Journal of International Economics 72(1), 202-221
May, 2007
Abstract. Financial liberalization often leads to financial crises. This link has usually been attributed to poorly designed banking systems, an explanation that is largely static. In this paper we develop a dynamic explanation, by modelling how a newly-liberalized bank's opportunities and incentives to take on risk develop over time. The model reveals that even if a banking system is well-designed, in the sense of having good long-run properties, many countries will enjoy an initial period of rapid, low-risk growth and then enter a period with an elevated risk of banking crisis. This transition emerges because of the way in which the degree of foreign competition, the marginal product of capital, and the bank's own net worth simultaneously evolve.