Economists have argued that finance can facilitate growth and increase stability. There are, however, reasons that finance, especially the quantity of credit, can be a source of instability. While there is a vigorous debate on the benefits and costs of the financial sector, there is no direct evidence of whether more finance is related to a higher probability of future systemic banking crises. By using panel data for 150 countries from 1960 to 2009, I find that a larger quantity of finance measured by the ratio of private credit to GDP is associated with a higher probability of future systemic banking crises, a result that is robust to excluding the recent global financial crisis. This effect is stronger for countries whose quantity of private credit is relatively larger. An increase in the equity market capitalization relative to the outstanding credit is associated with a lower probability of a systemic banking crisis.

Debt crises are often preceded by sharp decouplings in cross-country bond yields after prolonged periods of convergence. We model such decouplings as shifts from pooling to separating equilibria that are triggered by a large tax revenue shock. As investors lack full information on both the extent of the shock and governments ’ capacity to adjust spending, they revise priors on the fiscal outlook by observing differences in resort to borrowing: when only a sub-set of countries intensifies post-shock market tapping, this signals to investors tangible discrepancies in the mean and variance of fiscal outlooks. In our setting, such “fiscal discoveries ” manifest via spreads rather than borrowed quantities, with debt and the interest burden both rising and default becoming a likely equilibrium outcome. Using an extensive cross-country dataset spanning 1970-2010, we show that this mechanism is consistent with the dynamics of most debt crises. Model calibrations also show that shifts between pooling and separating equilibria appear highly sensitive to changes in key parameters, casting a skeptical note on the stability of too heterogeneous country pools under fiscal de-centralization.

The financial crisis has entered a dangerous phase. I argue in this article that the retrenchment currently taking place in the European banking sector has broad implications for financial stability. More generally, I argue that the focus should be on “global liquidity imbalances, ” rather than “global imbalances. ” Global liquidity imbalances track the liquidity mismatch across countries and over time, which may or may not result in current account deficits and surpluses (that is, global imbalances). 1.