This paper examines the risk factors associated with fiscal costs of systemic banking crises using cross-country data. We differentiate between immediate direct fiscal costs of government intervention (e.g., recapitalization and asset purchases) and overall fiscal costs of banking crises as proxied by changes in the public debt-to-GDP ratio. We find that both direct and overall fiscal costs of banking crises are high when countries enter the crisis with large banking sectors that rely on external funding, have leveraged non-financial private sectors, and use guarantees on bank liabilities during the crisis. The better quality of banking supervision and the higher coverage of deposit insurance help, however, alleviate the direct fiscal costs. We also identify a possible policy trade-off: costly short-term interventions are not necessarily associated with larger increases in public debt, supporting the thesis that immediate intervention may be actually cost-effective over time.
The recent global financial crisis has renewed policy and research interest in the effects of banking crises on public finances (Laeven and Valencia,2013; Lane,2011). Since 2007, there have been 25 new systemic and borderline systemic banking crises, mostly in advanced economies, which have often carried significant fiscal costs. In Iceland and Ireland, for example, the cost of government intervention amounted to more than 40 percent of GDP, and public debt increased by more than 70 percent of GDP in five years(Laeven and Valencia,2013). The magnitude of these costs is not unusual, compared to past crises. Systemic banking crises have often resulted in marked deteriorations of public finances, although the impact has varied across countries. The median fiscal cost of direct government intervention during the crises that occurred between 1980 and 2011 was about6 percent of GDP; about one third of crisis episodes recorded direct fiscal costs exceeding 10 percent of GDP. Yet, these direct costs do not capture the full impact of banking crises on public finances; these crises also affect public finances indirectly through crisis-induced recessions and higher borrowing costs (Claessens and others,2011; IMF,2015). The overall cost of crises can be better captured by the change in public debt, which includes direct budgetary costs as well as indirect fiscal costs that materialize through the impact of crises on the real economy(as well as any cost recovery). Seen through this prism, the overall costs of banking crises are even larger. The median increase in public debt during the four years that followed crises occurred over 1980–2011was more than14percent of GDP, with the increase exceeding 40percent of GDP for the 11 most costly crises.2The most recent wave of crises has been no exception, with the median increase in public debt being about 24 percent of GDP; the increase in some countries more than doubled this amount (Deutsche Bank,2013). Explaining the magnitude and the cross-country differences in fiscal costs of banking crises remains a challenge. Empirical studies have largely focused on direct fiscal costs and suggest that the determinants of banking crises—such as initial macroeconomic conditions, financial sector characteristics, and countries’ institutional features, may help explain observed differences in the severity of the fiscal impact of banking crises(Demirguc-Kunt and Detragiache,1998). However, most of this empirical literature dates back to late 1990s and early 2000s; as such it does not account for the complexities of modern banking sectors, for example, cross-border linkages. In addition, this literature mainly considers the determinants of fiscal costs separately, not accounting for possible interactions among clusters of risk factors. Finally, the empirical literature has not paid much attention to the overall fiscal costs and the impact of banking crises on public debt. Yet, this is an important policy issue: speedy interventions, although initially costly, may lead to better macroeconomic performance and smaller increases in public debt (IMF,2015). This paper provides an empirical analysis of the factors associated with direct fiscal costs of banking crises and public debt dynamics. It combines several recent datasets.