As expected, domestic factors play a critical role in determining whether an individual country enters into crisis. High levels of foreign and short-term debt, an earlier period of rapid domestic credit growth (measured as the change in domestic credit to GDP ratios over the previous five years), low levels of international reserves, and an overvaluation of the real exchange rate all increase the of risk of banking crises.

Figure 11 reports the estimated sensitivity of banking crises to the different variables identified in the econometric work. It shows the absolute value of the relative importance of each identified factor in contributing to an increase or decrease in the likelihood of a crisis.<sup>8</sup>

# **Box 6  The banking-crisis regression model**

The probability that a country will suffer a banking crisis is modeled as a function of global factors, contagion factors, and domestic factors. To assess the role of all three sets of factors on the likelihood of a crisis in a given developing country, a pooled probit model is estimated (see annex 4 for a detailed description).

The modeling work focuses on banking crises in developing countries using crisis data developed by Laeven and Valencia (2012) because the determinants of banking causes in developing countries may be distinct from those of high-income countries (Eichengreen, Rose, and Wyplosz 1996, Eichengreen and Rose 1998, Eichengreen and Arteta 2000). To avoid sample selection problems, explanatory data for the 67 developing countries that did not have a banking crisis are added to the 95 developing countries in the Laeven and Valencia data set, all of which had a banking crisis during the sample period. Observations for the three years following a crisis are dropped from the panel, so that the explanatory power of domestic factors that may have triggered a crisis are not diminished by inclusion of their post-crisis period when the binary crisis variable would be zero. All explanatory variables except global factors are entered with a one period lag in order to minimize endogeneity problems.

# **Global factors**

Seven measures of global effects were tested for the model: global risk appetite, global interest rates, global growth, global liquidity, global bank leverage, and global commodity prices. Global risk appetite was measured by the Chicago Board of Trade Volatility Index (VXO), a measure commonly used to capture risk appetite in the global financial markets. Global growth is measured by the first principal component of real GDP growth in the Euro Area, Japan, United Kingdom, and the United States. Global liquidity is proxied by M2 as a share of GDP in the United States. Global interest rates are measured by the first principal components of rates on long-term government bonds in Germany, Japan, United Kingdom, and the United States. Global commodity prices are measured by the agricultural commodity index and energy commodity index.

# **Contagion factors**

Following Forbes and Warnock (2012) and IMF (2013a), but giving precedence to variables that allowed for a wider country coverage, four variables were included to capture contagion effects: trade openness, trade linkage, financial linkage, and regional contagion. Trade openness is measured by a country’s trade with the rest of the world scaled by its GDP. Trade linkage is defined as the bilateral trade volume between two countries (scaled by each country’s total trade with the rest of the world) and multiplied by an indicator variable defined as equal to 1 if the trading partner is experiencing a banking crisis, and to 0 otherwise. Financial linkage is defined as the total bank claims between a country and BIS reporting banks scaled by GDP to capture the country’s degree of integration with the global financial markets and hence exposure to financial contagion. Regional contagion is defined as the number of countries in the same region experiencing a banking crisis.

# **Domestic factors**

Ten separate variables were considered to capture country-specific factors: current account and fiscal balance, total 8 More specifically, the figure shows the estimated impact of one standard-deviation shock to each variable on the external debt and a share of short term debt, domestic credit growth, inflation, per capita GDP growth, ratio of M2 to predicted risk of banking crisis. Using the absolute value of coefficient facilitates comparison of relative importance of reserves, ratio of reserves to imports, and a measure of real exchange rate overvaluation. The definition of each variables in influencing the predicted risk. See Chuhan, Classens, and Mamingi (1998) and IMF (2013a) for applications variable is shown in Table A4.2 in the annex 4.

of similar approaches.

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