Causes of banking crises: Deregulation, credit booms and asset bubbles, then and now Saktinil Roy a, ⁎, David M. Kemme b,1 a Centre for Finance, Economics and Operations Management, Athabasca University, 301-22 Sir Winston Churchill Avenue, Saint Albert, Canada AB T8N 1B4 b Department of Economics, University of Memphis, Memphis, TN 38152, USA article info abstract Article history: Received 22 November 2010 Received in revised form 28 March 2012 Accepted 2 April 2012 Available online 11 April 2012 We examine similarities in the run-up to banking crises using two criteria for their predictability: i) the percentage of a specified number of years prior to a crisis correctly called; and ii) the percentage of true alarms of total alarms for a crisis. Using panel logit models we find that a banking crisis will be sparked by the collapse of a real asset bubble. While such bubbles are associated with popular stories of a new era and an increasingly deregulated financial system, in most cases, this would occur even in the absence of sustained surges of capital inflow, accumulation of public debt, low interest rate policies, or structural shocks. We also find that an increase in income inequality inflated the recent housing bubble. © 2012 Elsevier Inc. All rights reserved. JEL classification: E32 E37 C22 C23 Keywords: Banking crisis Similarity Logit 1. Introduction The unfolding of events after the US subprime market collapse of 2007–2008 and the subsequent great contraction marked a paroxysm in a supposedly “new era” of “great moderation” and continuing growth. Indeed, those dramatic changes took many by surprise. Yet, as we know today, a few researchers predicted this unhappy episode. 2 Shiller (2005, pp. xiii–xiv), for example, had argued that the rapid surges in the housing markets of the United States and other countries in the early 2000s were unexplained by the long-term domestic economic fundamentals. He expounded 3 —also in his more recent work 4 —that primarily people's belief in ever-rising home prices fed a housing bubble, and such a belief spread as the bubble itself was inflating. Similar financial booms in history, such as the California housing boom of the 1880s or the most recent stock and housing booms in Japan, Finland, Norway and Sweden, were also associated with the wishful thinking of ever increasing asset prices 5 and they also eventually collapsed, albeit with impacts much smaller than those that characterize the current turmoil. As this paper shows, prior asset bubbles caused by people's imagination of a “new era” in a period of increasing financial liberalization and regulatory imprudence best explain the current global crisis and the historical banking crises. International Review of Economics and Finance 24 (2012) 270–294 ⁎ Corresponding author. Tel.: + 1 780 418 7545; fax: + 1 780 459 2093. E-mail addresses: saktinil@athabascau.ca (S. Roy), dmkemme@memphis.edu (D.M. Kemme). 1 Tel.: +1 901 678 5408; fax: +1 901 678 0876. 2 Nouriel Roubini made a prediction of the crisis at the IMF on September 7, 2006. Baker (2002) and Rajan (2005) were among others who predicted the crisis. 3 See chapter 2, Shiller (2005). 4 See chapters 2–3, Shiller (2008). 5 Kindleberger and Aliber (2005) struck a similar note. “Euphoria” of market participants is an important aspect in their historical account on “manias, panics and crashes.” 1059-0560/$ – see front matter © 2012 Elsevier Inc. All rights reserved. doi:10.1016/j.iref.2012.04.001 Contents lists available at SciVerse ScienceDirect International Review of Economics and Finance journal homepage: www.elsevier.com/locate/iref