How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents, who experience idiosyncratic liquidity shocks, can invest in a liquid storage technology or in a partially illiquid Cobb Douglas technology. By pooling liquidity risk, banks play a growth enhancing role in reducing inefficient liquidation of long term projects, but they may face liquidity crises associated with severe output losses. We show that middle income economies may find optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system. Therefore, middle income economies could experience banking crises in the process of their development and, as they get richer, they eventually converge to a financially safe long run steady state. Finally, the model replicates the empirical fact of higher costs of banking crises for middle income economies.

This paper attempts to reconcile the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity.  On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (e.g., Levine, Loayza, and Beck 2000).  On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (e.g., Kaminski and Reinhart 1999).  This paper starts by illustrating these opposing effects by, first, analyzing the dynamics of output growth and financial intermediation around systemic banking crises and, second, showing that the growth enhancing effects of financial depth are weaker in countries that experienced such crises.  After these illustrative exercises, the paper attempts an empirical explanation of the apparently opposing effects of financial intermediation.  This explanation is based on a distinction between transitory and trend effects of domestic credit aggregates on economic growth.  Working with a panel of cross-country and time-series observations, the paper estimates an encompassing model of long- and short-run effects, following Pesaran, Shin, and Smith (1999)’s Pooled Mean Group Estimator.  The main result of the paper is that a positive long-run relationship between financial intermediation and output growth co-exists with a, mostly, negative short-run relationship.
 
 

This paper explores the relation between real exchange rate risk and growth in an economy characterized by asymmetric financial opportunities. This common feature of middle income economies is represented by the coexistence of a tradable sector with perfect access to capital market and a non-tradable sector subject to financial constraints. The financially constrained sector can then become a source of bottlenecks harming the growth performance of the whole economy. In this context, the presence of a systemic bail-out guarantee enables non-tradable firms to ease the credit constraint and to increase investment by taking real exchange rate risk through a currency mismatch between domestic revenues and foreign liabilities. We show that with such risk-taking, the economy will experience a ''bumpy'' growth path: episodes of rapid financial development and economic growth with a reduction of bottlenecks and episodes of twin crises with real exchange rate depreciation coinciding with widespread default and bankruptcies. By contrast, in absence of real-exchange rate risk, the economy will follow a safe but slow growth path. We argue that a domestically financed systemic bail-out guarantee inducing such a risky growth path can be ex-ante welfare enhancing.