index
(EMPI) which combines all of the above three components. EMPI is
defined as the weighted average of the normalized changes in the
exchange rate, the ratio of gross international reserves to M1, and
the nominal interest rates.
1 eit 1
 m mUSt
 (rrt − rUSt )
it
EMPIit = − − + study adopts a pragmatic approach and calculates an aggregate
e eit r mit mUSt i
where EMPIit is the exchange rate market pressure index for coun-
try i in period t; eit is country i’s currency per U.S. dollar in period t;
 e is the standard deviation of the relative change in the exchange
rate (eit /eit ); mit is the ratio of gross foreign reserves to M1 for
country i in period t, rit is the nominal interest rate for country i
in period t; rUSt is the nominal interest rate for the United States
in period t;  r is the standard deviation of the difference between
the relative changes in the ratio of foreign reserves to M1 in coun-
try i and the United States [(mit /mit ) − (mUSt /mUSt )]; and  i is
the standard deviation of the nominal interest rate differential
(rit − rUSt ).
Several studies propose alternative ways of calculating the EMPI,
by excluding interest rate differentials, international reserves or
interest rate variables (Frankel and Rose, 1996; Zhang, 2001). How-
ever, Eichengreen et al.’s method is considered more appropriate
because it captures both successful and unsuccessful specula-
tive attacks and outperforms the other models in the experiment
using the crisis data of six Asian countries from 1970 to 2001
(Lestano et al., 2003). A period of currency crisis is identified if
EMPIit > ˇ EMPI + EMPI , where  EMPI is the sample standard devi-
ation of EMPI and EMPI is the sample mean of EMPI. Our study sets
a threshold value of ˇ = 2 based on Lestano et al. (2003).
We obtained the relevant data (e.g., exchange rates, gross for-
eign reserves, M1, and interest rates) for each country from the
Please cite this article in press as: Kim, T., et al., Role of financial regulation and innovation in the financial crisis. J. Financial Stability (2012),
http://dx.doi.org/10.1016/j.jfs.2012.07.002
International Financial Statistics (IFS) published by the IMF. A coun-
try’s shock in foreign exchange markets is calculated by the number
of months that the EMPI exceeds the threshold level. We observe
that a total of 144 shocks related to the currency crisis occurred in
105 countries, from January 2007 to October 2009. There was no
significant difference in the rate of currency crisis among alterna-
tive exchange rate regimes.4
3.2. Measures of determinants
3.2.1. Regulation
This study uses the regulation data collected by Barth et al.
(2008) who carried out a survey on bank regulation and supervi-
sion for 143 countries in 2005 and 2006. For the countries without
data, this study uses primarily the 2000–2003 data from Barth et al.
(2004). The index of the restrictions on bank activities measures
the extent to which banks have regulatory restrictions on their
activities in securities, insurance and real estate markets. Entry
requirements reflects the number of requirements needed to obtain
a banking license, and diversification evaluates whether explicit,
verifiable and quantifiable guidelines exist for asset diversifica-
tion and whether banks are allowed to make loans abroad. Capital
regulation measures the degree to which banks have regulatory
restrictions on the amount of required capital, and private moni-
toring is the degree to which regulations enable the private sector
to monitor banks. The measure of government-owned banks reflects
the extent to which the banking system’s assets are government-
owned, and official supervisory power shows the extent to which a
country’s commercial bank supervisory agency has the power to
take corrective actions.
3.2.2. Financial innovation
Only a few studies examine the effect of financial innovation on
financial crises, partly due to the vague definition of financial inno-
vation and a lack of readily available data (Frame and White, 2004).
Studies of innovation in other industries often use R&D expendi-
ture or the number of patents as a measure of innovation; however,
financial service firms often do not have separate R&D budgets and
financial patents are used very infrequently (Lerner, 2006). This
index as a proxy for assessing the degree of financial innovation in
a country. Based on the availability of cross-country data, we con-
sider three variables of financial innovations to construct a single
proxy for the extent of financial innovation in a country: inter-
est rate derivatives,5 venture capital and private equity (VC/PE),6
and securitization7 (Gropp et al., 2007). These three variables are
4
According to the classification of IMF, we can classify the de facto exchange rate
arrangements of 132 countries into three broad categories: hard pegs, soft pegs,
and float (IMF, 2008). There were 16 shocks related to the currency crisis in 11 of 16
countries with hard pegs arrangements (the average currency crisis per country was
1.45), 61 shocks in 43 of 51 countries with soft pegs arrangements (the average of
1.42), and 67 shocks in 51 of 65 countries with floating arrangements (the average
of 1.31).
5
Interest rate derivatives (or interest rate swaps) are dominant in the derivatives
market. According to the Bank for International Settlements (BIS, 2007), the share of
interest rate derivatives among over-the-counter (OTC) derivatives was 69.7% with
$292 trillion.
6
Venture capital and private equity (VC/PE), which provide emerging companies
with capital and management support, are increasingly considered a new type of
institution in the financial sector. The shadow banking system, which is believed to
have played an important role in the recent crisis, consists of hedge funds, invest-
ment banks, and VC/PE.
7
Securitization refers to the creation of securities from a portfolio of consolidated
assets or future receivables for sale to investors who resell them to the public. The
process can be explained by the “originate-and-distribute” model, in which loans are
pooled, trenched (divided into classes) and then resold via securitization in order to
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consistent with Tufano’s definition of financial innovation in that
interest rate derivatives are a form of new financial instruments;
venture capital and private equity, of new institutions; and securiti-
zations, of new markets. New financial technologies, such as ATMs
and smart cards, are not considered here due to the unavailability
of cross-country data. An aggregate index of financial innovation
is then constructed from these three variables by using the factor
analysis.
The data on interest rate derivatives were collected from BIS
(2007), which covers 54 countries in 2007. The VC/PE variable is
measured as the total amount of capital provided to emerging firms
until the buy-out stage of those firms (Wright et al., 2005). Data
for 22 countries in 2007, which cover more than 91% of the global
VC/PE investment, were collected from various websites of venture
capital and private equity associations. For securitization, the data
for 45 countries in 2006 or 2007, which include most securitization-
issuing countries, were collected from various sources (Table 1).
3.2.3. Financial structure
A country’s financial structure can be classified either as
bank-based or market-based (Levine, 2002). For countries with
a bank-based financial structure, such as Japan and Germany,
banks are thought to (i) improve capital allocation and corpo-
rate governance, (ii) enhance investment efficiency and economic
growth, and (iii) mobilize capital to exploit economies of scale.
However, corruption is likely to happen for powerful banks with
lax government regulation. On the other hand, for countries with
a market-based structure, such as the United Kingdom and the
United States, the market is thought to (i) foster greater incentives
to monitor firms, (ii) enhance corporate governance by facilitating
takeovers, and (iii) facilitate risk management. However, greater
market development may hinder corporate control and economic
growth due to fewer incentives to exert corporate control. The type
of financial structure in each country is included in the regres-
sion analysis to control for the different levels of vulnerability to
financial crises.
Beck et al. (2009) provide a database on the financial struc-
ture indicators of 69 countries. For the missing data, this study
collects data primarily from other sources such as central banks
or monetary authorities. The financial structure indicators consist
of activity, size, and efficiency. As a first step, four measures are
calculated using Beck et al.’s method for the period from 2003
to 2007: (1) private credit by deposit banks/GDP, (2) bank over-
head costs/total assets, (3) stock market capitalization/GDP, and (4)
stock market total value traded/GDP. Then, each indicator is com-
puted using the natural logarithm of the following ratios: (4)/(1)
for the activity indicator, (3)/(1) for the size indicator, and (4)/(2)
for the efficiency indicator. Each indicator is averaged over the
whole period, and an aggregate index is constructed from these
indicators by using factor analysis. A higher value implies a more
market-based financial structure.
3.2.4. Other control variables
Macroeconomic variables are considered to be related to a coun-
try’s financial stability. From 26 macroeconomic indicators, Lestano
et al. (2003) select five variables that are most closely related to
banking and currency crises: annual percentage changes in M1,
M2, size of commercial bank deposits, GDP per capita, and national
savings. Our study includes these five indicators for the years 2005
offload risks (Brunnermeier, 2009). The securitization market can be broadly classi-
fied as mortgage-backed-securities (MBS) and asset-backed securities (ABS) by the
type of collateral, and this study considers both types as measures of a new financial
market.
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5
and 2006 as control variables, and these data are collected from
IFS, nations’ central banks and statistics agencies of each country.
The data sources of all variables and their summary statistics are
presented in Tables 1 and 2.
4. Methodology and results
4.1. Methodology
With count data as a dependent variable, either the Poisson or
negative binomial regression model can be used. The Poisson model
specifies that each dependent variable yi is drawn from a Poisson
distribution with parameter i , which relates to the regressors xi .
y
e−i i i
Prob(Yi = yi |xi ) = .
yi !
The most common formulation for i is the log-linear model
(ln i =x i ˇ), and the log-likelihood function then becomes

n
 
ln L = −i + yi xi ˇ − ln yi ! .
i=1
The parameters of this function are estimated with the maxi-
mum likelihood technique.
When the variance of yi is different from the mean, an alterna-
tive negative binomial regression model is used. In a generalized
Poisson model, the unobserved effect (εi ) is incorporated into the
conditional mean (Greene, 2003),
ln i = xi ˇ + εi = ln i + ln ui .
Then, the distribution of yi conditional on xi and ui remains Pois-
son with a conditional mean and variance i assumed to be equal
to its mean. If we assume a gamma distribution for ui = exp(εi ), we
get the negative binomial model as
 ( + yi ) yi
Prob(Yi = yi |xi ) = r (1 − ri ) ,
 (yi + 1) () i
where ri = i /(i + ). The mean of this model is i , and the variance
is i (1 + (1/)i ).
To check whether a model follows the Poisson model, we test
the hypothesis  = 0 for both the banking crisis and the currency
crisis model. The tests of  = 0 are rejected in our data, so the nega-
tive binomial regression model is appropriate because the variance
is larger than the mean (“overdispersion”). The dependent variable
in our data contains many zeros; there are 52 zeros for 132 coun-
tries in the banking crisis model and 27 for the 132 in the currency
crisis model. Thus, we performed the Vuong test which compares
the zero-inflated negative binomial model with the standard nega-
tive binomial model. We found that the standard negative binomial
model performs better in both crisis models.
It is possible heteroskedasticity may exist in our cross-country
data. The Breusch–Pagan heteroskedasticity test rejected the con-
stant variance in OLS regressions for the banking crisis (but not
for the currency crisis). To control for possible heteroskedasticity,
White (1980) robust estimation method is applied to all regres-
sions. We have also compared the results by adding regional
dummies, but did not find a significant difference in the results.
Multicollinearity was also tested with the Variance Inflation Fac-
tor (VIF), but no severe problem was identified. A correlation
matrix presented in Table 3 implies that there is no strong corre-
lation among regulation variables. Another important issue in the
empirical model can be inconsistency due to reverse causality or
endogeneity, and this will be discussed in Section 4.6.
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Table 1
Variables, definition, and sources.

Variable Period Definition and source

Financial crisis
Banking crisis 2007–2009 A crisis dummy, which takes on the value of one if there is a monthly occurrence of shock related
to the banking crisis such as bank runs, emergency liquidity support, and deposit freezes, and the
value of zero otherwise. IMF’s International Financial Statistics (IFS)
Currency crisis 2007–2009 A crisis dummy, which takes on the value of one if a monthly EMPI exceeds the threshold level and
the value of zero otherwise. IMF’s International Financial Statistics (IFS)
Regulation
Restrictions on bank activities 2006 The extent to which banks have regulatory restrictions on their activities in securities, insurance
and real estate markets. Barth et al. (2008)
Entry requirements 2006 The number of requirements needed to obtain a banking license. Barth et al. (2008)
Diversification 2006 Evaluation whether explicit, verifiable and quantifiable guidelines exist for asset diversification
and whether banks are allowed to make loans abroad. Barth et al. (2008)
Capital regulation 2006 The degree to which banks have regulatory restrictions on the amount of required capital. Barth
et al. (2008)
Private monitoring 2006 The degree to which regulations enable the private sector to monitor banks. Barth et al. (2008)
Government-owned banks 2006 The extent to which the banking system’s assets are government-owned. Barth et al. (2008)
Official supervisory power 2006 The extent to which a country’s commercial bank supervisory agency has the power to take
corrective actions. Barth et al. (2008)
Financial innovation
Interest rate derivatives 2007 OTC single currency interest rate derivatives turnover by country and counterparty. BIS’s Triennial
Central Bank Survey of Foreign Exchange and Derivatives Market Activity (2007)
Venture capital and private equity 2007 Total amount invested by venture capital and private equity investment firms.
PricewaterhouseCoopers (2008), Global Private Equity Report; Latin America Venture Capital
Association (2008), Scorecard on the Private Equity and Venture Capital Environment in Latin
America and the Caribbean; British Private Equity and Venture Capital Association (2008), BVCA
Private Equity and Venture Capital Report on Investment Activity; European Private Equity and
Venture Capital Association (2008), Central and Eastern Europe Statistics; Emerging Markets
Private Equity Association (2009), EMPE Industry Statistics; Israel Venture Capital Research Center
(2008), Summary of Israeli High-Tech Company Capital Raising; PRNewswire (2008), Venture
Equity Latin America’s 2007 Year-End Report Announced.
Securitization 2006/2007 Securitization issuance based on originating country. Europe Securitization Forum (2008),
Securitization Data Report; International Financial Services London (2009), Securitisation;
Deutsche Bank (2007), The Role of Investment Banks in the Securitization Process; International
Finance Corporation (2008), Global Securitisation Review.
Control variables
Financial structure 2003–2007 An aggregate index, which is constructed from some macroeconomic indicators by using the
factor analysis. Beck et al. (2009)
M1 growth 2005–2006 12-month percentage change in M1. IMF’s International Financial Statistics (IFS)
M2 growth 2005–2006 12-month percentage change in M2. IMF’s International Financial Statistics (IFS)
Growth of commercial bank deposits 2005–2006 12-month percentage change in commercial bank deposits. IMF’s International Financial Statistics
(IFS)
Growth of GDP per capita 2005–2006 12-month percentage change in GDP per capita. IMF’s International Financial Statistics (IFS)
Growth of national savings 2005–2006 12-month percentage change in national savings. IMF’s International Financial Statistics (IFS)

4.2. Effects of individual regulatory measures
We start with a model with only the regulatory variables for
each crisis, and regression models 1 and 4 in Table 4 illustrate
the effects of the seven measures of financial regulations on the
banking crisis and the currency crisis, respectively. The restric-
tions on bank activities, entry requirements, and private monitoring
have negative (i.e., stabilizing) effects on the banking crisis. For the
currency crisis, government-owned banks have a positive (i.e., exac-
erbating) effect but official supervisory power has a negative effect.

Table 2
Summary statistics of variables.

Variable Unit Mean S.Dev. Min Max Median

Financial crisis
Banking crisis Count 2.84 4.05 0 17 1
Currency crisis Count 1.09 0.73 0 3 1
Regulation
Restrictions on bank activities Count 10.77 2.24 4 16 11
Entry requirements Count 7.57 0.97 3 8 8
Diversification Count 1.39 0.58 0 2 1
Capital regulation Count 5.08 1.67 1 8 5
Private monitoring Count 5.90 1.25 2 9 6
Government-owned banks % 0.16 0.22 0 0.943 0.5
Official supervisory power Count 10.93 2.05 5 14 11
Control variable
M1 growth % 0.19 0.18 −0.072 1.499 0.16
M2 growth % 0.19 0.18 −0.506 0.893 0.15
Growth of commercial bank deposits % 0.14 0.14 −0.015 0.718 0.11
Growth of GDP per capita % 0.11 0.07 0.013 0.331 0.10
Growth of national savings growth % −0.55 11.43 −105.94 51.50 0.13

Note: Indices of financial innovation and financial structure are the scores of factor which have a zero mean and a standard deviation of one.

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Table 3
Correlations among selected variables.

Restrictions Entry Diversi- Capital Private Government- Official Financial Financial M1 M2 Growth of Growth of Growth of
on bank require- fication regulation monitoring owned supervisory innovation structure growth growth com. bank GDP per national

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activities ments banks power deposits capita savings

Restrictions on bank activities 1

Entry requirements −0.0934 1

T. Kim et al. / Journal of Financial Stability xxx (2012) xxx–xxx

(0.2870)
Diversification −0.1622 0.0747 1
(0.0631) (0.3943)
Capital regulation 0.0124 0.0024 −0.1181 1
(0.8881) (0.9779) (0.1775)
Private monitoring −0.1944* −0.0555 0.1070 0.1005 1
(0.0255) (0.5272) (0.2220) (0.2515)
Government-owned banks 0.1782* −0.1798* −0.1071 0.0240 −0.0696 1
(0.0410) (0.0391) (0.2216) (0.7847) (0.4280)
Official supervisory power 0.2513* 0.0850 −0.0223 −0.0601 −0.1216 −0.0852 1
(0.0036) (0.3322) (0.7998) (0.4935) (0.1648) (0.3314)
Financial innovation −0.1490 0.0210 −0.0538 0.0470 0.1386 −0.0829 0.0004 1
(0.0883) (0.8112) (0.5400) (0.5924) (0.1130) (0.3445) (0.9966)
Financial structure −0.2575* −0.0716 −0.0208 0.2303* 0.3429* −0.1991* 0.0208 0.2494* 1
(0.0029) (0.4148) (0.8131) (0.0079) (0.0001) (0.0221) (0.8130) (0.0039)
M1 growth 0.1764* −0.0391 −0.0716 −0.2392* −0.2084* 0.0757 0.0328 −0.1344 −0.2322* 1
(0.0430) (0.6564) (0.4145) (0.0057) (0.0165) (0.3882) (0.7092) (0.1244) (0.0074)
M2growth −0.0120 0.1177 −0.0780 0.0386 −0.1649 −0.0593 −0.1426 −0.0717 −0.0403 0.0389 1
(0.8910) (0.1787) (0.3738) (0.6604) (0.0588) (0.4992) (0.1028) (0.4141) (0.6461) (0.6579)
Growth of com. bank deposits −0.0067 0.0463 −0.0127 −0.1749* −0.1832* −0.0482 −0.1379 −0.0833 −0.1206 0.6498* 0.6413* 1
(0.9397) (0.5980) (0.8855) (0.0448) (0.0355) (0.5830) (0.1148) (0.3425) (0.1683) (0.0000) (0.0000)
Growth of GDP per capita 0.2216* −0.0407 −0.2613* −0.1165 −0.2950* 0.1865* −0.0653 −0.1557 −0.1541 0.5942* 0.4323* 0.5529* 1
(0.0107) (0.6430) (0.0025) (0.1836) (0.0006) (0.0322) (0.4572) (0.0747) (0.0777) (0.0000) (0.0000) (0.0000)
Growth of national savings −0.1208 −0.0291 0.0589 −0.0773 0.0165 0.0786 −0.1077 0.0101 0.1516 −0.1182 0.0694 0.0752 −0.1104 1
(0.1678) (0.7405) (0.5020) (0.3781) (0.8511) (0.3704) (0.2190) (0.9085) (0.0826) (0.1772) (0.4290) (0.3914) (0.2076)

p-Values in parentheses.
*
p < 0.05.

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Table 4
Effects of financial regulation and innovation on financial crises.

Variable Banking crisis Currency crisis

1 2 3 4 5 6

Regulation
Restrictions on bank activities −0.231*** −0.205*** −0.220*** −0.003 0.001 −0.004
(0.053) (0.055) (0.056) (0.029) (0.027) (0.027)
Entry requirements −0.185* −0.233** −0.263** 0.018 0.047 0.047
(0.102) (0.106) (0.103) (0.046) (0.055) (0.055)
Diversification 0.217 0.355 0.414* −0.031 0.014 −0.001
(0.207) (0.225) (0.234) (0.096) (0.096) (0.097)
Capital regulation −0.054 −0.061 −0.052 0.053 0.063* 0.063*
(0.068) (0.077) (0.076) (0.035) (0.036) (0.035)
Private monitoring −0.186* −0.103 −0.104 −0.051 −0.064 −0.059
(0.096) (0.097) (0.097) (0.045) (0.047) (0.047)
Government-owned banks −0.086 0.168 0.211 0.439** 0.480** 0.486**
(0.605) (0.650) (0.646) (0.213) (0.200) (0.197)
Official supervisory power −0.085 −0.050 −0.058 −0.052* −0.058** −0.059**
(0.055) (0.056) (0.057) (0.027) (0.027) (0.026)
Financial innovation 0.190*** −0.132*
(0.057) (0.073)
Control variables
Financial structure 0.149 0.068 0.167*** 0.185***
(0.150) (0.150) (0.057) (0.057)
M1 growth −0.674 −0.180 1.228* 1.195*
(1.480) (1.502) (0.631) (0.628)
M2 growth 0.890 1.240 0.091 0.051
(1.212) (1.213) (0.522) (0.518)
Growth of commercial bank deposits 2.000 1.363 −0.758 −0.689
(1.994) (2.019) (0.925) (0.919)
Growth of GDP per capita 0.249 0.577 0.424 0.276
(3.013) (2.952) (1.171) (1.165)
Growth of national savings 0.011 0.012 0.007* 0.007
(0.020) (0.020) (0.004) (0.004)
Constant 6.802*** 5.397*** 5.614*** 0.533 0.091 0.164
(1.370) (1.406) (1.453) (0.709) (0.710) (0.715)
Observations 132 132 132 132 132 132
Pseudo R-squared 0.029 0.045 0.052 0.017 0.041 0.045
Log pseudo-likelihood −273.930 −269.431 −267.374 −156.609 −152.716 −152.178

Note: Robust standard errors in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

We then added the control variables including the financial
structure index in regression models 2 and 5. While private monitor-
ing becomes insignificant, the negative effects of restrictions on bank
activities and entry requirements on the banking crisis become more
significant. This finding supports Hypotheses 1a and 1b in terms of
the banking crisis. The negative effect of restrictions on bank activi-
ties is in contrast to the findings of Barth et al. (2004), which report
that stronger regulatory restrictions on bank activities slow down
bank development and increase the vulnerability of the banking
system to exogenous shocks. We also run regression models with
the set of countries used by Barth et al. (2004), and our result is
robust to the choice of countries. Apart from the different dataset
used in this study, this conflicting result may be explained by the
different financial environments in our study period and by the
stronger contagion effects due to globally interlinked economies.
Our result is also different from that of Shleifer and Vishny (1998),
who argue that strict entry requirements hamper efficient bank
competition and negatively affect the economy. Our result suggests
that implementation of deregulatory measures to ease the entry
requirements may weaken the stability of the banking sector.
When we considered the control variables in the currency crisis
model, the positive effect of government-owned banks and the neg-
ative effect of official supervisory power still hold, which supports
Hypotheses 1f and 1g, respectively. In addition, capital regulation
has a positive effect, supporting Hypothesis 1d. A fragile bank-
ing system is vulnerable to turmoil in foreign exchange, and state
ownership is likely to reduce the investment in the financial infras-
tructure, which leads to a weak banking sector (Caprio and Peria,
2006). Market failure and information asymmetry are typical causal
factors in the currency crisis, and the result of official supervisory
power is consistent with the view that official supervision amelio-
rates market failure and mitigates information asymmetry (Barth
et al., 2004).
The Basel agreements, especially regarding capital regulations,
are criticized for their procyclical effects, which can lead over-
lending in booms and underinvestment in recessions (Borio et al.,
2001; Danielsson and Shin, 2003; Benink et al., 2008). This study
finds empirical evidence for the procyclicality of capital require-
ments with regard to currency crises. The result is consistent with
the view that capital regulations amplify procyclicality through
changes in exchange rates in many countries, especially countries
which have a substantial proportion of foreign currency assets
and liabilities (Danielsson and Jonsson, 2005). It also supports the
argument that foreign currency lending was a contributing factor
to vulnerabilities in the recent crisis (Working Group on Basel III
implementation in Emerging Europe, 2012).
4.3. Effects of financial innovation
Regression models 3 and 6 in Table 4 illustrate the effects of
financial innovation on the banking and currency crises, by con-
sidering the aggregate index of financial innovation. The result is
intriguing since the financial innovation variable has a positive
effect on the banking crisis, but a negative effect on the currency
crisis. The result for the banking crisis is consistent with the view
that excessive use of financial innovation leads to sharp increases in

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debt and bubbles in credit and assets, which are typically observed
in a banking crisis (Reinhart and Rogoff, 2008). On the other hand,
the result in the currency crisis suggests that financial innovation
can stabilize the exchange market and mitigate information asym-
metry, which was one of the causal factors of the currency crisis.
To test the robustness of assigning zero values to the coun-
tries with no financial innovation data, we run a regression with
a sub-sample including only those countries for which at least one
of the measures (interest rate derivatives, VC/PE, and securitiza-
tion) is nonzero. The main variables maintain the same signs for
the alternative samples, though the significances of some variables
changed. The coefficients of financial innovation show the expected
sign, and its effect on the currency crisis is significant.
4.4. Effects of other economic factors
Regression models 5 and 6 in Table 4 show that countries with
market-based financial structure are more likely to experience a
currency crisis. This result is consistent with the view that a liberal-
ized capital market is likely to experience a stop in capital inflow or
a sudden capital outflow, triggering a currency crisis. Rapid growth
in M1 and national saving are also positively associated with a cur-
rency crisis, indicating that excess liquidity fuels the speculative
attack on the currency (Lestano et al., 2003).
However, the remaining variables in Table 4 are not statisti-
cally significant. Rose and Spiegel (2010) found no robust plausible
causes for the recent global crisis in their cross-country analysis,
and they are skeptical of the effectiveness of an early warning sys-
tem based on the observation of other macroeconomic variables.
The effects of macroeconomic variables on the financial stability
vary by country, and our results support Rose and Spiegel’s argu-
ment.
4.5. Effects of regulatory combinations
Several regulatory measures are implemented simultaneously
in most countries, and a specific combination of the mea-
sures can have countervailing or amplifying effects on financial
crises. Following Barth et al. (2004), we considered three inter-
action terms, namely (restriction on bank activities) × (official
supervisory power), (entry requirements) × (diversification) and
(capital regulation) × (official supervisory power).
We found that the effect of the combination of entry require-
ments and diversification is different from the effect without
the interaction term. Although implementation of strong entry
requirements alone avoids the accumulation of systemic risks in
the banking sector, it can aggravate a banking crisis if implemented
with a greater diversification, supporting Hypothesis 2b. This result

Table 5
Effects of the interactions of regulation on financial crises.

Variables Banking crisis Currency crisis Banking crisis Currency crisis Banking crisis Currency crisis
1 2 3 4 5 6

Regulation
Restrictions on bank activities −0.036 −0.012 −0.197*** 0.000 −0.205*** 0.001
(0.143) (0.062) (0.055) (0.027) (0.056) (0.026)
Entry requirements −0.226** 0.046 −0.784*** −0.031 −0.233** 0.047
(0.106) (0.055) (0.290) (0.114) (0.106) (0.055)
Diversification 0.288 0.022 −3.151* −0.469 0.356 0.015
(0.230) (0.106) (1.705) (0.689) (0.227) (0.098)
Capital regulation −0.059 0.064* −0.056 0.065* −0.063 0.049
(0.076) (0.036) (0.075) (0.036) (0.220) (0.077)
Private monitoring −0.079 −0.066 −0.089 −0.061 −0.103 −0.064
(0.096) (0.048) (0.103) (0.047) (0.097) (0.047)
Government-owned banks 0.163 0.486** 0.022 0.473** 0.167 0.480**
(0.653) (0.206) (0.640) (0.200) (0.664) (0.201)
Official supervisory power 0.096 −0.070 −0.059 −0.058** −0.052 −0.071
(0.136) (0.058) (0.056) (0.026) (0.191) (0.072)
Control variables
Financial structure 0.181 0.165*** 0.182 0.171*** 0.149 0.168***
(0.150) (0.056) (0.148) (0.056) (0.150) (0.057)
M1 growth −0.420 1.180* −0.922 1.228* −0.671 1.229*
(1.463) (0.645) (1.525) (0.631) (1.520) (0.632)
M2 growth 0.950 0.065 0.859 0.103 0.892 0.086
(1.186) (0.525) (1.222) (0.523) (1.227) (0.523)
Growth of commercial bank deposits 1.750 −0.698 2.051 −0.758 1.997 −0.738
(1.955) (0.924) (2.016) (0.924) (2.035) (0.933)
Growth of GDP per capita −0.046 0.465 1.669 0.483 0.249 0.427
(3.034) (1.195) (3.129) (1.169) (3.010) (1.170)
Growth of national savings 0.012 0.007 0.010 0.007* 0.011 0.007
(0.019) (0.004) (0.020) (0.004) (0.020) (0.004)
Interaction term
Restrictions on bank activities × Official supervisory power −0.000 0.000
(0.000) (0.000)
Entry requirements × Diversification 0.469** 0.064
(0.232) (0.090)
Capital regulation × Official supervisory power 0.000 0.000
(0.002) (0.001)
Constant 2.871 0.288 9.260*** 0.644 5.414** 0.230
(2.407) (1.056) (2.291) (0.967) (2.519) (0.918)
Observations 132 132 132 132 132 132
Pseudo R-squared 0.047 0.041 0.051 0.042 0.045 0.041
Log pseudo-likelihood −268.938 −152.703 −267.870 −152.639 −269.431 −152.711

Note: Robust standard errors in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

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implies that insufficient competition in the banking system due
to strong entry requirements can aggravate the financial stabil-
ity due to strict diversification guidelines. Table 5 summarizes this
interrelated effect of the regulatory combinations. We found no
significant interaction between restriction on bank activities and
official supervisory power or between capital regulation and official
supervisory power.
4.6. Endogeneity test
As discussed in Section 4.1, we need to check the reverse
causality or omitted variable problem in our estimation analysis.
Financial regulations and innovations presumably increase finan-
cial (in)stability, but certain regulations and innovations can be
adopted to cope with financial turmoil. However, the timings of
our observation of the regulatory and innovation variables are
predetermined. That is, the data on financial crises are observed
from 2007 to 2009, while innovation and regulatory variables are
observed prior to 2007. Based on the sequence of observations in
each variable, the possibility of reverse causality would not be a
serious issue.
The omitted variable problem may occur when an exoge-
nous factor affects both financial crises and regulations, and the
instrumental variable approach can address this problem. For
the negative binomial model, the two-step test suggested by
Wooldridge (2002) can be used to perform the instrumental vari-
able approach. Only a few studies consider the instruments for
institutional variables. For example, Acemoglu et al. (2001) used
mortality rates of colonial settlers as an instrument for institutional
quality, and Hall and Jones (1999) used the countries’ latitudes or
the fractions of the population speaking English and Western Euro-
pean languages as the first language. These instrument variables
indicate the influence of Western culture on each country. Since
Acemoglu et al.’s approach is available only for European countries
or their former colonies, we use the average latitude and longitude
of each country as an instrument. The two-step test with these
variables did not find their endogeneity.
5. Conclusions
This study used a global dataset of 132 countries to examine the
effects of various types of regulatory measures and financial inno-
vation on the recent financial crisis. The empirical results show
that the effects of these variables on the crisis are much more
nuanced and complex than suggested by existing studies, and we
cannot make a sweeping judgment on the roles of deregulations
and hyperactive financial innovations in the financial sector.
Regulatory measures such as stronger restrictions on bank activ-
ities and strengthened entry requirements have decreased the
probability of banking crises. While capital regulation and govern-
ment ownership of banks have positive effects on the likelihood of
currency crises, official supervisory power has a negative effect.
Another important result of this study is that some regulatory
combinations can have countervailing effects on financial stability.
For example, though implementation of strong entry require-
ments alone contains a banking crisis, it can aggravate the crisis
if implemented simultaneously with greater diversification. While
excessive use of financial innovation contributed to the recent
banking crisis, it contained the currency crisis. However, a caveat
should be mentioned about the implication of financial innovation
since valid data were available only for a part of the sample.
The recent global crisis has led to unprecedented international
cooperation. The G20 mandated its Financial Stability Board (FSB)
to develop strong regulatory and supervisory policies for financial
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stability and to coordinate comprehensive global regulatory
reform. The results of this study can provide some insights for
implementing global financial regulatory reforms. First, while
Basel III is designed for banks and supervisors to monitor Liquidity
Coverage Ratio in significant currencies under newly adopted
liquidity standards, it still remains a question whether the pro-
cyclicality of the capital requirements with regard to the currency
crisis risk can be mitigated under the capital framework of Basel III.
Second, newly proposed regulatory measures should be carefully
evaluated because their combinatory effects can have very differ-
ent implications from the individual effects. Third, several groups
have recommended reforms on financial innovations such as OTC
derivatives and venture capital and private equity. The effects of
financial innovation may depend on the type of crisis, and careful
evaluation of the environments will help achieve financial stability
without stifling innovation.
This study can be extended in a few directions. First, while
this study addresses the problem of reverse causation by using
2005–2006 regulatory data and 2007–2009 financial crisis data,
there could be a longer time lag between the implementation
of regulations and their detectable effects in the financial sector.
The current European debt crisis illustrates that there might be
a time lag between the banking crisis and the debt crisis, and
consideration of this lag will provide further insights of various
determinants. Second, regulatory variables in this study include
only those related to the banking industry. Future studies can also
consider the measures in other financial sectors such as the insur-
ance industry, bond market and foreign exchange markets. Third,
the use of more extensive cross-county data on financial innova-
tion, including sophisticated indicators (e.g., foreign exchange or
currency swaps), can provide further insights, though the avail-
ability of relevant data presents a major obstacle. Fourth, financial
fragility may also be related to the generosity of deposit insur-
ance, financial openness or legal origin, and consideration of these
additional variables is another extension of this study.
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