What Can Academics Contribute to the Study of Financial Stability ?

There were hardly any banking crises between 1939 and 1971, so their later reemergence came as a surprise. Central bank supervisors responded practically by discovering and encouraging the adoption of current best practice in risk management by individual banks, without much theoretical input, whereas economists have mostly focused on models which abstract from default. But default is central to analysis of financial stability. Shubik pioneered introducing default into formal models, and we aim to develop this further. Meanwhile, estimating the probability of default (PD) for individual, or groups of, banks is central to the Basel II process. I HISTORICAL BACKGROUND From the late 1930s until about 1970 there was relatively little concern, academic or otherwise, about bank failures and financial instability. This was largely because there were no such failures. Table 1 and Figure 1, taken from Bordo, Eichengreen et al. (2001), show the frequency of various kinds of crises from 1880 to 1997. A remarkable feature of this is the virtual absence of either banking crises, or joint banking and currency crises, in any part of the world between 1945 and 1971. 189 *This paper was delivered as the Central Bank of Ireland Edgeworth Lecture at the Nineteenth Annual Conference of the Irish Economic Association at Kilkenny, May 7, 2005. e-mail: [email protected] Table 1: Crisis Frequency Year Banking Currency Twin All Crises Crises Crises Crises 1880-1913 2.30 1.23 1.38 4.9