Understanding financial crises: a developing country perspective

Abstract

How does a developing economy shift dramatically from a path of reasonable growth before a financial crisis, as was the case in Mexico in 1994, to a sharp decline in economic activity after a crisis? This article explains this puzzle by outlining an asymmetric information framework for analyzing banking and financial crises. The framework shows why the banking sector is so important to the economy, particularly in developing countries, and provides a rationale for bank regulation and supervision. The framework is also used to show why banking and financial crises occur and why they can have such a devastating effect on the economy. An important policy implication is that an appropriate institutional structure is critical for preventing banking and financial crises in developing countries and for reducing their undesirable effects should they occur. There are comments and a discussion on this paper, p 63-77.