NCPA - National Center for Policy Analysis

Financial Crises Aren't Caused By Lending Booms

February 26, 2002

Lending booms -- when the amount of private credit increases rapidly relative to a country's gross domestic product -- have been blamed for banking crises in many countries, including Chile (1982), Mexico (1994), and Thailand (1997). But are they really so bad?

Lending booms in developing countries involve the extension of credit by foreigners. As lending increases, the quality of funded projects declines, and the banking sector becomes more vulnerable to crises -- specifically, the inability to pay foreign debts from hard currency reserves.

Since investment booms often follow deregulation of foreign capital investment, the "cure" is often to impose controls on short-term capital inflows or on private credit growth. Such capital controls can exacerbate economic problems.

Based on an international comparison, researchers say lending booms are not inherently bad, and usually do not lead to such dire outcomes -- except in Latin America.

  • They find that while a lending boom may precede most banking crises, banking crises do not follow most lending booms.
  • However, the probability that a banking crisis and a balance of payments/currency crisis will follow a lending boom is twice as high in Latin America than in the rest of the world.
  • Latin America has experienced a sharp increase in lending booms during the 1990s, and they have made Latin American economies considerably more volatile and vulnerable to banking and balance-of-payments crises.

Latin American lending booms have followed financial deregulation, capital account liberalization and large capital inflows. But the crises that sometimes followed the booms may have as much to do with the reaction of authorities to increases in domestic interest rates, declining foreign currency reserves and the failure of exchange rate- stabilization. (Exchange rate stabilization is a policy aimed at maintaining the value of the currency vis-a-vis a foreign hard currency.)

Source: Andrew Balls, "Do Lending Booms Lead to Financial Crises?" NBER Digest, September 2001; based on Pierre-Olivier Gourinchas, Rodrigo Valdés, and Oscar Landerretche, "Lending Booms: Latin America and the World," NBER Working Paper No. 8249, April 2001, National Bureau of Economic Research.

For NBER Digest text


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