Banking Risk and the Open Economy Trilemma: Insights from a Panel Data Approach

Abstract This paper analyzes the impact of the open-economy trilemma on banking risk. Since no country can fully achieve monetary independence, exchange rate stability, and financial openness simultaneously, most adopt intermediate policy configurations. The study investigates whether a more convergent policy combination, composed of partial financial integration, managed exchange rate flexibility and partial monetary independence, reduces banking risk, and seeks to identify which policies of the trilemma best act to reduce banking risk. To examine the relationship between the trilemma policy choices and banking system stability, the latter represented by the Z-SCORE as an indicator of banking risk, we analyze a dataset covering 92 countries from 2000 to 2019, particularly considering the repercussions of the 2008 GFC. The results indicate that greater monetary policy independence and exchange rate stability reduce banking risk, while higher financial openness and more divergent policy arrangements increase it. This study is the first to examine the relationship between the open-economy trilemma configurations and banking risk. By employing a broad cross-country sample and the trilemma policy divergence index, we provide novel insights into how different policy combinations influence financial stability.