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Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies

A significant body of literature has emerged on financial crises in emerging markets. This literature focuses primarily on macro explanations for the onset and propagation of a financial crisis. For example, in a recent paper, Francis, Hasan and Hunter (2002) provide evidence that liberalization of emerging financial markets has resulted in the integration of developing countries’ capital markets into global capital markets, thereby resulting in a higher likelihood of financial crises in emerging markets.

More recently, Chen and Hasan (2005) and Dwyer and Hasan (2007) show that many financial crises involve bank runs resulting from deteriorating depositor sentiment about the health of the banking industry. While these macro explanations seem plausible, there is an important missing element. Investment distortions (such as, excessive risk-taking, and investments in non-value maximizing pet projects), and the degree of economic specialization, i.e., whether an economy is specialized in a few products/activities, or is sufficiently well diversified, appear to have had a significant role in contributing to the precipitation and propagation of recent financial crises (see, Corsetti, Pesenti, and Roubini, 1999).

In this paper, we model the vulnerability of an economy to a financial crisis as arising from the interaction of the degree of economic specialization and the mode of financing of the investment opportunities. We define a financial crisis as the joint occurrence of the low payoff state for all firms in an economy. Our main results are as follows: First, we show that the probability of a financial crisis increases in the degree of economic specialization.

Second, intermediated financing, the most commonly available source of financing in emerging economies, has two countervailing effects on the probability of a financial crisis. On the one hand, bank debt financing decreases the degree of economic specialization by increasing the access to intermediated financing for an increased menu of activities than that would have been financed with only internal financing by entrepreneurs (we refer to this as the financial access effect). On the other hand, the form of bank financing (debt) causes the well-known risk-shifting incentives leading to over investment in risky projects (we refer to this as the leverage effect). The net effect on the probability of a financial crisis depends on which of these two effects dominates.

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Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies