Dynamic Panel Analysis of Systemic Banking and Financial Crisis: The Role of Fiscal Policy

Abstract

Is fiscal indiscipline a threat to systemic banking crises and financial stability? Given the unique challenges faced by the financial sector in developing economies after long periods of unfunded budget deficits, this paper argues that systemic derivatives of fiscal policy inconsistencies can trigger banking crisis. Specifically, the financial risks posed by fiscal indiscipline—a policy regime characterized excessive spending, inadequate revenue collection, persistent budget deficits, and high public debt can instigate instability throughout the economy. The paper showed empirically that in a dynamic binary response model environment, government deficits are more likely to result in a systemic banking crisis. More importantly, the likelihood of systemic banking crisis increases as government deficit begins to rise, reaches a maximum, and then diminishes after a certain threshold. Second, as the GDP default weight of a country increases, the probability of systemic banking crisis falls in both a static and a dynamic environment. Finally, systemic banking crisis spurred by fiscal deficit has domino effect, with exchange rate against the dollar plays negligible role. We conclude that running unfunded fiscal deficit as a long-term policy framework requires prudent financial management to mitigate these risks posed by the deficit overhang.