This paper aims to investigate whether stock markets can reduce the output costs of banking crises. The work is motivated by Alan Greenspan’s claim that capital markets serve as a financial “spare tire” in the event of a banking crisis.
We test the impact of stock market capitalization, liquidity and turnover on the output losses of 76 banking crises in 66 countries over the period of 1975-2008.
Our results indicate that stock markets can mitigate the effect of banking crises on economic activity. There is also some evidence that foreign equity holdings lower output costs.
These results suggest that the development of equity markets will contribute to reducing the costs of banking crises. Such development, however, should be accompanied by adequate supervisory and regulatory oversight.
Our analysis is the first direct empirical investigation of the impact of stock markets on the output costs of banking crises. This paper demonstrates that equity markets can lessen the severity of such crises.
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