Financial deregulation, while beneficial in the long-term, seems to be linked to instability. Intense competition for deposits appears to be an ingredient in instability. We examine the aftermath of deregulation in Croatia, which included rapid growth of both deposits and deposit interest rates, followed by numerous bank failures. Using panel regression techniques, we find evidence of “market-stealing” via high deposit interest rates. We connect high deposit interest rates to bank failure using logit models. High deposit interest rates were a reliable signal of risk-taking. When supervisory capabilities and powers are weak, deposit interest rate regulation may be worth considering.

Recent research connects lending booms with increased risks of banking and currency crisis. Another strand of literature connects financial deepening with long-term growth. Together, these findings pose dilemmas for policymakers. In the case of Croatia, we find that rapid loan growth increased the probability of credit quality deterioration and stimulated current account and foreign debt problems. Conventional monetary tightening was not very effective, due to capital inflows. Unconventional measures such as capital controls also had limited effectiveness. We propose limiting negative impacts by pro-active monetary policy, more restrictive fiscal policy and increased capital requirements for fast-growing banks, rather than measures to prevent lending booms ex-ante.