The long run effects of banking crises on investment

A large body of research has established that banking crises lead to a steep decline in output, investment, and employment. This literature finds that economic growth resumes in about 2-3 years, the amount of time that it typically takes to resolve the major problems in the financial sector.  However, even though economic growth resumes, some recent studies find that there may be a long term decline in the level of output which remains below its pre-crisis trend for years. For example, Cerra and Saxena (AER, 2008) find that ten years after a banking crisis, output remains about 7 percent below its pre-crisis trend.  Hence, banking crises may have persistent effects on the economy.

This literature, however, has not explored which components of output drive the prolonged decrease below trend and through which channels. In this paper, we explore how investment, a key component of output, is affected by banking crises. Further, we explore how confidence in the banking sector may be a key channel through which banking crises may lead to lower investment for a prolonged period of time. Confidence in the banking system can erode with repeated crises or when the effects are widespread within a country, for example, causing losses on deposits or extensive bank closures. We test whether this confidence channel can account for the investment decline observed after banking crises.

We use data for 150 countries from 1963 to 2007, including the well-know Reinhart and Rogoff (2008) data on banking crises episodes. We find that banking crisis have a prolonged negative effect on investment. In fact, the investment to GDP ratio is on average about 10 percent lower during each of the 7 to 9 years following a banking crisis.  We also find that this adverse effect is due largely to loss of confidence.  Results show that experiencing repeated crises over time, which we argue reduces confidence in the system, may reduce investment and partly account for the persistence of the effect.  Furthermore, we find that in countries where the banking crises imposed significant negative costs on wide segments of the population, confidence in the banking system is reduced leading to the prolonged decrease in investment.