Bank governance, bank runs and the effectiveness of

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

depend on the directions of the flows, which may magnify or offset the contagion effects originated domestically and/or overseas. Therefore, it has become more important and urgent to understand better how the economy is affected by the deregulation of the banking system and the liberalization of capital flows if one wishes related policies implemented/liberalized to do a better job to stop the economy from bleeding or to divert the economy from crises instead of worsening the economy. This is why the analysis in this book will discuss the cases with and without capital flows as well as having a separate chapter (Chapter 5) to discuss bank governance.

The banking system without capital flows has its own inherent problems. As well, as documented by current banking literature, liquidity shortfalls are one of the key problems of the banking system. When the liquidity problems are not resolved in time, bank insolvency and bank runs are inevitable. The causes of liquidity shortfalls vary in different cases, situations and countries. The causes include the mismatch of maturity [Tirole (2002, chapter 2)] and the panic of creditors [Diamond and Dybvig (1983)], as well as risk-taking behaviours of the banks [Calomiris (2009)]. Note that the implicitly assumed zero-profit banks in the traditional literature have left the banks little space to absorb shocks and increased the possibility of bank runs. This assumption has been severely criticized. The bank runs would then interrupt the financial and other economic activities and drive the economy into crises and recessions. To prevent bank runs and their associated crises and recessions, central banks and international organizations, such as the International Monetary Fund (IMF), have provided shortterm lending facilities to resolve the liquidity problems of banks. Despite various sources of liquidity provision, bank runs and banking crises continue to occur, as shown in the most recent crises. When more countries experience bank runs and banking crises which require liquidity provision to be in place, the promise of the IMF to provide lending has in turn threatened the financial positions of many central banks and the IMF. Does it mean that liquidity provision is insufficient in preventing banking crises? If so, what more can be done to prevent bank runs and crises? It is also one of the goals of the book to address these questions by modelling profit-maximizing banks to identify the circumstances in which liquidity provision would be effective or ineffective.

The format and the impacts of capital controls

To limit the exposure to global risks without restoring bank regulations, capital controls have been popularly adopted as macro-prudential policies. Capital controls aim to restrict flows and can be implemented in various ways and formats. However, the impacts of controls are not limited to flows but also to the sectors connecting to the flows. Unfortunately, the associated impacts on the connecting sectors by capital controls are not always desirable. Depending on the ways and formats of capital controls as well as economic conditions, capital controls would affect the economy through various channels. Therefore, it is important to be cautious when assessing the real impacts of capital controls by conducting