Recent studies reveal that over the last two decades more than 120 countries experienced some kind of systemic or nonsystemic banking crisis.1 Systemic episodes typically refer to periods of pervasive bank unsoundness coupled with significant bank runs (or other substantial portfolio shifts), deposit freezes, bank holidays, collapses of financial firms, and/or massive government interventions. Nonsystemic crises refer to periods of extensive bank unsoundness that did not result in any of the events described above.
Banking crises have the potential to complicate the conduct of monetary policy for a number of reasons. First, these episodes may destabilize money demand and money multipliers. Second, crises may diminish the effectiveness of monetary instruments. Third, crises may affect the relation between prices and monetary indicators—the variables that help monetary authorities monitor and explain the behavior of prices (e.g., monetary aggregates, interest rates, exchange rates, etc.). Finally, crises may ultimately reduce the government’s ability to achieve its inflation objective.
A number of factors may cause money demand to become unstable during banking crises. Lack of confidence in the banking sector may cause individuals to withdraw their deposits from banks and to hold other financial assets instead (like government bonds) or even real assets. When banking crises are coupled with currency crises (and especially if dollar deposits are not accepted in local banks), individuals may prefer to hold foreign currency instead. Such portfolio shifts may give rise to money demand instability. It is also possible that banking crises may lead banks themselves to curtail the growth of their assets and their liabilities. For example, if banks are saddled with nonperforming loans, and consequently choose to limit the amount of loans they make, the growth of deposits may change drastically simply as a result of a slowdown in the growth of assets, even if banks do not experience runs on deposits. In this case too, the behavior of broad money (M2) may become unstable as a result of crises.
Banking crises may affect the relation between prices and monetary indicators in a number of ways. Money demand instability may cause monetary aggregates to become unreliable indicators of price behavior. Market segmentation between sound and unsound banks may make interest rate signals misleading, since they could reflect liquidity or solvency problems at particular banks, instead of the overall tightness in the banking system. Also, during crises, the growth of bank credit may become more dependent on bank capital levels than on the monetary policy stance. In general, the transmission of monetary policy through the money supply and interest rates may be distorted by illiquid or insolvent banks’ inability to adjust their reserves or lending to monetary policy actions and by their diminished sensitivity to interest rate changes.
Despite the potential adverse impact of banking crises on monetary policy implementation, this issue has not received much attention in the recent banking crisis literature.2 Lindgren, Garcia, and Saal (1996), Garcia-Herrero (1997), and Khamis and Leone (2001) are exceptions. The first two studies present anecdotal accounts of the monetary impact of banking crises in a sample of countries. However, they do not examine the consequences of crises in a systematic empirical manner.3 On the other hand, Khamis and Leone (2001) present a thorough empirical analysis of the issue, but focus only on the question of money demand stability during the 1994 financial crisis in Mexico.
In the same way that the recent literature on banking crises has largely neglected to study the monetary consequences of these episodes, existing studies on money demand and price behavior have not examined the impact of these crises either. Baba, Hendry, and Starr (1992), Ericsson, Hendry, and Prestwich (1998), and Ericsson and Sharma (1998) are some of the most notable examples of money demand models. These studies: (i) address the potential nonstationarity of the variables that explain money demand; (ii) build error correction models that control for cointegrating relations among the variables included; and (iii) test for the constancy of the model parameters over periods of financial innovation and liberalization.
Regarding the behavior of prices, there is a vast empirical literature on the “information content” of monetary indicators.4 This literature analyzes the marginal explanatory power of the variables included in the price equations, over different periods. For example, a number of studies for the U.S. have examined whether the information content of money (i.e., its ability to explain prices) has fallen over time as a result of financial liberalization and innovation, but not financial crises. Furthermore, these papers have largely ignored issues of stationarity, cointegration, and parameter stability.
Recently some empirical studies have identified stable price equations for a number of countries, using cointegration analysis and error correction modeling. For example, De Brouwer and Ericcson (1998), Durevall (1998), and Juselius (1992), obtain well specified, constant models for prices in Australia, Brazil, and Denmark, respectively, over the last three decades. Neither these papers nor the money demand studies, however, examine the impact of banking crises on the behavior of prices and the demand for money.
This paper conducts an empirical analysis of the monetary effects of banking crises. In particular, it concentrates on two issues. First, the paper evaluates the claim that money demand stability is threatened by the occurrence of banking crises. It focuses on M2, since the demand for narrow money is more likely to be affected by financial innovation and deregulation, events that can themselves lead to instability. Secondly, the paper analyzes the relation between monetary indicators and prices and tests whether crises lead to structural breaks.
Given that crises have become pervasive in recent decades, understanding their impact on money demand and prices is becoming increasingly important. Furthermore, the stability of money demand and price equations is relevant both from a statistical and economic standpoint. Constancy is required to ensure the validity of other statistical tests performed. More fundamentally, models that fail parameter constancy tests cannot be used for forecasting or for analyzing economic policy. Furthermore, a model can have a high R2, signaling that the information content of a variable or group of variables is high, yet it may still be nonconstant and, therefore, unreliable. Thus, whether money demand models and price equations are stable over time is a more relevant question for policymakers than whether the information content of certain monetary indicators varies over different samples. As long as money demand and price equations remain stable over crisis periods, policymakers can continue to rely on the precrisis models to forecast the behavior of these variables and to analyze the impact of different policies adopted during or after crises.
Focusing on the experience of seven countries over the period from 1975 to 1998, this study analyzes the monetary consequences of banking crises in Chile (1981–87), Colombia (1982–88), Denmark (1987–92), Japan (1992–98), Kenya (1985–89 and 1992–95), Malaysia (1985–88), and Uruguay (1981–85). The dates in parentheses correspond to the periods identified by Caprio and Klingebiel (1996) and Lindgren, Garcia, and Saal (1996) as banking crisis episodes.
The sample in this paper is restricted to only seven countries due to data constraints and because the detailed empirical methodology pursued makes it difficult to implement this approach for a larger number of countries. Though limited, this sample is diverse in that it covers a number of geographical regions, focuses on countries with banking sectors of different sizes, and includes both developing and developed countries.5 Developing countries tend to be more volatile than developed countries, and governments in the former set of countries usually have fewer policy tools at their disposal.6 Thus, it is interesting to study whether there are systemic differences in the monetary impact of crises across these groups of countries.
For each country, cointegration analysis and error correction modeling are used to obtain appropriate dynamic specifications for money and prices. Parameter constancy tests are conducted on the estimated money demand equations to study whether money demand becomes unstable during crisis periods. Finally, parameter constancy tests are also performed to determine whether crises cause structural breaks in the relation between prices and monetary indicators.
With the exception of Uruguay, no systemic cross-country evidence is found that banking crises cause money demand instability in the sample.7 Also, the paper finds that money, exchange rates, foreign prices, and domestic interest rates are significant indicators of price behavior, even during crisis periods. Finally, the results on price stability are mixed. While most of the coefficients in the price equations are not affected by banking crises, for three of the seven countries, evidence of instability (primarily variance nonconstancy) is found in these equations.
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