UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS DETERMINANTS OF BANKING CRISIS IN DEVELOPING COUNTRIES :\ A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Development Economics By LuO'ng Duy Quang Academic supervisor: Dr. Nguy~n Van Phuc. Ho Chi Minh city, March 2010 - 1- I UAN VAN CHAT LUONG download : add luanvanchat@agmail.co ACKNOWLEDGEMENT To be able to complete this thesis, I have been received a great support from many people. First of all, I would like to thank my supervisor, Dr.
Nguyen Van Phuc for his valuable guidance, comments, advice and encouragement during my completion of this thesis. I would like to express my deep appreciation and sincere thanks to Assoc. Le Bao Lam for his valuable orientations in the first days of searching further education. I am grateful to my all teachers and staffs of the Vietnam-Netherlands Program, particularly, Assoc.
Nguyen Trong Hoai for his assistance during the first days I study in this program. Many thanks are respectfully sent to my manager, Mr. Nguyen Tu Han, and my colleagues for their encouragement and support during my writing thesis duration. Finally, I am indebted to my family, especially my parent and others who give me great encouragement and support for my study.
-2- UAN VAN CHAT LUONG download : add luanvanchat@agmail.co TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.5 Structure of the thesis:. 6 CHAPTER II: LITERATURE REVIEW 2.2 Banking crisis theory:. 17 CHAPTER III: MODEL SPECIFICATION AND DATA 3.2 Theoretical model and model specification:.2 Real short-term interest rate: .3 Estimation strategy and statistical tests of the model: .5 Data filler process;. 27 CHAPTER IV: REGRESSION RESULTS AND TESTING HYPOTHESIS 4.1 Accessing the best unbiased model:.2 Significance of explanatory variables: .3 Minimization of banking crisis frequency: .36 CHAPTER V: WELL-KNOWN CRISES AND PREDICTION POWER OF THE MODEL -3- UAN VAN CHAT LUONG download : add luanvanchat@agmail.1 Thai Banking Crisis~···················································································································································39 5.2 Uruguay's crisis: Victim of contagious effect .3 Implementing the best unbiased model to Thailand and Uruguay cases: failure to explain the crisis originating in balance of payment crisis.43 CHAPTER VI: CONCLUSION AND POLICY RECOMMENDATION LIST OF TABLES Table 1: Regression results ofbanking crisis determinants: the panel eliminating observations following end year of crisis.
31 Table 2: Regression results of banking crisis determinants: the panel eliminating observations following first year of crisis. 33 Table 3a: Average marginal effects of determinants case for those countries without deposit insurance system. -37 Table 3b: Average marginal effects of determinants case for those countries with deposit insurance system. 37 Table 4: Banking indicators before the crisis erupt (December 31,2001 }.
41 LIST OF FIGURE Figure 1: Breakdown structure of liability side of Uruguay banking system before crisis erupt. 41 Figure 2: Peso/US$ exchange rate and evolution of US$ reserves. -43 Figure 3: Predicted probability of banking crisis in Uruguay and Thailand with specification 5a. 44 -4- UAN VAN CHAT LUONG download : add luanvanchat@agmail.co CHAPTER I: INTRODUCTION 1.1 Problem statement: The banking crises that erupted in US in 2007 are the latest in a series of such episodes that have been experienced by economies in various regions of the world in recent years.
In the 1990s, banking crises have occurred in Europe (the 1992-93 crises in the European Monetary System's exchange rate mechanism), Latin America (the middle of 1990s), as well as in East Asia (the 1997-98 crises in Indonesia, Korea, Malaysia, the Philippines, and Thailand). These crises have been costly in varying degrees both in lost output and in the fiscal expense to rescue fmancial sectors. Through fmancial system, their significant spillovers spreads internationally and in a number of situations international financial assistance have required to mitigate their severity, costs and spillovers to other countries. In the wake of these recent crises, issue of what determinants affecting to occurrence of banking crisis has been a hot topic for economists in both developed and developing countries around the world.
Accessing this question is quite significant because it does not merely help authorities have confident base for their policies making process but it also is necessary to build up early warning system so that the crisis can be prevented beforehand. However, understanding determinants of banking crisis is not an easy task. Financial innovations and the increased integration of global financial markets are driving forces that make us harder to deal with this issue. Such factors push financial system to evolve rapidly and generate new risks for financial system.
One critical thing is that development of fmancial market seems so complicated and exceeds our knowledge and prediction. What we can do as crisis comes is waiting for crisis wave and witnessing its effects on our life. Thus, widely spreading influence of financial crisis, especially in banking sector, and its possible consequences obviously show important role of researches about determinants of banking crisis. Even though this issue is not new, it always deserves to pursue.
- 5- UAN VAN CHAT LUONG download : add luanvanchat@agmail.co This paper, thus, will focus on examining theoretical paths that lead to occurrence of banking crisis. From that place, early warning system is developed to deal with crisis. However, because of data limitation, the scope of study narrows in developing countries during period 1974-2002.2 Research objectives: Some objectives of the thesis are to identify: (i). Determinants of banking crisis.
Threshold values of determinants which minimize banking crisis occurrence probability. Suggest policies recommendation to prevent banking crisis. What are determinants of banking crisis? (ii). How do determinants affect on probability of banking crisis occurrence? (iii).
How is marginal effect of each variable on probability of banking crisis evaluated? 1. Key determinants such as real interest rate, deposit insurance, and exchange rate would have positive effects on probability of banking crisis. Margial effect of each variable on probability of banking crisis is helpful to reduce risk of crisis.5 Structure of the thesis: The thesis includes 6 chapters: Chapter 1: The introduction of the thesis. Chapter 2: Literature review Fundamental components of banking cns1s such as key defmition, conceptual framework, theories and empirical studies will be discussed in this chapter.
Firstly, defmition of banking crisis is clarified. Then, theoretical part will review the relationship between dependent variable {banking crisis) and explanatory -6- UAN VAN CHAT LUONG download : add luanvanchat@agmail. Empirical work is the last one mentioned in this chapter. Chapter 3: Model specification and data.
The top priority of this chapter is to develop necessary steps to obtain the best unbiased model for data analysis steps later on. To fulfill this purpose, advantages and disadvantages of potential models is initially analyzed. Next, strategy to obtain model specification from originally conceptual one will be presented. Other important issues relating to data such as data filler process, data sources are also mentioned in this chapter.
Chapter 4: Regression result and testing hypothesis In chapter 4, second objective of this paper will be fulfilled. The chapter begins with analytic steps to access the best unbiased model. Then, hypotheses relating to sources of banking crisis are tested to provide basis of policy recommendation. The last part of the chapter will investigate marginal effects of the most significant variables on probability of banking crisis.
From that place, policymaker could proceed to maximize effectiveness of macro-policies on frequency of the crises. Chapter 5: Well-known crises and prediction accuracy of model In the first part of chapter 5, two shrinking cases of banking crisis (Thailand and Uruguay) in Latin America and Asia will be reviewed. For convenient purpose, events are arranged in chronology with two obvious parts: prior to the crisis and afterwards the crisis. Then, prediction power of model will be discussed after analyzing results and information collected from prediction model and descriptive evidences of crisis.
Chapter 6: Conclusion and policy recommendation. - 7- UAN VAN CHAT LUONG download : add luanvanchat@agmail.co CHAPTER 2: LITERATURE REVIEW This chapter initially focuses on clarifying the defmition of banking crisis. Then, various theories of banking crisis are introduced in order to get hypotheses on how determinants affect on probability of banking crisis occurrence. Finally, the chapter closes with empirical studies of banking crisis that help the readers understand how other researchers have approached their research questions, what dataset they have collected as well as which models and statistical methods they have used.1 Key Definition: Banking crisis: Effects of banking crisis is always huge and costly to resolve.
Despite economies may experience different kinds of crisis, one thing ruled out is that if the collective effects of financial collapse is large enough, the government is forced to intervene. Therefore, Ergungor and Thomson (2005), as cited by Caprio and Klingebiel (1996b), suggest that when central bankers think that a particular shock to the financial system could develop into systemic problem, and the monetary authorities begin to respond, banking system is considered as crisis. In other words, banking crisis can be defmed in terms of behaviors of central banks. Kaminsky and Reinhart ( 1996) share this perspective in his study by clarifying two policies of central bank in crisis period.
Under this view, banking crisis links closely with two types of events (1) bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions (as in Venezuela in 1993); and (2) if there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution (or group of institutions) that marks the start of a string of similar outcomes for other financial institutions. As discussed by Kaminsky and Reinhart (1996), this approach is not without drawbacks. It could date the crises too late, because the financial problems usually begin well before a bank is finally closed or merged; it could also date the crises too early because the worst of crisis may come later. Moreover, data of banking crisis in - 8- UAN VAN CHAT LUONG download : add luanvanchat@agmail.co terms of their approach is available at limited level.
Kaminsky and Reinhart (1996) just list system banking crisis of more than 20 countries. This makes it harder for • researchers to expand the scope of study. Given data limitation, this paper, thus, follows definition of banking crisis developed by Caprio and Klingebiel (1996b). Accordance with his perspectives, banking crisis is the case in which the net worth of the banking system has been almost or entirely eliminated.
This creates something contradiction as banking problem in many nations is still to appear when a banking system has positive net worth. However, Caprio and Klingebiel (1996b) indicate that the problem would be much easier if defmition of banking crisis above linked with insolvency of banking system. More obviously, that is, bad loans are strong enough to "blow out" system's capital. Based on data of banking sector in developing countries during 1980s, Caprio and Klingebiel (1996b) suggest that nonperforming loans must account for at least 5 percent of total loans so that loan loss would be sufficient to wipe out banking system.
Under this definition, Caprio and Klingebiel (1996b) track more than 80 systemic banking crises around the world. This dataset is updated through various studies including Caprio and Klingebiel (1996c) and Honohan et al (2005).2 Banking crisis theory: A number of studies have been developed around the world to provide insight view as well as explain logic behind crisis trouble in banking sector 1• One interesting thing is that there is no hope to find full theory in any study. The theory is supplemented across study to study. For that reason, in order to catch whole picture of banking crisis, it is quite useful to examine various studies.
This paper, thus, introduces banking crisis theory mainly referring to works of Ergungor and Thomson (2005) and Demirguc-Kunt and Detragrache (1998a) because they are the most updated and easily understandable version.