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Net external position, financial development, and banking crisis

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Abstract

Does the external position of a country that is conditioned on financial development impact the likelihood of a systemic banking crisis? We address this question using data from 149 emerging, developing, and advanced countries from 1970 to 2011, as well as a variety of statistical tools. Our findings are twofold. First, we find that the net external position of a country significantly affects its likelihood of a systemic crisis depending on the level of financial development. Conditional on low to moderate financial development, countries can lower the risk of banking crises significantly by maintaining a net foreign creditor status. Second, we find that the level of financial development raises a country’s crisis risk significantly, while its impact depends on the net asset position. This indicates a potential amplification effect in which countries with more developed and complex financial systems that are also debtor countries have a higher potential of incurring a systemic banking crisis.

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Notes

  1. In Greece, Portugal, and Spain, average net external liabilities were around 36% of GDP in 2000, while by the end of 2007, such liabilities amounted to 87%.

  2. This quote belongs to Catao Luis and Milesi-Ferretti (2014).

  3. See, for instance, Mendoza et al. (2009) and references therein.

  4. The role of differences in domestic financial market development in producing external imbalances has been examined by other studies in the literature such as Caballero (2016).

  5. Other studies exist that claim threshold levels, but Kose et al. (2011) is one of the leading studies that analyze this framework empirically.

  6. For more information, see Svirydzenka (2016). Financial institutions include banks, insurance companies, mutual funds, pension funds, and other types of nonbank financial institutions, while financial markets include stock and bond markets. Furthermore, within financial markets and financial institutions, different dimensions are measured such as depth, access, and efficiency.

  7. Net external position is defined as the sum of net claims of domestic residents on nonresidents.

  8. As noted in Catao Luis and Milesi-Ferretti (2014), in the case of Ireland, “its debt/equity split is heavily distorted by its sizable mutual fund industry, whose liabilities are recorded as equity instruments but whose assets include both equity and debt.”

  9. This definition is similar to that used by Reinhart and Rogoff (2008). For a discussion of the definition of other databases such as Caprio and Klingebiel (1996), Demirgüç-Kunt and Detragiache (1998, 2005), and Kaminsky and Reinhart (1999), see Davis and Karim (2008). Furthermore, see Chaudron and de Haan (2014), on inconsistencies between the three major databases in the identification and timing of crises.

  10. See Demirgüç-Kunt and Detragiache (1998), Aizenman and Noy (2013), Barrell et al. (2010), and Caggiano et al. (2014). See also Claessens and Köse (2013), which provides a comprehensive survey of the literature on financial crises.

  11. The macroeconomic factors considered in Demirgüç-Kunt and Detragiache (1998) are inflation, rate of growth of real GDP, external terms of trade, ratio of credit to the private sector to GDP, rate of depreciation of the exchange rate, ratio of M2 to foreign exchange reserves, government surplus as a percentage of GDP, ratio of bank cash, reserves to bank assets, and real short-term interest rate. The authors find low GDP growth, excessively high real interest rates, and high inflation all significantly increased the likelihood of systemic problems.

  12. Mendoza and Quadrini (2010).

  13. Borio and Lowe (2002), Goodhart (2007).

  14. Other studies that associates excessive credit expansion and financial crises are Kindleberger (1978), Hume and Sentence (2009), and Reinhart and Rogoff (2009).

  15. In both studies, the analysis covers 14 developed countries from 1870 to 2008.

  16. See Eichengreen and Rose (1998) and Caggiano et al (2014).

  17. Related to previous studies, see references in Catao Luis and Milesi-Ferretti (2014).

  18. Frankel and Saravelos (2012) offered a fourth category that uses a qualitative and quantitative analysis of the behavior of various variables around a crisis occurrence by splitting countries into a crisis and noncrisis control groups.

  19. Comelli (2014) compared how two competing parameter-limited dependent variable EWS (fixed effects logit and random effects probit) that predicted in-sample and out-of-sample currency crises in emerging market economies. They found their performances are quite close and sensitive to estimation sample size.

  20. See Demirgüç-Kunt and Detragiache (2000) and Davis and Karim (2008) for more information.

  21. See Wooldridge (2010, ch. 15, Section 8) for a further rationale for reliance on a pooled probit model.

  22. Davis and Karim (2008:99).

  23. A multivariate probit is used by Eichengreen and Rose (1998), Aizenman and Noy (2013), Caprio et al. (2014) among others.

  24. In the literature, see Ito (2004), Klomp (2010), Noy (2004), Barrell et al. (2010), and Wong et al. (2010) among many others for applying the same methodology.

  25. The net foreign asset position, which is defined as foreign assets minus foreign liabilities divided by GDP.

  26. Among those, see Demirgüç-Kunt and Detragiache (1998, 2005), Barrell et al. (2010), and Catao Luis and Milesi-Ferretti (2014).

  27. Cohen (1988) defines 0.1 < |r| < 0.3 as small correlation; 0.3 < |r| < 0.5 as medium/moderate correlation; |r| > 0.5 as large/strong correlation.

  28. We have discussed expected impacts and signs of these explanatory variables in Sect. 2.1.

  29. Abbreviations for financial markets, financial development, financial institutions, financial institutional access, and financial markets depth.

  30. Since one of the main purposes of this study is to find out the impact of net external position of countries on the probability of banking crisis, we do not use the level of net foreign asset/liabilities variable in estimations. Involving the level of net foreign asset/liabilities indicator opens new questions beyond asking the impact of creditor/debtor position of a country as well as the difficulty of interpreting interaction terms with financial development.

  31. Ben Naceur et al. (2019) address the impact of financial development on the likelihood of banking crisis. They use the same financial development database and analyze the impact for advanced and emerging countries separately. Their results match to a major extent with our results, when we carry the estimations at advanced and emerging countries detail.

  32. See Karaca-Mandic et al. (2012) and Norton et al. (2004) regarding the analysis of interaction terms in nonlinear models.

  33. We choose to report marginal effects using these three indicators of financial development, as only the interaction terms with the net asset dummy variables are found to be statistically significant in Table 2.

  34. See Catao Luis and Milesi-Ferretti (2014) for further discussion.

  35. For further discussion, see Danielsson et al. (2016) and references therein.

  36. These additional results are not presented here, but available from the authors upon request.

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Authors and Affiliations

  1. International Monetary Fund, Washington, USA

    Mahir Binici

  2. Central Bank of the Republic of Turkey, İstiklal Cad. No:10 Ulus, Ankara, Turkey

    Aytül Ganioglu

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  1. Mahir Binici
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  2. Aytül Ganioglu
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Correspondence to Aytül Ganioglu.

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The views expressed here are those of the authors and should not be attributed to the Central Bank of the Republic of Turkey or the IMF, their Executive Boards, or management. We thank Luis Catão and Gian Maria Milesi Ferretti for useful discussions and comments.

Appendix 1

Appendix 1

See Tables 8, 9 and 10.

Table 8 Variable definitions and sources
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Table 9 Summary statistics
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Table 10 Financial Development Index Pyramid taken from Svirydzenka (2016)
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Binici, M., Ganioglu, A. Net external position, financial development, and banking crisis. Empir Econ 61, 1225–1251 (2021). https://doi.org/10.1007/s00181-020-01899-z

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