The impact of financial liberalization on financial instability is theoretically ambiguous. By including financial liberalization policies in a standard model of the loan market with asymmetric information, this article identifies the entry of risky entrepreneurs and decreased borrowing costs as two channels by which financial instability exerts an impact. A new data set, covering 85 countries during 2000-2009, provides proxies for the financial instability of impaired bank loans. Using an existing measure of financial liberalization, this investigation finds that more liberalized countries experienced a steeper increase in impaired loans after the 2008 global financial crisis. These findings have several research and policy implications.
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