Regulatory Lags, Liberalization and Vulnerability to Banking Crises

This article explores the effect of delays in updating prudential regulation on countries' likelihood of experiencing banking crises, and it disentangles the impact of different aspects of regulation on crisis onset. I argue that delays in revising banks' prudential regulation allow banks to adopt risky behavior. This increases a country's vulnerability to systemic banking crises. This effect, however, is conditional on the level of liberalization of the financial market. At lower levels of liberalization, banks have stronger incentives to escape regulation's constraints and to take advantage of regulatory lags. At high levels of liberalization, the effect of regulatory lags is curbed, possibly by market discipline. Statistical analyses on a sample of developed and developing countries, 1974-2005, support this argument and help rule out the competing learning hypothesis. These results suggest that the effects of institutions can vary with the passage of time