Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies

We model the vulnerability of an economy to a financial crisis as arising from the interaction of the degree of economic specialization and the intermediated financing of the investment opportunities. The probability of a financial crisis is shown to increase in the degree of economic specialization. Bank debt financing (the most common source of intermediated financing in emerging economies) has the beneficial effect of lowering the degree of economic specialization by increasing access to financing of investment opportunities that would not have been financed due to wealth constraints of entrepreneurs (financial access effect). However, bank debt financing induces risk-shifting incentives (leverage effect). The net effect on the probability of a financial crisis depends on which of these two effects dominates. We show that commonly employed mechanisms in managing financial crises, particularly bailouts, induce an additional agency cost on the part of banks. Since the bailout is focused only on the financial crisis state, it distorts bank incentives to concentrate its loans in specific sectors (bank debt concentration effect). We propose a solution mechanism that consists of two tax structures: (1) a corporate tax that changes the ex ante incentives of the residual claimants in the right direction by concavifying the pay-off structure of the after-tax cash flows, and (2) a tax on bank cash flows that eliminates the bank debt concentration effect. Our proposed solution mechanism is targeted towards prevention rather than an ex post resolution of a financial crisis. The foundation for our main results linking financial crisis with the degree of economic specialization is supported by the available data (presented in the form of a couple of empirical tests) - a full-fledged empirical analysis of the predictions of this theory paper is left for future research. Implementation issues and empirical/policy implications are also discussed