Banking Crises and Crisis Dating: Theory and Evidence*

TLDR: In this paper, the authors formulate a simple theoretical model of a banking industry which models: the arrival of a systemic bank shock; its turning into a crisis; and the government's policy response.

Abstract: Many empirical studies of banking crises have employed “banking crisis” (BC) indicators that supposedly date the beginnings and ends of crises. We argue that these BC indicators are constructed using primarily information on government actions undertaken in response to bank distress. We formulate a simple theoretical model of a banking industry which models: the arrival of a systemic bank shock; its turning into a crisis; and the government’s policy response. Then we use implications of the theory to construct empirical indicators of systemic bank shocks. We show empirically that our theory based indicators of systemic bank shocks consistently predict BC indicators, employing widely-used BC series that have appeared in the literature. The implication is that BC indicators actually measure lagged government responses to crises, rather than the occurrence of crises per se. We next reexamine the impact of some key economic factors affecting both the probability of a systemic bank shock and the probability of a government response. These include the bank market structure (competition), the presence of deposit insurance, other external shocks, and currency crises. Disentangling the separate effects of systemic bank shocks and government responses turns out to be crucial in understanding the roots of banking fragility. Key macroeconomic, structural, and institutional features of economies have effects on the likelihood of a government response that are totally different from their effects on the likelihood of a banking crisis. Many findings of a large empirical literature need to be reassessed and/or re-interpreted.