Assessing the fiscal implications of banking crises

Summary

Focus

We propose a method to compute the probability distribution of the potential fiscal cost of a banking crisis - a key input in assessing the adequacy of a country's fiscal buffers. Using a sample of banking crises in advanced and emerging market economies, we approximate the cost with the post-crisis increase in government debt. We then examine which pre-crisis economic developments help anticipate those costs. We finally use that information to compute the probability distribution of the costs for individual countries given prevailing economic conditions.

Contribution

A large literature has assessed the probability of banking crises, but relatively few studies have analysed their fiscal cost. And yet, for a policymaker, estimating the losses from a rare event such as a crisis should be at least as important as estimating its probability. We take a step towards filling this gap.

Findings

The level and growth of credit to the private non-financial sector, foreign exchange reserves and the ratio of bank capital to assets help predict the post-crisis increase in public debt. While they vary substantially across countries, the fiscal buffers against the risk of a banking crisis can be sizeable, far above 10% of GDP.

Abstract

We propose a method for computing the distribution of the potential fiscal cost of a banking crisis - a key input in assessing the adequacy of a country's fiscal buffers. First, we use a cross-section of banking crises to identify the risk factors that predict the post-crisis increase in public sector debt - a measure of the overall fiscal cost of a crisis. Next, we use these risk factors to compute country-specific distributions of that cost in the event of a crisis. We find that the level and growth of credit to the private non-financial sector, foreign exchange reserves and the ratio of bank capital to assets are relevant predictors. As an illustration, we apply the method to the conditions prevailing in 2018 and find that the potential fiscal costs could be sizeable: with a probability of 95%, public debt could approach 40% of GDP on average across countries. Our illustrative estimates are probably upper bounds: while they indicate that higher bank capital can substantially reduce fiscal costs, they exclude the broader benefits of the wide-ranging reforms after the Great Financial Crisis.

JEL Classification: E62, G01, H68, H81

Keywords: banking crises, public debt, fiscal space, fiscal buffers, macro-financial stability framework