Financial crises and institutional quality

Are financial crises particularly bad for economies, if the institutional quality deteriorates at the onset of crises? Policy responses can mitigate adverse consequences of financial crises. However, implementation and effectiveness of prudent policy actions are in turn dependent on the institutional environment. Using panel data for a large set of countries, I show that a weakening in the institutional quality within the period of a banking crisis is associated with additional output losses, above and beyond the effects of the individual banking crisis and weakening in the institutional quality, which are long lasting. This is not the case for a deterioration in the institutional quality within the periods of debt and currency crises. Finally, I document that additional losses from a deterioration in the institutional quality at the onset of a banking crisis are more pronounced in financially less open economies in which domestic policy actions are potentially more crucial in recovery. These suggest that policymakers should take steps to strengthen the institutional environment to facilitate recovery, especially during the periods of banking distress.