Interest Rate Liberalization And Banking Fragility:International Experience And Cross-country

As early as1970s, Mckinnon(1973) and Shaw(1973) had put forward the theory of "Financial deepening". They discussed the relationship between interest rate liberalization and the development of economy. From then on, Galbis(1979) et al. had suggested several amendments for the "Financial deepening" theory, while "The Endogenous Growth Theory" developed their theory and argued that the financial development should be treated as the first mission of governments (especially the governments of developing countries).Since the middle of1970s, with the development of the "Financial deepening" theories, the interest rate liberalization had become the mainstream of the national development of financial markets. This paper differentiates the patterns of interest rate liberalization between "gradual type" and "radical type"."Gradual type" liberalization includes United States, Korea and so on while "radical type" liberalization happened mainly in Argentina and Chile. By comparing the two patterns of interest rate liberalization, this paper concludes that firstly, the external environment of the reform should be stable. Secondly, interest rates should be relaxed gradually and under supervisory control. Thirdly, the whole process of reform need proper policies and stabilized financial framework.The process of interest rate liberalization is always followed by risks and more serious banking crises. This paper discussed the possible transmission mechanism from interest rate liberalization to the banking crisis. Firstly, the severe fluctuation of interest rate may result in the interest rate risk, while the overstated exchange rates would lead to the exchange rate risk. Secondly, the narrower spread may result in liquidity risk. Thirdly, adverse selection and moral hazard would also occur in the process of interest rate liberalization reform. All of these risks probably result in more fragile banking system, or more seriously banking crisis.In the part of empirical analysis, by using the Logit model and sample of79countries from1980to2010, this paper investigates the probability of commercial banking crisis caused by the interest rate liberalization. The empirical results show that the interest rate liberalization (or banking freedom rate) significantly improves the probability of banking crisis, and the impact is only on systemic banking crisis. Moreover, the Rate of growth of real GDP, Real GDP per capita, Terms of trade change, Inflation and M2/reserves are also approved to influence banking crisis.Based on the theoretical and empirical analysis, the conclusion and policy suggestions for China are, firstly interest rate liberalization reform in China need stable external environment, especially the financial market. Secondly, the coordination of foreign exchange policies and fiscal plans are needed. Thirdly, commercial banks must promote the power of kernel competition by the product and technique innovations. Fourthly, interest rates supervision mechanism should be established. Last but not least, our interest rate liberalization reform needs to be carried out gradually and smoothly.