A Blessing in Disguise? Banking Crises and Institutional Change

We test if banking crises cause institutional reforms. Many banking crises are indirectly caused by a weak and volatile macroeconomic environment. This weakness is in turn often caused by the countries’ economic and political institutions. A possible outcome of a banking crisis is therefore institutional reforms that improve the macroeconomic outcome and consequently reduce the risk of future problems in the banking sector. Specifically, we test three hypotheses: that only major banking crisis that affects economic growth leads to institutional reforms, that reforms implemented lead to more market-oriented economic institutions and more accountable and stable political institutions, and that democratic countries are more likely to reform than non-democratic countries. Our hypotheses are tested using a data set including 56 countries from 1985 to 2009. Institutional quality is measured using four indices: the ICRG index of political institutions, the Fraser index of economic freedom, the KOF index of trade and capital restrictions and the KOF index of political globalization. Our results support the first two hypotheses: only major banking crises cause institutional reforms and those reforms make economic institutions more market oriented and political institutions more stable and accountable. Our results do not support the third hypothesis, all countries irrespective of political regime reform institutions following a major banking crisis.