Why do Banks Fail before BOP Crises? An East Asian Perspective

Recent emerging market experience highlights that, in general, banking crises begin before currency crises. While empirical research is yet to establish the direction of causality, BOP crises have been interpreted and modeled only as consequence of financial sector meltdowns in the recent crisis literature. The evidence points out that equity and real estate prices decline well in advance of BOP crisis and stabilize only after the worst of the currency crisis is over. Drawing our motivation from the observed timing of stock market declines and subsequent bank failures before BOP crises, we develop a framework where we establish a reverse causation between the ‘twin crises’. We show that, if firms heavily rely on debt finance and banks are exposed to firms’ asset valuations, a sudden prospective BOP crisis can cause a banking crisis in the empirically observed chronological order. Next, we explore the existence of self-fulfilling crisis equilibria under the assumption of government bailout guarantees and a predetermined level of net government transfer to the private sector if banks fail, the government assumes additional public liabilities, which it is subsequently expected to finance through seignorage. It is shown that, if in addition, a decline in firms’ valuations constrain foreign credit, a BOP crisis can not only have severe adverse output effects; it can also be self-fulfilling. ∗I am thankful to Carlos Végh, Amartya Lahiri, and Luisa Lambertini for helpful comments and suggestions. I am also thankful to Sunanda Roy, Alvaro Riascos and other UCLA students for useful comments. All remaining errors are mine. Address for correspondence: Department of Economics, 260 Heady Hall, Iowa State University, Ames IA 50011; E-mail: [email protected]