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Learning from History: Volatility and Financial Crises

Jon Danielsson, Marcela Valenzuela and Ilknur Zer

This version: October 2017
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Abstract

We study the effects of stock market volatility on financial crises by constructing a cross-country database spanning up to 211 years and 60 countries. Prolonged periods of low volatility have strong in-sample and out-of sample predictive power over the incidence of banking crises and can be used as a reliable crisis indicator. Neither the level of volatility nor high volatility predicts crises. Low volatility leads to excessive credit build-ups and balance sheet leverage in the financial system indicating that agents take more risk in periods of low risk, supporting the dictum that “stability is destabilizing.”