Introduction 5 the banking system”. Also in Allen and Gale (2007b, p 10), currency crises are defined as “a forced change in parity, abandonment of a pegged exchange rate or an international rescue”. Both banking crises and currency crises are classified as the two key features of financial crises [Tirole (2002), chapter 1]. Financial crises are defined as “a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries, which spread through the financial system, disrupting the market’s capacity to allocate capital”, according to Eichengreen and Portes (1987, page i). Regarding the frequency of the occurrence of banking crises, Tirole (2002, chapter 1) finds that banking crises have occurred more often in recent decades after the 1970s. Expanding to historical data, Eichengreen et al (2008) find that 50 per cent of financial crises have coincided with banking crises and only 2 per cent have coincided with currency crises. Focusing on the recent period after 1973, both Bordo et al (2001) and Allen and Gale (2007b, chapter 1) find that banking crises have occurred more frequently after 1973. Moreover, Tirole (2002, chapter 1) points out that starting in the 1970s, the crises have been related to bank failures which were not the case in the period prior to the 1970s when banking systems were highly regulated and banking activities were limited. In the 1970s, banking systems were deregulated jointly with financial liberalization as well as the liberalization of capital accounts/ controls. Because the liberalization of capital accounts is defined as “easing the restrictions of capital flows across a country’s borders”, based on Kose and Prasad (IMF, 2012), it is also called the liberalization of capital controls in many studies.
The role change of the banking systems While the deregulation of banking systems and financial liberalization have expanded banks’ activities, the liberalization of capital accounts/controls has led to the rapid growth of capital flows, which has, in turn, increased the role of banking systems and provided the banking system more opportunities to involve and to engage in new activities at an international level. The increasing activities involved by the banks have expanded the roles of banks to be not only a middleman and a portfolio manager but also to be a major player in the financial markets. As a major player, the banks would seek maximum profits. This implies that the traditional way to model banks as zero profit is no longer suitable for the modern economy. The policies which draw from the models with zero-profit banks must be revisited. When banks seek to maximize profits, on one hand, the profits of the banks may serve to finance liquidity shortfalls and reduce the probability of bank runs and banking crises. On the other hand, the goal to maximize profits may have the banks overlook/mismanage risks and expose themselves to various credit defaults and global risks. The exposure to global risks would make the banks more vulnerable and sensitive to the shocks and contagion effects and hence increase the probability of bank runs and banking crises. When capital flows are added to the analysis, it is not only the banking system but also the sectors to/from which the flows are injected/withdrawn that would be affected by the fluctuations of capital flows. How the fluctuations would benefit or damage the economy would
