Financial liberalization fuels booms, raises crisis risk
A new Federal Reserve study finds that financial liberalizations directly expanding credit supply lead to temporary economic booms but increase the risk of financial crises. The research uses a new cross-country database of banking regulation policies.
Credit supply shifts, then the bust
The study constructs a new cross-country database of 21 banking regulation indicators for 18 advanced economies since World War II. It distinguishes liberalizations that directly relax credit supply constraints from broader financial reforms.
Liberalizations directly affecting credit supply lead to substantial expansions in private credit, concentrated in non-tradable sectors like real estate.
A single credit-supply liberalization raises real private credit by about 3.5% over five years, while a major liberalization (at least three regulations) boosts it by over 12%.
These expansions are not accompanied by higher interest rates, consistent with an outward shift in credit supply.
Real GDP rises over the following 2 to 4 years, but these gains are temporary, with GDP returning to trend in the medium run.
Only credit-supply liberalizations generate these boom-bust dynamics.
Fragility follows liberalization
The analysis uses a new cross-country database of 21 banking regulation indicators for 18 advanced economies since World War II, documenting 386 distinct policy changes.
This dataset enables a detailed study of financial liberalization's effects.
The paper links banking deregulation to medium-term growth reversals through heightened financial fragility.
Credit booms, particularly in non-tradable sectors, often culminate in systemic financial crises, which impose severe economic costs.
The risk of financial crises rises sharply after a short period of low-risk growth.
Eight years post-liberalization, the cumulative crisis risk is 10 percentage points higher.
Welfare gains, but at what cost?
The study quantifies the complex trade-off of financial liberalization, offering crucial insights for ongoing debates on deregulation.
While short-term growth benefits are evident, the significant increase in medium-term crisis risk presents a substantial economic cost.
The welfare exercise underscores that for moderately risk-averse agents, the net benefits are ambiguous, highlighting the need for careful policy design.