Accepted Manuscript

Do political factors influence banking crisis?

Rashad Hasanov, Prasad Sankar Bhattacharya

PII: S0264-9993(18)30268-2
DOI: 10.1016/j.econmod.2018.08.010
Reference: ECMODE 4703

To appear in: Economic Modelling

Received Date: 21 February 2018

Revised Date: 30 July 2018
Accepted Date: 11 August 2018

Please cite this article as: Hasanov, R., Bhattacharya, P.S., Do political factors influence banking crisis?,
Economic Modelling (2018), doi: 10.1016/j.econmod.2018.08.010.

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 ACCEPTED MANUSCRIPT
Do political factors influence banking crisis?±

Rashad Hasanov£ and Prasad Sankar Bhattacharya¥

PT
Abstract

RI
This paper investigates the impending political determinants of banking crisis in advanced
economies. In particular, we consider the impact of domestic credit growth on the likelihood

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of banking crisis and analyse possible constraints on the part of the governments in curbing

US
the unsustainable credit growth. The endogeneity corrected results reveal that the household
credit growth has greater impact on the likelihood of banking crisis than the enterprise credit
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growth. The political channel shows that if governments are concerned about domestic
approval rates, then there is a higher chance of credit boom, which in turn increases the
prospect of banking crisis. Interestingly, the findings reveal that the presence of an
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independent and well-functioning central bank mitigates the crisis probability and reduces the
opportunistic behaviour of governments.
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JEL Classification: E6, G01, F3

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Keywords: Banking crisis; domestic credit; institutions; elections

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AC

±
We would like to thank the Editor and two anonymous reviewers for their insightful comments. In addition,
the authors would like to thank the participants of the 44th Australian Conference of Economists for their useful
feedback. In addition we would like to thank Mark Wohar, Cem Karayalcin and Tapas Mishra for comments on
earlier versions of the paper. All remaining errors are mine.
£
Senior Analyst, Portfolio Analysis Division, Department of Treasury and Finance, Victoria, Australia. E-mail:
r_hassanov@yahoo.com.
¥
Corresponding author. Address for correspondence: Department of Economics, Deakin University, 221
Burwood Highway, Burwood, Victoria 3125, Australia; E-mail: prasad.bhattacharya@deakin.edu.au, Phone:
+61392446645
 ACCEPTED MANUSCRIPT
Do political factors influence banking crisis?

Abstract

PT
This paper investigates the impending political determinants of banking crisis in
advanced economies. In particular, we consider the impact of domestic credit growth on

RI
the likelihood of banking crisis and analyse possible constraints on the part of the
governments in curbing the unsustainable credit growth. The endogeneity corrected

C
results reveal that the household credit growth has greater impact on the likelihood of

US
banking crisis than the enterprise credit growth. The political channel shows that if
governments are concerned about domestic approval rates, then there is a higher chance
AN
of credit boom, which in turn increases the prospect of banking crisis. Interestingly, the
findings reveal that the presence of an independent and well-functioning central bank
mitigates the crisis probability and reduces the opportunistic behaviour of governments.
M
D

JEL Classification: E6, G01, F3

TE

Keywords: Banking crisis; domestic credit; institutions; elections

C EP
AC

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1. Introduction

The key aim of the paper is to investigate the potential political determinants of banking
crisis in advanced economies. The highly developed economies are generally
characterized by good macro-prudential institutions with well adhered checks and
balances in place to withstand any possible crisis in the financial systems including

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banking crisis (Pauly, 2008). In addition, the political process seems to be free from
rampant corruption and does not influence/dictate the financial authorities unlike many
other developing countries. Yet, the advanced countries are not immune from the

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vagaries of recurrent banking crisis. Thus, understanding the possible channels through
which political and institutional factors may affect the banking crisis remains very

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important. .

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There are several reasons why banking crisis merits specific attention. First, banking
crises are more frequent in comparison to other crises involving currency or debt, both
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for emerging and advanced economies (Reinhart and Rogoff, 2013). Second, banking
crises tend to have pervasive adverse effects on potential output and unemployment,
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two of the most important macroeconomic indicators for policymakers. Reinhart and
Rogoff (2009) show that, in the aftermath of banking crises, output declines on average
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by 9 per cent and unemployment increases by 7 per cent. Third, banking crisis may lead
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to subsequent crises like sovereign debt crisis and thus can be termed as a warning
signal (Reinhart and Rogoff, 2011). Finally, banking crisis would generate risk spill
over effects or contagion effects (Alter and Beyer, 2013; Poirson and Schmittmann,
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2013). Given the interconnectedness of financial systems across countries, and more so
for developed countries, one would expect that any major crisis in one or more key
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countries (say in the United States of America or USA) would rapidly spread to other
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closely connected developed countries like the United Kingdom (UK). For example, the
subprime lending crisis in the US mortgage market in the late 2007 affected a number
of developed or G7 countries like the UK subsequently in 2008 onwards. Thus, banking
crisis in one country could be treated as a harbinger to crisis in another country.

The extant literature has widely discussed the boom-bust cycles in domestic credit as
one of the crucial determinants of banking crisis (Demirguc-Kunt and Detragiache,
1998; Kaminsky and Reinhart, 1999). A number of recent studies have scrutinised this

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relationship with a larger group of countries over a longer period; for example,
Schularik and Taylor (2012) use a dataset consisting of 14 Organisation for Economic
Cooperation and Development (OECD) countries for 1880–2010 and show that credit
growth remains one of the key determinants of banking crisis. Gourinchas and Obstfeld
(2012) employ a bigger dataset and reaffirm this finding with credit expansion and real
currency appreciation being the two most robust and significant predictors of financial

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crises in both advanced and emerging economies. Aikman, Haldane and Nelson (2014)
conclude that large fluctuations in credit could be termed as precursors for subsequent
banking crises.

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The credit boom has been the central topic in banking crisis literature as it often

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culminated to financial crises. This may happen via several channels. Consumption

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channel, for example, would lead to overstimulated aggregate demand which overheats
the economy. This, in turn, puts upward pressure on prices (especially asset prices) and
appreciate the real exchange rate. The result is reduced exports and increased imports,
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creating trade deficit. Bakker and Gulde (2010) show that by 2008 countries with
highest credit growth had highest inflation and biggest loss of competitiveness
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measured with unit labour cost-manufacturing based real exchange rate.

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Further, during benign economic environment the lenders have over-optimistic

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expectations about borrowers’ ability to pay back. Consequently, many borrowers

(households as well as enterprises) suddenly become more creditworthy. This leads to
excessive credit growth with many risky borrowers. Thus, expectations channel would
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augment the number of bad loans during upward phases of credit cycle (Gersl and
Seidler, 2012). However, when the credit bubble bursts, there is a sudden increase in
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non-performing loans, which causes problems for the banking sector.

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Another channel through which credit bubble may affect the economy is accountability,
especially, the loss of accountability. It is hard to obtain good signals of performance
during periods of credit boom. Hence, managers and politicians may extract benefits
during such time without fear of punishment (Fernandez-Villaverde, Garicano and
Santos, 2013). Thus, at times of bubble, the governance may deteriorate and institutions
get weaken which would have ramifications for the present analysis.

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While the effects of domestic credit growth on the incidence of banking crises have
been carefully documented in the literature, the interplay between such credit expansion
with political and institutional determinants of policy choices have received limited
attention (Chang 2007). History has shown that politics and institutional quality play
significant roles in the lead-up to financial crashes and their aftermath (Rajan 2010).
Thus, we harp on three important political and institutional determinants, viz.,

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government stability, central bank independence as well as time to elections and
analyse how these factors would trigger banking crisis in presence of credit growth.

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The political business cycle theory argues that governments tend to ease economic
policies to derive political benefits. The empirical literature, however, reports mixed

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findings. Alesina, Roubini and Cohen (1997) provide evidence in favour of election

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effects on macroeconomic policies and outcomes in OECD economies. On the other
hand, Brender and Drazen (2005) posit that economic outcomes have insignificant
effects on the probability of being elected in a democracy.
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The inclusion of central bank independence is guided by the observation that greater
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autonomy of central banks prevents financial systems from political pressures and
mitigates the costs associated with time inconsistency problems (Quintyn and Taylor,
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2002). Doumpos et al. (2015) investigate the effect of central bank independence on the
soundness of banking system and find it to be more pronounced for smaller banks
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during banking crisis.

Time remaining to elections is another crucial factor which may have a bearing on
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banking crisis (Keefer, 2006). The reason is that if politicians decide to ’ride’ political
boom, then their behaviour would be affected by upcoming elections. In other words,
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we would expect governments may encourage liberal credit disbursement mechanisms

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just before the election to entice their clienteles. Hence, analysing the role played by
time to elections would be important.

The credit growth (either household or enterprise credit) intertwined with the above
political and institutional determinants assumes particular importance since there is
evidence that despite being one of the fundamental causes of banking crises, not all
credit booms are unsustainable. For example, Dell’Ariccia, Igan, Laeven and Tong
(2014) find that only about one-third of boom cases result in financial crises, while the

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rest are followed by extended periods of below-trend economic growth. Given this
finding, it would be interesting to investigate why some credit booms trigger crisis.
Could the turmoil be driven by political and institutional factors?

Acemoglu, Johnson, Robinson and Thaicharoen (2003) address institutional aspects of

macroeconomic volatility and financial crises and find that countries with distortionary
institutions and policies tend to be more vulnerable. Similarly, Pauly (2008) contends

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that stable and well-functioning financial markets in the advanced economies with clear
operating rules, respect for private property, prudential supervision and a reliable lender

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of last resort help these countries in mitigating the damage emanating from financial
crises. Herrera, Ordonez and Trebesch (2014) argue that, in some cases, governments in

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emerging market economies allow domestic credit to grow unsustainably as politicians

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derive political mileage from unregulated financial markets. Thus, the financial system
in general and the banking sector in particular becomes vulnerable to any endogenous
or exogenous shocks which may bring about crisis.
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Taking a cue from the above discussion, the paper analyses two related research
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questions. First, it re-examines how the aggregate credit growth as well its’
components, enterprise and household credit growth, is linked with the incidence of
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banking crisis. Second, it investigates the roles played by government stability, central
bank independence and time to elections in triggering banking crisis in presence of such
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credit build up.

The empirical analysis uses univariate probit and bivariate probit models in a panel
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setup given that the focus is on deciphering the likelihood of banking crises. These
models are employed as the dependent variable takes 1 or 0 values indicating
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experiencing banking crisis or not (and experiencing credit boom or not in the bivariate
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probit specification) at a point in time. First, the probit model is estimated in presence
of cross-sectional fixed effects, time fixed effects as well as standard economic controls
to alleviate any unobserved heterogeneity or omitted variables problems. Later, to
address potential endogeneity concerns, the recursive bivariate probit model is
employed as the recent studies argue that (Li, Poskitt and Zhao 2016 and references
therein) bivariate probit would alleviate endogeneity even in the absence of
instrumental variables provided the structural equations are rooted in theory and,
therefore, correctly specified. A number of robustness checks are conducted within the

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bivariate probit setup and an additional robustness is employed using the panel ordinary
least squares (panel OLS) with dummies.

The ensuing analysis contributes to the literature in two ways. First, the paper employs
a unique approach to tackle the potential endogeneity problem arising from reverse
causality or omitted variables. The results from earlier studies need to be interpreted
with caution due to their limited ability to disentangle the causal effect as the

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relationship between banking crisis and credit growth may run in reverse direction. For
instance, it is an accepted practice that central banks inject liquidity in the financial

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system to avoid excessive credit contractions (Hasman, Lopez and Samartin, 2011) in
the aftermath of a crisis. A recent example of this type of intervention is when the

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monetary authorities opted for easing monetary policy and infused liquidity into the

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banking system after the subprime lending crisis and its possible contagion effects in a
number of advanced economies. In such circumstances, the credit growth should not be
treated as exogenous because it is directly affected by the central bank’s decision to
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boost the economy. To reduce the potential bias from possible omitted variables or
reverse causality, the recursive bivariate probit model is employed with identification
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restrictions imposed based on theoretical justifications. This strategy helps to generate

an exogenous variation in domestic credit growth and estimate its impact on the
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likelihood of banking crisis in a system of two equations.

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The second novelty of the paper relates to investigating the political and institutional
dimensions of banking crises. As previously mentioned, government stability, central
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bank independence and time to elections would shape up possible banking turmoil. But
the precise nature of these factors could only be revealed when looked at jointly with
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the excessive credit build up. Given the focus is on advanced countries, these particular
variables assume much importance as a priori the researcher would not expect much
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heterogeneous impact of these factors in such countries.

The results reveal that robust relationship exist between domestic credit growth and
likelihood of banking crisis in advanced economies. This finding is in line with earlier
studies by Aikman, Haldane and Nelson (2012) and Schularik and Taylor (2012).
Disaggregating the aggregate credit measure with household credit and enterprise credit
suggests that the former poses significantly higher risks to the banking sector which
resonates with the finding of Buyukkarabacak and Valev (2010). An increase in

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household credit increases the likelihood of a banking crisis by 6.0 to 8.2 percent;
whereas, a 1 percent increase in enterprise credit increases the probability of a banking
crisis by 1.7 percent to 2.8 percent, depending on the value of the government stability
variable. However, the estimates for enterprise credit become statistically insignificant
in the robustness check.

In terms of political determinants, a high government stability score (used as a proxy

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for domestic popularity) reduces the likelihood of banking crisis; that is, the higher the
government’s domestic approval rating, the lower is the likelihood of a banking crisis.

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Another interesting result is that time to elections enters the regression with a positive
and statistically significant coefficient which suggests that the probability of a banking

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crisis decreases closer to an election. Given the political costs of a banking crisis at the

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onset of an election, this finding probably makes practical sense.

The estimates from the bivariate probit model, which addresses potential endogeneity,
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confirm that unsustainable household credit booms have positive bearing on banking
crisis. Interestingly, the government popularity remains effective only for the total
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credit variable, as the coefficients for enterprise and household credit become
statistically insignificant. This suggests that if governments are concerned about
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domestic popularity, they do not entice specific groups of borrowers and concentrate on
the aggregate clientele. Further, results indicate that central bank independence has the
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detrimental impact on the probability of banking crisis when we use the total credit
measure. Conversely, the time-to-elections variable enters the credit boom equation
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with a negative sign and the banking crisis equation with a positive sign. Thus, with
impending elections, there is a high likelihood that the incumbent government may
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allow a credit boom. However, given the huge political costs of banking crisis, the
governments tend to avoid such a disastrous situation at any cost in the lead-up to
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elections.

Overall, the results produce significant evidence in favour of the political business
cycles. We find that the reputation concern mechanism (Herrera et al. 2014) of the
incumbent government is valid in OECD countries as well. However, the presence of an
independent central bank mitigates the negative effect stemming from the government’s
opportunistic behaviour. In regards to policy, the paper highlights the importance of a
well-functioning central bank in reducing vulnerability to possible banking crisis. This

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particular finding assumes much more importance as proponents of central bank
independence argue that the true independence would lead to broader ramifications
beyond setting up independent monetary policy framework to stabilize inflation. The
other interesting issue is that oversight matters even in the advanced economies as
governments may delve into opportunistic behaviour in the run up to elections, a
finding readily be attested to developing countries. Appropriate monitoring and robust

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checks and balances should be put in place to remedy such institutional drifts which
may end up in triggering banking crisis.

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The remainder of this paper is organised as follows. Section 2 discusses the data and
variables. The econometric methodology is described in Section 3. Section 4 contains

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the results and discussions. Finally, Section 5 concludes the paper.

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2. Data and variables AN
2.1. Dependent variable

The empirical analysis is based on 1672 quarterly observations for 22 countries1

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covering the period of the first quarter of 1995 to the last quarter of 2013. The data for
the dependent variable, banking crises, are derived from the dataset constructed by
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Babecky et al. (2013), who aggregate information about the occurrence of crises from
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several influential papers, including Laeven and Valencia (2012) and Reinhart and
Rogoff (2011). According to this aggregation approach, the crisis dummy equals 1 if at
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least one of the sources claims that a crisis occurred. Based on this dataset, 298
episodes are identified where the banking crisis dummy equals 1. Note that this does
not necessarily mean there were 298 banking crisis episodes, as in most cases the
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persistence of the crises increases the tally by up to 14.6 per cent of the total
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observations.

2.2. Explanatory variables

We use either the change in credit-to-GDP ratio or the credit boom dummy as one of
the explanatory variables interchangeably (depending on the empirical specifications

1
Countries included in the analysis are Australia, Austria, Belgium, Denmark, Finland, France, Germany,
Greece, Hungary, Ireland, Italy, Luxembourg, Mexico, the Netherlands, Norway, Poland, Portugal,
Spain, Sweden, Switzerland, the UK, and the US.

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mentioned in the next section). The data for these are collected from the Bank for
International Settlements (BIS) database. Following Dell’Ariccia et al. (2014) we code
credit boom dummy 1 if: (i) the deviation from the trend2 is greater than 1.5 times its
standard deviation and the annual growth rate of the credit-to-GDP ratio exceeds 10 per
cent, or (ii) the annual growth rate of the credit-to-GDP ratio exceeds 20 per cent. The
end of the boom is identified when the growth of the credit-to-GDP ratio is: (i) negative

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or (ii) falls within three-quarters of one standard deviation from its trend and its annual
growth is below 20 per cent.

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The other explanatory variable, government stability (govstab in the Figures reported
later) is used as a proxy for the domestic popularity of the incumbent government.

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Herrera et al. (2014) argue that the government stability variable from the International

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Country Risk Guide (ICRG) is highly correlated with domestic approval rates (for
available data). It ranges from 1 to 12, with 1 being extremely instable (unpopular)
government and 12 being perfect stability.
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In addition to direct effects, we also examine the indirect effects of credit booms at
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different levels of government popularity. For this purpose, credit measures are
interacted with the government stability variable.
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2.3. Control variables

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Two sets of control variables are employed: institutional controls and standard
macroeconomic controls. The choice of these variables is guided by three
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considerations: (i) theoretical underpinnings, (ii) availability of quarterly data and (iii)
findings from earlier studies.
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The first institutional control variable is the central bank independence. Klomp and de
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Haan (2009) show that there is a robust negative relationship between central bank
independence and financial instability. They argue greater independence from external
pressure implies that central banks are less politically constrained to prevent financial
distress and would allow them to act faster and more decisively when a crisis erupts.

Data for central bank independence are derived from Dincer and Eichengreen (2014).
The authors augment the index proposed by Cukierman, Webb and Neyapti(1992). The
2
Long-term trend is calculated using Hodrick-Prescott filter with the lambda set to the standard 40000.

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latter methodology uses 16 criteria reflecting the independence of chief executive
officers (CEOs) of central banks, their independence in policy formulation, their
mandate or objective, and stringency of limits on their lending to the public sector.
Dincer and Eichengreen (2014) add following measures to capture other aspects of
independence: (i) limits on the reappointment of the CEO, (ii) measures of provisions
affecting (re)appointment of other board members similar to those affecting the CEO,

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(iii) restrictions on government representation on the board, and (iv) the intervention of
the government in exchange rate policy formulation. Overall, the index is bound
between 0 and 1, where 1 represents completely independent central banks, and 0

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represents non-independent central banks. The authors compare central bank

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independence and transparency in 1998 and 2010 and conclude that there is a trend
towards greater independence and transparency.

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The second institutional control is time remaining to elections (time-to-elections
henceforth). Notwithstanding the presence/absence of an independent central bank, time
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remaining to elections should not be ignored. The reason is that if politicians decide to
exploit political boom, then their behaviour would be influenced by forthcoming
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elections. In other words, we may find governments actively encouraging liberal credit
disbursements just before the election to entice their support base. Hence, controlling
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for time-to-elections would be important. The time-to-elections data are derived from
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the Polity IV dataset. Note that due to the large number of parliamentary republics in
the dataset, the focus is on time to parliamentary elections only.
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In regards to the standard macroeconomic variables as controls, we use official

reserves, change in real GDP and inflation as controls in the univariate probit model.
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Additionally, the change in financial openness, level of private consumption and the
change in short-term interest rate are used in the bivariate probit model.
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The official reserves play important role in restricting banking crisis (Obstfeld,
Shambaugh and Taylor, 2010; Calvo, 2006) as the central banks would like to hold
reserves to provide cushion against any possible upheaval in the domestic banking
sector. The banking crisis probability would diminish if there are enough reserves
available to shield the banks from any external or internal shocks. Thus, we use reserves
(logarithm of reserves) as a control variable in the empirical analysis.

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Two additional macroeconomic control variables are the change in real GDP (or real
GDP growth) and inflation. Real GDP growth would be helpful in capturing adverse
macroeconomic developments that hurt banks’ balance sheet. Introducing inflation into
the model serves as a proxy for high nominal interest rates and poor macroeconomic
management (Demirguc-Kunt et al., 1998). As shown by English (1996), chronic high
inflation tends to be associated with an overblown financial sector, as financial

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intermediaries profit from the float on payments. When inflation is drastically reduced,
banks see one of their main sources of revenue disappear, and generalized banking
problems may follow.

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The change in financial openness is used as a control with the idea that embracing

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increased openness may make economies vulnerable to banking crisis. Financial

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openness is derived from Chinn-Ito (2006, 2008) index (the updated version is used)
where 1 indicates perfectly open and 0 indicates perfectly closed financial markets.
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We also include log of private consumption in the bivariate probit specification. The
extant empirical research show that fuelled by availability of credit, consumption
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growth often precedes banking crisis (Hardy and Pazarbasioglu, 1998).

Following Beck et al. (2003), changes in the real short-term interest rates is used in the
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bivariate probit model to capture banks’ cost of funds. Positive shock to short-term
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interest rates may negatively impact banks’ balance sheets if most of their assets are
tied to low fixed-rates. In other words, failure to increase lending rates would adversely
affect banks’ performance, as low-rate assets do not produce enough income
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(Demirguc-Kunt and Detragiache, 1998). Mishkin (1996) argues that this was the case
in USA during savings and loans crisis in 1980s. In 1970s, when interest rates were
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quite low, the banks had fixed their assets - long-term mortgages and loans. Dramatic
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rise in interest rates in late 1970s and early 1980s resulted in higher cost of funding for
the banks, which was not covered by income generated from low fixed rates. This
resulted in billions of dollars loss for savings and loan institutions.

The data for macroeconomic control variables are obtained from the Eurostat and the
OECD Statistics portal.

3. Econometric methodology

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3.1. Univariate probit model

Consider the binary variable banking crisis (BC), which is determined by the latent
variable BC*:

∗
= + (1)

where, X is a vector of explanatory and control variables for banking crises:

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1, ℎ ( ∗
> 0)
= (2)
0, ℎ " ( ∗
≤ 0)

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Conditional on information set, Ω % , the banking crisis dummy has a Bernoulli
distribution with a parameter probability & . The probit model estimates the conditional

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probability of future banking crisis. The parameters of the model may be estimated

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directly using maximum likelihood estimation. We estimate the following equation
using the univariate probit model:
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Pr () = 1|Ω % ) = +, + ∆ . .&, + / "0 , + 1∆ . .&, "0 , + 2′ (3)

In Equation (3), ∆creditgdp is the change in domestic credit-to-GDP and govstab is the
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proxy for government popularity, as described in the data section. Apart from the direct
effect of credit and government stability, we also include their interaction in the
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baseline model to capture any indirect effects. X is a vector of control variables which
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include the central bank independence, log of reserves, change in real GDP, inflation, ,
and time to parliamentary elections. The time-to-election is added to reflect the
government’s time constraint. +, represents country dummies.
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One methodological difficulty of using country and time dummies in binary regression
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models relates to the issue of incidental parameters. In the presence of small N and
large T (which is the case in this paper), the structural parameters cannot be consistently
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estimated. Hence, following Schularick and Taylor (2012), we use a model with
country dummies only. Error terms are clustered by countries to allow for possible
cross-section correlation.

Following Equation (3), the analysis is extended to differentiate between credit to

households and credit to enterprises. The specification are given in Equations (4) and
(5):

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Pr () = 1|Ω % ) = +, + ∆ , + / "0 , + 1∆ , "0 , + 2′ (4)

Pr () = 1|Ω % ) = +, + ∆ℎ"4 , + / "0 , + 1 ∆ℎ"4 , "0 , + 2′ (5)

Our a priori expectation is that enterprise credit would have minimal impact than
household credit in exposing economies to banking crises. The theoretical literature
predicts that enterprise credit raises capital accumulation and productivity and increases
economic growth; whereas, household credit has no long term effects on growth

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(Buyukkarabacak and Valev 2010).

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3.2. Bivariate probit model

An issue with estimating Equation (3), as well as with Equations (4) and (5), is that

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credit growth may be endogenous. The probability of a credit boom occurring could be

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determined by other unobservable characteristics that are correlated with other
explanatory variables. Potential reverse causality may also result in biased estimates.
AN
For instance, credit growth may stem from the easing of monetary policy after a
banking crisis starts. In this case, the causality in the relationship runs from the crisis to
the credit boom.
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One way of addressing endogeneity in models with binary outcomes is to employ the
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recursive bivariate probit model. Minetti and Zhu (2011), for example, employ similar
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method to estimate the effect of credit rationing on firms’ exports. Minetti and Zhu
(2011) use instrumental variables in estimating the bivariate probit model. However, the
recent literature argues that (Li, Poskitt and Zhao 2016 and references therein) bivariate
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probit would alleviate endogeneity concerns even in the absence of instrumental

variables provided the parametric equations are correctly specified. The intuition and
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the working of the bivariate probit model is outlined below.

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The bivariate probit model is a joint model of two binary outcomes. In the context of
the present study, the dependent variables of the equations are banking crisis (BC,
defined in the data section, refer to Equation (7) below) and credit boom (CB) dummies
(discussed in the previous section, refer to Equation (6) below). The latter equals 1 if
there is a credit boom, and 0 otherwise. Note that we use the CB dummy as a proxy for
excessive credit growth in the univariate probit regressions. These two dichotomous
variables are determined by two latent variables BC* and CB*, which are governed by:

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= 6/ +
(6)
/
∗
5 1

∗
=6 + /
∗
+ (7)

0 1 =
7 8 ~: ;7 8 , < >?
/ 0 = 1

where vectors 6 and 6/ include explanatory and control variables for banking crisis
and credit booms respectively.3 Error terms are distributed as standard bivariate normal

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distributions with a correlation coefficient =. The bivariate probit model is recursive in
that the banking crisis outcome depends on both exogenous variables and the outcome

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of the credit boom regression; whereas, the credit boom equation depends on exogenous
variables only. Hence, in this estimation, the crisis equation is structural and the credit

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boom equation is a reduced-form equation. Later, to check for robustness, we also use

US
the bivariate probit model with the lagged dependent variable.

As in the univariate probit model, the values of BC and CB are not observed directly.
AN
The bivariate probit model specifies the outcomes as follows:

1 ∗
>0
= (8)
0 ∗
≤0
M

1 ∗
>0
= (9)
0 ∗
≤0
D

We obtain the estimates of parameters from maximising the log likelihood function
TE

with respect to β = ( , /, 1) and the correlation coefficient between error

terms and /.
EP

Estimating two binary probit models in one equation system may yield more consistent
estimates compared to estimating each probit model separately. If the error terms are
C

not independent (cov( , /) ≠ 0), the findings of the univariate probit model are
AC

affected by the endogeneity problem; thus, using two separate probit models will
generate consistent estimates of the parameters.

One issue in estimating the bivariate probit is finding a set of identifying restrictions
that are significant determinants of the endogenous variable, but these should also be
orthogonal to the residuals of the main equation (Fleming and Kler, 2008). Further,
appropriate instrumental variables need to be used to estimate the parameters

3
Note that subscript i, which denotes cross-sections, is ignored for convenience.

14
 ACCEPTED MANUSCRIPT
consistently. A number of recent papers (Li, Poskitt and Zhao 2016 and references
therein), however, argue that bivariate probit would alleviate endogeneity concerns
even in the absence of any instrumental variables provided the parametric equations are
correctly specified. The correct specifications depend on the nature of the presumed
relationship hypothesized by the researcher. Thus, based on theoretical underpinnings
and following Minetti and Zhu (2011), we exclude important credit boom variables

PT
from the banking crisis equation. As a result, we obtain exogenous variation in the
probability of experiencing a credit boom.

RI
Based on the above discussion, we estimate the following system of equations:

& " ( , = 1) = & " (A + BA/ + 2′A1 + / > 0) (10)

C
& " ( , = 1) = & " ( + / , +2′ 1 + > 0) (11)

US
where, X is the vector of control variables and Z is the vector of variables generating
exogenous variation in the credit boom equation. We exclude government stability,
AN
central bank independence, the change in credit-to-GDP, log of private consumption
expenditure as well as the change in short-term interest rate from the banking crisis
M

equation to make it identifiable. Apart from the same three control variables from the
univariate probit model (change in real GDP, inflation and time-to-election), there are
D

three unique exogenous variables, viz., credit boom, log of reserves and the change in
financial openness, which help the banking crisis equation to be identified. The credit
TE

boom, given the theoretical motivation provided before, plays the most crucial role in
banking crisis across countries and even in the developed world (Schularik and Taylor,
EP

2012; Aikman et al., 2014; Buyukkarabacak et al., 2010). The logarithm of reserves is
part of the control variables in the univariate probit specification as well and remains an
C

important driver of banking crisis. The official reserves play important role in
restricting banking crisis (Obstfeld, Shambaugh and Taylor, 2010; Calvo, 2006) as the
AC

central banks would like to hold reserves to provide cushion against any possible
upheaval in the domestic banking sector. The change in financial openness is also
linked with banking crisis (Angkinand, Sawangngoenyuang and Wihlborg, 2010) with
the observation that the strength of capital regulation and regulatory framework could
provide important hedging against banking crisis.

The credit boom equation is identified as there are five unique exogenous variables
(government stability, central bank independence, change in credit-to-GDP, log of

15
 ACCEPTED MANUSCRIPT
private consumption and change in the short-term interest rate) which are chosen based
on strong theoretical justifications provided in the data section (sub-section 2.3). Just to
reiterate, a stable government would not embark on whimsical credit policies to win
over their clientele as their time in office is not bounded by such myopic gain. An
independent central bank provide important regulatory oversight to mitigate unpleasant
credit build up which are not supported by economic fundamentals. The change in

PT
credit-to-GDP, by the very nature of it, would drive credit boom if there is uncontrolled
growth of credit, be it household credit or enterprise credit. The log of private
consumption is an important determinant of credit boom as the extant empirical

RI
research highlight that insatiable private consumption would drive up credit availability.

C
Finally, the change in the short-term interest rate is also linked with credit boom as the
banks would like to provide more credit to customers if there is negative shock to

US
interest rates to maintain the same level of credit revenue (Rungcharoenkitkul, 2015).
On the other hand, with a positive shock to interest rate, there could still be credit boom
AN
as banks may lower their screening standards to provide more loans to customers
(Dell’Ariccia, G. and R. Marquez, 2006) in presence of a competitive banking
environment.
M

In this setup, the recursive bivariate probit model predicts the probability of
D

experiencing a credit boom (from Equation (10)) and uses it in Equation (11) instead of
TE

actual CB values.

The main difference between the baseline probit model and the bivariate probit model is
EP

the absence of an interaction term in the latter. This is because the interaction term in
the probit model consists of the product of credit growth and government stability. In
C

the bivariate probit model, we estimate the credit boom and banking crisis equations
within the system setup. Hence, credit boom, which is the proxy for credit growth,
AC

cannot be interacted with government stability. Thus, in this case, we only gauge the
direct effect of credit boom on banking crisis.

3.3. Panel OLS model4

4
We thank an anonymous reviewer for this particular robustness check suggestion.

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Finally, we perform additional robustness checks with the following panel OLS model
for the change in overall credit as the main explanatory variable. Since the dependent
variable is binary, the specification boils down to estimating a linear probability model.

Pr() = 1|Ω % ) = A, + C ∆ . .&, + C/ "0 , + C1 ∆ . .&, "0 , + C2′ (12)

The above model is estimated with and without cross-sectional and time fixed effects

PT
like Equation (3) before with the same control variables. There are some obvious issues
with the panel OLS model. First, panel OLS with dummies as dependent variable is a

RI
linear probability model which ignores the discreteness of the dependent variable.
Additionally, in terms of predictions, the predicted probability would not be between 0

C
and 1 in the linear probability model which is a cause of concern. Finally, the model
inherently assumes a linear relationship between the dependent variable and the

US
independent variables, but that need not necessarily be the case. Nevertheless, panel
OLS with dummies could be used as an additional robustness check to verify the
AN
predicted relationship between domestic credit growth and banking crisis.

4. Results and discussions

M

4.1. Results from the baseline univariate probit model

D

Table 1 presents the baseline results from the univariate probit model. We start with the
TE

probit regression with no country dummies and control variables. These estimates are
presented in Column 1. From Columns 2 to 5, country dummies and control variables
EP

are gradually added to the regression. The first three variables in Table 1 are of primary
interest, so the discussion of results will be focused on these variables.
C

[Insert Table 1 about here]

AC

Major findings from Table 1 could be summarized as follows. First, the change in total
credit-to-GDP enters regressions with positive but statistically insignificant coefficients
in specifications with no interaction term (Columns 1 and 2). However, when we add
the interaction term and control variables in Columns 3 and 4, it becomes significant at
the 99 per cent confidence level and the results indicate that credit growth increases the
likelihood of a banking crisis. This finding is in line with Demirguc-Kunt et al. (1999)
and Schularik and Taylor (2012). As discussed earlier, credit expansions are treated as a

17
 ACCEPTED MANUSCRIPT
precondition for banking crisis in both theoretical and empirical literature. Interestingly,
the magnitude of the effect increases as we control for other variables. This suggests
that, once other economic and political factors are taken into account, the effect of
credit growth becomes more pronounced. Thus, there is a positive relationship between
credit expansion and the probability of banking crisis.

Second, the government stability variable enters the regression with a negative

PT
coefficient, and it is statistically significant in three out of four specifications. Thus, an
increase in a government’s popularity score is associated with the lower likelihood of a

RI
banking crisis which suggests that countries with low government stability are more
likely to experience a banking crisis. In the previous section, we argue that governments

C
may allow an unnecessary credit boom if they are concerned about their domestic

US
approval rating. Hence, the result could be interpreted as governments’ willingness to
facilitate unsustainable credit growth in order to boost their domestic approval rating.
This finding is in line with the literature which posits that credit growth in an economy
AN
is affected by its political system; for instance, Calomiris and Haber (2014) argue that
politics are ‘baked into’ the property rights systems that underpin banks. Thus, the
M

banking system may be heavily influenced by the political system and the political
institutions may hinder efficient functioning of banks.
D

Third, the coefficient of the interaction term suggests that domestic credit growth has a
TE

differential effect on government stability levels. To understand the differential effect,

consider Figure 1 which depicts the marginal effects of domestic credit growth on the
EP

probability of a banking crisis at different levels of government stability. The slope of

the curve is negative, meaning that the lower the government’s stability, the higher the
C

marginal effect of domestic credit growth. For example, when the government stability
score is 4, a one per cent growth in domestic credit-to-GDP will increase the probability
AC

of a banking crisis by almost four per cent. On the other hand, in countries with popular
government, the marginal effect of credit growth is more than two per cent. These
results confirm that growth in domestic credit increases the likelihood of a banking
crisis. However, when the popularity of the incumbent government is high, it has less
incentive to engage in unnecessary expansionary monetary policy; whereas unpopular
governments concerned with their chance of re-election may use unsustainable credit
expansion as a political tool and hence create preconditions for possible banking crisis.

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[Insert Figure 1 about here]

Herrera et al. (2014) reach a similar conclusion for emerging market economies. The
authors show that, due to a lower level and higher volatility of domestic approval rates
in emerging economies, governments prefer to delay or avoid corrective policies during
booms. The reputation concerns in these economies are translated into a higher
likelihood of financial crises. However, the authors do not find similar results for

PT
advanced economies. In this respect, our results are novel, suggesting that the
reputation mechanism could also be in place in developed countries.

RI
The signs of control variables are, in general, in line with expectations, except for the

C
central bank independence. One would expect that independent central banks would
implement corrective measures to curb credit growth and reduce the probability of a

US
banking crisis. However, in our model, the sign of the coefficient indicates otherwise,
although it is not statistically significant.
AN
One more important variable that needs to be discussed is the time-to-elections variable.
This is the measure of time remaining until the next parliamentary election. We can
M

conclude that the less time left until the election, the lower the probability of a crisis.
This finding can be interpreted in a number of ways. To begin with, time-to-elections
D

may reflect the attitude of governments at the onset of an election. Before an impending
TE

election, if the economy is in trouble, the governments tend to tackle the problem
swiftly; otherwise, they may be thrown out of the office after elections. In addition, this
finding may imitate the reckless behaviour of some governments after being elected.
EP

More specifically, incumbent governments would use growth and employment-

inducing policies in the lead up to an election, which tend to have negative long-term
C

consequences. Interestingly, political pressure on monetary policy may be observed

AC

even in the presence of independent central banks in advanced economies. For example,
Drazen (2002) claims that despite having no control over monetary policy, incumbent
politicians put significant pressure on the Federal Reserve Bank in election years. As a
result, central bank may end up partially accommodating the pressure.

It is clear that banking crises tend to occur further from elections. In Figure 2, the
vertical axis shows the number of banking crises in the dataset, while the horizontal
axis presents the number of quarters since the last election. Figure 2 reveals that 160 out

19
 ACCEPTED MANUSCRIPT
of 219 banking crises occur during the first two years after the election. This constitutes
more than 73 per cent of banking crisis observations.

[Insert Figure 2 about here]

Next, the total credit figure is separated into credit to households and enterprise credit.
Since the main variable of interest is the interaction term, we focus on the marginal

PT
effects of household and enterprise credit growth on the probability of banking crises.
This will help to determine the driver of the positive relationship that is found earlier

RI
between the total credit measure and banking crises.

Table 2 shows the marginal effects of total credit growth (Column 2), enterprise credit

C
(Column 3) and household credit (Column 4) at different values of the government

US
stability variable (Column 1). It suggests that growth in total credit-to-GDP increases
the probability of a banking crisis by 3.9 per cent at the lowest level of the government
AN
approval rate. The estimates in Column 3 indicates that this probability increases by
only 2.8 per cent when the growth is in enterprise credit. For household credit, the
marginal effect is 8.2 per cent (Column 4). Interestingly, even in the countries with the
M

most popular government, a 1 per cent increase in household credit increases the
likelihood of a banking crisis by 6 per cent. This means that the positive relationship
D

established between credit growth and banking crises is mostly driven by the growth in
TE

household credit. Figure 3 supports the findings from Table 2.

[Insert Table 2 about here]

EP

[Insert Figure 3 about here]

C

4.2. Results from the bivariate probit model

AC

Table 3 presents the results from the bivariate probit model estimations (Equation (10)
and Equation (11)) for total credit, enterprise credit and household credit (Models 1, 2
and 3), respectively. The bivariate probit model consists of two equations. It first
estimates the equation for credit boom (first stage) and then proceeds with plugging in
the estimated values of the credit boom into the banking crisis equation (second stage).

[Insert Table 3 about here]

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There are two main improvements over the baseline findings reported earlier. First, the
estimates are consistent than the estimates from two separate univariate probit models,
especially for the total credit and household credit models (refer to the probability
values from the Likelihood test results). Second, all political and institutional variables
of interest, including the central bank independence, produce statistically significant
results with correct signs in a majority of specifications.

PT
Taking a look at the estimates in the credit boom equation of the total credit model
(Column 2, Table 3), we find three interesting subtleties. First and foremost, the central

RI
bank independence variable becomes statistically significant and negative, implying
that the central bank independence has a dampening effect on total credit boom. Thus,

C
countries with independent central banks tend to have a lower likelihood of a credit

US
boom. This finding is very important as it brings to the fore the effectiveness of a well-
functioning, truly independent central bank in controlling unnecessary credit expansion
which may culminate into a banking crisis in future. Second, the government stability
AN
variable is negative and statistically significant. Thus, more stable and popular
governments tend to avoid credit booms; whereas, less popular governments tend to use
M

credit booms as a possible tool for their re-election. Finally, the change in total credit-
to-GDP remains positive and significant coefficient. Therefore, an increase in the
D

change to total credit-to-GDP increases the probability of a credit boom. This is not
TE

surprising, as the credit boom dummy is derived from credit growth.5 The last two
findings are in line with the results from the baseline univariate probit model.
EP

The results from the banking crisis equation (Column 3, Table 3) reveal some important
facts. Predicted total credit boom has a positive and statistically significant effect on the
C

banking crisis after controlling for a host of other factors. This result is in line with
theoretical considerations discussed above. In other words, the result confirms that
AC

banking crises are preceded by boom in credit markets.

The time-to-election variable is also positive and statistically significant, reaffirming

the presence of political business cycles before and after elections and their possible
bearing on the banking crisis. This is an important finding in the sense that there
appears to be a detrimental impact of political business cycles even in the advanced
countries as well.
5
Note that growth in total credit does not necessarily mean that the country enters a credit boom.

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Two variables have dampening effects on the likelihood of banking crisis when total
credit is used. The first one is the change in real GDP. Positive real economic growth
usually suggests improving general economic conditions, which in its turn reduces the
number of non-performing loans and the probability of banking crisis. Note that the
change in real GDP is also hampering the credit boom and this finding remain
consistent with the baseline univariate probit model as well. The other variable is the

PT
change in financial openness. This result implies that more open economies tend to be
less vulnerable to banking crises. Demirguc-Kunt and Detragiache (1998) argue that
banks may hedge some of their risks by lending from overseas. Hence, the expansion of

RI
cross-border lending increases banks’ strength, especially in small open economies. Our

C
finding confirms this argument.

US
Now concentrating on the results from the enterprise credit boom (Columns 4 and 5,
Table 3), the central bank independence retains its negative sign, but it is not
statistically significant. The government stability is positive and significant; whereas,
AN
for the total credit case earlier, it was negative and significant. Thus, the government
stability has a different bearing on enterprise credit boom, and the result can be
M

interpreted as the government in office (and particularly the less populist one) is not
using the enterprise credit as a possible way of enticing the voters to cling into power.
D

In terms of other controls, change in credit-to-GDP is positively influencing the credit

TE

boom; however, the change in real GDP is mitigating the credit boom. In addition, CPI
inflation has a positive and statistically significant effect on the enterprise credit boom.
The findings from the banking crisis equation are in line with the results from the
EP

banking crisis equation when total credit is used. Note that the magnitude of the time-
to-election variable is marginally higher than that of the total credit equation (Column
C

3, Table 3). Thus, political business cycle has a significant role in predicting banking
AC

crisis when we use the enterprise credit.

The findings using the household credit (Columns 6 and 7, Table 3) largely emulate the
results obtained from the analysis of total credit with the exception of the central bank
independence. The central bank independence in now positive in sign but it is not
statistically significant; thus, central bank independence has no bearing in regulating
household credit boom. This finding is interesting as one would argue that central banks
may have to take much more proactive roles in regulating household credit boom which

22
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is not supported by the data we have at hand. Note that the central bank independence
played the ‘pacifier’ role in mitigating the total credit boom. Taken together, central
bank independence still matters in abetting the total credit boom, but it is not significant
enough to counter the boom associated with household credit. Further, the change in
credit-to-GDP has the largest impact (in terms of magnitude) on the credit boom in the
case of household credit.

PT
4.3. Robustness checks

RI
Next, we perform several robustness checks of the results from the bivariate probit
model. First, a lagged banking crisis dummy is added to the credit boom equation of the

C
bivariate probit model. The aim here is to capture the potential feedback from any
preceding banking crisis to the credit boom in the sense that the incidence of banking

US
crises in the previous year may trigger a credit boom in the current year. The second
approach uses lags of the independent variables in both equations of the bivariate probit
AN
model. Using lagged independent variables may help in reducing the bias caused by
potential reverse causality. Finally, an alternative estimation strategy is employed (the
M

panel OLS model) and the results are compared with the bivariate and univariate probit
models.
D

4.3.1. Results of bivariate probit model with lagged banking crisis

TE

Table 4 presents the results of the bivariate probit model where the lagged banking
crisis dummy is included in the credit boom equation. The findings in Columns 2 and 3
EP

as well as in Columns 6 and 7, corresponding to total credit and household credit

respectively, reveal that the likelihood of a boom in aggregate credit and credit to
C

households increases after a banking crisis. In effect, this result reflects the aggressive
monetary policy implemented by central banks around the world to mitigate the damage
AC

from the Global Financial Crisis (GFC) of 2007–2009. This is in line with the findings
of Mishkin (2010), who shows that the shock emanating from the GFC was
considerably stronger than the shock produced by the Great Depression. Nevertheless,
the economic downturn was significantly lower due to aggressive and effective
monetary policy. This policy included liquidity provisions in which central banks
expanded credit to the private sector.

[Insert Table 4 about here]

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Interestingly, the banking crisis coefficient for the enterprise credit growth is negative,
suggesting that enterprise credit declines in the aftermath of banking crises. This
mimics the real world experience in the aftermath of the recent GFC. However, the
Likelihood test for the enterprise credit model (Columns 4 and 5) recommends rejection
of the null hypothesis, suggesting that the results of the bivariate probit model are not
superior to those of the two separate univariate probit models.

PT
The other variables of interest, viz., the central bank independence remains robust to the
addition of banking crisis dummy in the credit boom equation pertaining to total credit

RI
as in Table 3. Similarly, the government stability variable retains its negative sign for
the total credit and household credit boom equations, though for the latter it loses the

C
statistical significance. The time-to-election again shows positive and statistically

US
significant effect on the banking crisis irrespective of the nature of the credits used.

4.3.2. Results of the bivariate probit model with lags

AN
In Table 5, the bivariate probit model is estimated with independent variables lagged by
four quarters.6 The model is separated into two stages. In the first stage, we expect that
M

all explanatory variables to have a lagged effect on credit booms, except for time-to-
elections. As mentioned earlier, the time-to-elections variable is assumed to have a
D

direct, contemporaneous effect on credit booms, as policymakers may increase/decrease

TE

domestic credit based on the time until the next election; consequently, it would not
have any delayed (or lagged) effect. In the second stage, the credit boom and other
explanatory and control variables have a lagged effect on the probability of a banking
EP

crisis. Again, we use the contemporaneous value of the time-to-election variable.

C

[Insert Table 5 about here]

AC

The results that stand out are as follows. There is a positive relationship between
banking crises and credit booms. When the credit boom is separated into household and
enterprise credit, only the effect of household credit is statistically significant. Further,
government stability retains its negative sign and significance in the case of total credit
and household credit. The time-to-elections variable is only significant for the total
credit, suggesting that governments tend to avoid a banking crisis closer to an election.

6
The results with up to eight lags are consistent with current estimates and are available upon request.

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4.3.3 Results from the panel OLS model

In this additional robustness check with panel OLS estimation (Table 6), the baseline
findings from Table 1 regarding the credit growth rate to GDP, government stability
and the interaction term remains consistent (Columns 1 to 4, Table 6). More
importantly, the panel OLS results support the findings from the bivariate probit model
in Table 3. In particular, the change in credit-to-GDP is positive and statistically

PT
significant in explaining banking crisis (Table 6), which could be attributed to the credit
boom channel in Table 3. One important institutional determinant, time to

RI
parliamentary elections remain statistically significant and positive in explaining
banking crisis when total credit is used (Column 4, Table 6). Similarly, change in real

C
GDP, or real GDP growth acts a pacifier to banking crisis in both the bivariate probit

US
and panel OLS models. In the panel OLS model, the log of official reserves reveal the
statistically significant dampening effect on banking crisis; whereas, in the bivariate
probit model, the mitigating effects were statistically insignificant.
AN
The results reiterate the importance of credit growth rate in explaining banking crisis
M

and more so when we control for other political and economic factors (control
variables). In presence of all controls as well as cross-sectional and time fixed effects
D

(Column 4, Table 6), there is a very high proclivity of banking crisis caused by
domestic credit growth. Note that government stability is not statistically significant in
TE

this instance, a finding akin to earlier result from Table 1. The magnitude of the
interaction term of domestic credit growth and government stability is much less than
EP

the univariate probit model (Table 1), however, they remain statistically very
significant. Given the negative sign of the interaction term, it would depend on the
C

government stability variable with lower government stability attributed to higher

domestic credit availability, which in turn, leads to banking crisis. Thus, with high
AC

government stability, the likelihood of banking crisis due to increased domestic credit
growth would diminish.7

Taking a look at the impact of enterprise credit growth (Columns 5 to 8, Table 6) and
household credit growth (Columns 9 to 12, Table 6) on banking crisis, we observe
similar findings like above. The bigger impact (in terms of magnitudes and in presence

7
Given that it is a linear probability model, the marginal effects would not make much sense, and,
therefore, not reported.

25
 ACCEPTED MANUSCRIPT
of all control variables) of household credit over enterprise credit growth in explaining
the banking crisis is quite remarkable. Likewise, the interaction terms are both negative
for enterprise as well as household credit growth, but the magnitudes reveal the
differential impact of these two separate credit growth variables. Household credit
growth has an overwhelming positive bearing on banking crisis which lends credence to
the earlier findings from the bivariate and univariate probit models.

PT
[Insert Table 6 about here]

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5. Conclusion

This paper investigates the likelihood of banking crisis, focusing on political and

C
institutional variables in presence of domestic credit growth in a sample of OECD

US
countries. Given the aim is to disentangle the likelihood of crisis, the study employs
probit models, and especially, the recursive bivariate probit model to decipher the
AN
potential causal impact of the credit expansion on banking crisis. Empirical estimations
reveal that household credit growth has a larger effect on the likelihood of a banking
crisis compared to enterprise credit growth. Importantly, the aggregate credit measures
M

have both direct and indirect bearings in triggering banking crisis, which in turn
depends on a crucial political variable, the level of government popularity. The
D

countries with higher government stability scores tend to have lower likelihood of a
TE

banking crisis, and the countries with low government stability are more susceptible to
banking crisis. Thus, the finding reveals existence of political business cycles in these
advanced countries.
EP

The central bank independence and time-to-elections variables, which shed light on the
C

political and institutional aspects of banking crisis, point to interesting subtleties. First,
the central bank independence tends to reduce the likelihood of a credit boom and
AC

banking crisis, which stems from the incumbent government’s opportunistic behaviour.
Thus, the independent central bank plays the role of a ‘pacifier’. Second, there is lower
chance of a banking crisis in the lead-up to an election. This can be interpreted as the
incumbents’ attempt in avoiding a crisis to increase their chance of re-election.
However, expansionary policies in the lead-up to an election may set the foundation for
unsustainable credit growth. Thus, the likelihood of a banking crisis increases after an
election. The results remain robust to different model specifications.

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The above findings have clear policy implications. Given that there is existence of
political business cycles, appropriate checks and balances should be put in place to
avoid any institutional drift which may trigger banking crisis. The central bank
independence should be viewed with a broader perspective which much encompassing
oversight roles. This will also help in restricting possible risk spill over both within and
across countries.

PT
In terms of extensions, one plausible avenue would be to investigate why household
credit has a greater impact on the likelihood of banking crisis in such scenarios. In

RI
particular, shedding lights on the particular transmission channels of household credit
growth and banking crisis would be important in devising appropriate mitigating

C
framework. This will be beneficial in developing effective macro-prudential regulation

US
and reducing the likelihood of banking crisis.

Compliance with Ethical Standards

AN
This study was not funded by any external grant or body or organization. The authors
declare that there are no conflicts of interests. This article does not contain any studies
M

with human participants performed by any of the authors.

D

References
TE

Acemoglu, D., Johnson, S., Robinson, J., Thaicharoen, Y. (2003). Institutional causes,
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Aikman, D., Haldane, A., Nelson, B. (2014). Curbing the Credit Cycle. The Economic
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PT
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Tables and Figures

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Table 1: The determinants of banking crisis in univariate probit specification

Variables (1) (2) (3) (4)

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Banking Banking Banking Banking

Crisis Crisis Crisis Crisis
∆ in Credit-to-GDP 4.193 2.723 29.09*** 28.46***
(0.324) (0.499) (0.001) (0.000)
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Government stability -0.210** -0.264*** -0.257*** -0.102

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(0.001) (0.000) (0.000) (0.110)

∆ in credit x government
-3.000*** -3.30***
stability
(0.001) (0.000)
Central Bank independence 0.696
(0.833)
Log of reserves -0.537*
(0.084)
∆ in real GDP -20.16***

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(0.000)
Inflation 4.617
(0.291)
Time-to-elections 0.03*
(0.044)
Control variables No No No Yes
Country dummies No Yes Yes Yes
Time dummies No No No Yes

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Observations 1587 1374 1374 876
Number of countries 22 19 19 16
Pseudo R-squared 0.058 0.12 0.13 0.21

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Note: Dependent variable is binary banking crisis dummy. Columns (1) to (4) contain the results of univariate
probit specification. Error terms are clustered at the country level. p-values are in parenthesis. ***, ** and *
stand for statistical significance at 1%, 5% and 10% level respectively.

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Table 2: Marginal effects of total, enterprise and household credit growth over the
probability of banking crises

Government
Total credit Enterprise credit Household credit
stability
(1) (2) (3) (4)
Marginal p- Marginal Marginal
p-value p-value

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effect value effect effect
4 0.039 0.00 0.028 0.003 0.082 0.00
4.5 0.038 0.00 0.027 0.003 0.081 0.00

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5.0 0.037 0.00 0.027 0.003 0.079 0.00
5.5 0.036 0.00 0.026 0.003 0.078 0.00
6.0 0.035 0.00 0.025 0.003 0.077 0.00

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6.5 0.034 0.00 0.025 0.003 0.075 0.00
7.0 0.033 0.00 0.024 0.003 0.074 0.00

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7.5 0.032 0.00 0.023 0.003 0.073 0.00
8.0 0.031 0.00 0.023 0.003 0.071 0.00
8.5 0.030 0.00 0.022 0.004 0.070 0.00
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9.0 0.029 0.00 0.021 0.004 0.068 0.00
9.5 0.028 0.00 0.021 0.004 0.067 0.00
10.0 0.027 0.00 0.020 0.005 0.066 0.00
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10.5 0.026 0.00 0.019 0.005 0.064 0.00

11.0 0.025 0.00 0.019 0.006 0.063 0.00
11.5 0.025 0.00 0.018 0.008 0.062 0.00
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12.0 0.024 0.00 0.017 0.01 0.060 0.00

Note: Columns (2) to (4) show marginal effects of growth in subsequent credit measure by 1 per cent on the
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probability of banking crisis given different levels of government stability figure (see Column 1).
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Table 3: The results of bivariate probit model

Total credit Enterprise credit Household credit

Credit Banking Credit Banking Credit Banking
Variables
Boom Crisis Boom Crisis Boom Crisis
(1) (2) (1) (2) (1) (2)
Model 1 Model 2 Model 3
Credit boom 2.150*** 1.403*** 1.807***
(0.000) (0.000) (0.000)

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Log of reserves -0.152 -0.130 -0.108
(0.113) (0.181) (0.163)

∆ in financial openness -70.4*** -110.6*** -72.91***

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(0.000) (0.000) (0.000)
∆ in real GDP -6.376 -14.7*** -23.36*** -14.07*** -12.49* -14.21***
(0.177) (0.000) (0.000) (0.000) (0.025) (0.000)

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Inflation 10.45 -4.102 14.05** -2.130 2.375 -2.786
(0.348) (0.413) (0.038) (0.575) (0.799) (0.514)

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Time-to-elections -0.0237 0.035*** -0.0155 0.036** 0.01 0.032**
(0.390) (0.009) (0.453) (0.021) (0.713) (0.025)
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Government stability -0.177* 0.140* -0.120*
(0.022) (0.074) (0.075)
Central Bank independence -1.077* -0.061 0.468
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(0.095) (0.946) (0.594)

∆ in Credit-to-GDP 29.08*** 28.69*** 61.51***
(0.000) (0.007) (0.000)
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Log of private consumption 0.0288 -0.124 -0.153

(0.708) (0.267) (0.395)
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∆ in short-term interest rate 11.72** 11.93*** 11.36*

(0.004) (0.003) (0.081)
Observations 982 979 979
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Likelilood test, chi-square 3.03 0.03 3.55

Prob. 0.08 0.86 0.06
Note: ***,**,* represent statistical significance at 1,5 and 10 per cent confidence levels respectively. Error terms are
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cluster by countries. Underlying null hypothesis of the likelihood test suggests two independent univariate probit models.
Probability of greater than 0.1 suggests significant correlation estimator (Winkelmann, 2012), hence bivariate probit
model is preferred.
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Table 4: Robustness check, bivariate probit model with lagged banking crisis dummy

Total credit Enterprise credit Household credit

Credit Banking Credit Banking Credit Banking
Variables
Boom Crisis Boom Crisis Boom Crisis
(1) (2) (1) (2) (1) (2)
Model 1 Model 2 Model 3
Credit boom 2.37*** -1.43*** 2.64***
(0.00) (0.00) (0.00)

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Log of reserves -0.132 -0.15 -0.077
(0.156) (0.15) (0.268)
∆ in financial openness -95.71*** -69.7*** -104.7***

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(0.00) (0.00) (0.00)
∆ in real GDP 4.79 -14.52*** -22.66*** -18.85*** 3.47 -12.4***
(0.43) (0.00) (0.00) (0.00) (0.54) (0.00)

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Inflation 8.43 -3.38 5.69 0.77 8.94 -2.52
(0.56) (0.49) (6.72) (0.86) (0.28) (0.56)

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Time-to-elections -0.03 0.035*** 0.01 0.02* -0.015 0.03**
(0.22) (0.01) (0.44) (0.09) (0.32) (0.02)

Banking crisis, lagged 2.5*** -1.73*** 2.82***

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0.00 (0.00) (0.00)
Government stability -0.14* 0.007 -0.055
(0.09) (0.65) (0.39)
Central Bank
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0.23 -0.306
independence -0.89**
(0.048) (0.32) (0.74)
∆ in Credit-to-GDP 11.81** 10.42 36.3***
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(0.042) (0.15) (0.06)

Log of private
-0.12 -0.06
consumption 0.05
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(0.47) (0.13) (0.61)

∆ in short-term interest
5.48 2.87
rate 7.70*
(0.06) (0.18) (0.32)
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Observations 982 979 979

Likelilood test, chi-
15.9 1.39 71.08
square
Prob. 0.01 0.24 0.00
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Note: ***,**,* represent statistical significance at 1,5 and 10 per cent confidence levels respectively. Error
terms are clustered by countries. Underlying null hypothesis of the likelihood test suggests two independent
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univariate probit models. Probability of greater than 0.1 suggests significant correlation estimator, hence
bivariate probit model is preferred.

Table 5: Robustness check, bivariate probit model with lagged explanatory variables

Total credit Enterprise credit Household credit

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Credit Banking Credit Banking Banking
Variables Credit Boom
Boom Crisis Boom Crisis Crisis

(1) (2) (1) (2) (1) (2)

Model 1 Model 2 Model 3

Credit boom , lagged 4 quarters 0.67* 0.24 0.80*

(0.06) (0.52) (0.06)
-
Log of reserves, lagged 4 quarters -0.23*** -0.235***
0.176***
(0.01) (0.00) (0.012)

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-
∆ in financial openness, lagged 4 quarters -81.6*** -76.31***
78.48***
(0.00) (0.00) 5.23
∆ in real GDP, lagged 4 quarters 15.69*** -10.88*** 19.18*** -10.74*** 9.72** -9.51***

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(0.01) (0.00) (0.00) (0.00) (0.04) (0.00)
Inflation, lagged 4 quarters 16.9*** 3.28 -3.91 5.00 5.96 4.708
(0.00) (0.51) (0.73) (0.30) (0.46) (0.30)

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Time-to-elections -0.04 0.03* -0.05** 0.03 -0.02 0.03

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(0.13) (0.08) (0.01) (0.11) (0.18) (0.13)
Government stability , lagged 4 quarters -0.191*** -0.097 -0.184***
(0.00) (0.43) (0.00)
Central Bank independence , lagged 4 quarters -0.494 0.90 1.00
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(0.45) (0.26) (0.13)
∆ in Credit-to-GDP , lagged 4 quarters 11.65 35.98*** 80.67***
(0.18) (0.00) (0.00)
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Log of private consumption , lagged 4 quarters 0.08 -0.101 -0.12

(0.48) (0.22) (0.37)
∆ in short-term interest rate , lagged 4 quarters 3.02 13.54*** 9.22*
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(0.44) (0.00) (0.054)

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Observations 974 964 964

Likelilood test, chi-square 8.78 3.23 10.51
Prob. 0.00 0.07 0.00
Note: ***,**,* represent statistical significance at 1,5 and 10 per cent confidence levels respectively. Error terms are cluster by
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countries. Underlying null hypothesis of the likelihood test suggests two independent univariate probit models. Probability of
greater than 0.1 suggests significant correlation estimator, hence bivariate probit model is preferred.
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Table 6: Robustness check, determinants of banking crisis in panel OLS model

Variables Total credit Enterprise credit Household credit

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(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
1.11 0.78 8.37*** 8.75***
∆ in Credit-to-GDP
(0.35) (0.52) (0.00) (0.00)

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1.05 0.41 10.16*** 10.18***
∆ in Enterprise credit to GDP
(0.47) (0.77) (0.00) (0.00)
4.40*** 3.51** 28.81*** 49.78***
∆ in household credit to GDP (0.01) (0.03) (0.00) (0.00)

SC
-0.05*** -0.05*** -0.05*** -0.01 -0.05*** -0.05*** -0.05*** -0.01 -0.05*** -0.05*** -0.05*** -0.01
Government stability
(0.01) (0.00) (0.00) (0.29) (0.01) (0.01) (0.01) (0.34) (0.00) (0.01) (0.01) (0.77)

-0.87*** -0.98***
∆ in credit x government stability

U
(0.00) (0.00)
-1.09*** -1.15***
∆ in enterprise credit x government stability
(0.00) (0.00)

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-3.201*** -6.228***
∆ in household credit x government stability
(0.001) (0.000)
0.12 0.16 0.13
Central Bank independence
(0.55) (0.44) (0.55)
-0.11* -0.12* -0.18*

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Log of reserves
(0.06) (0.03) (0.04)
-4.66*** -4.61*** -4.82***
∆ in real GDP
(0.00) (0.00) (0.00)
0.64 0.56 0.49

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Inflation
(0.50) (0.56) (0.58)
0.01** -0.01** -0.01**
Time-to-elections

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(0.04) (0.04) (0.04)

Control variables No No No Yes No No No Yes No No No Yes

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Country dummies No Yes Yes Yes No Yes Yes Yes No Yes Yes Yes

Time dummies No No No No No No No No No No No No

Observations 1587 1587 1587 1036 1545 1545 1587 1028 1545 1545 1545 1028
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Number of countries 22 22 22 16 22 22 22 19 22 22 22 19
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Adjusted R-squared 0.047 0.107 0.113 0.197 0.047 0.133 0.139 0.329 0.048 0.135 0.140 0.232

Note: Dependent variable is binary banking crisis dummy. Error terms are clustered at the country level. p-values are in parenthesis. ***, ** and * stand for statistical significance at 1%, 5% and 10% level respectively.

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Figure 1: Marginal effects of growth in domestic credit at different levels of

government stability variable

.06 .05 Average Marginal Effects of dcrtot with 95% CIs

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Effects on Pr(Bc)
.04

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.03

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.02

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.01

4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 10.5 11 11.5 12

govstab
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Note: Dotted lines show 95% confidence intervals.
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Figure 2: The number of banking crises after elections

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20
Banking crises, count

15

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10

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5

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0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

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Quarters since election
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Figure 3: Marginal effects of enterprise (left panel) and household (right panel) credit growth
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at different levels of government stability.

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Average Marginal Effects of dcre with 95% CIs Average Marginal Effects of dcrh with 95% CIs
.05

.12
.04

.1
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Effects on Pr(Bc)

Effects on Pr(Bc)
.03

.08
.02

.06
C
.01

.04
.02
0

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4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 10.5 11 11.5 12 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 10.5 11 11.5 12
govstab govstab

Note: Dotted lines show 95% confidence intervals.

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Highlights

Do Political Factors Influence Banking Crisis?

• The household credit growth increases the likelihood of banking crisis

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• The enterprise credit is not driving the banking crisis
• Governments anxious about domestic approval rates may encourage household credit

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boom which enhances the prospect of banking crisis
• The presence of an independent and well-functioning central bank mitigates the crisis

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probability

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