A theory of linkage between monetary policy and banking failure in developing countries

Purpose – The purpose of this paper is to present a model that studies the impact of a tightening monetary policy on banking failure in a developing country. Design/methodology/approach – The interest rate on treasury bills is included in the model to measure monetary policy. Since the model considers developing countries with low‐income level, the paper assumes that a secondary market does not exist. Findings – The model shows that, despite treasury bills constituting an alternative source of profit for banks in developing countries, a tightening monetary policy increases the probability of banking failure. In addition, the model shows that efficiency level explains the asymmetric effect of monetary policy on the profit of the banks. Practical implications – The policy implication of the results of the paper is that the central bank should take into account the adverse effect of a tightening monetary policy on banking failure, when planning policy decisions. Originality/value – The paper offers insights into the linkage between monetary policy and banking failure in developing countries.