The recent decline in commodity prices, especially for oil, has revived once again interest in their economic impact. Most commodities prices have declined by about 50 percent between mid-2014 and mid-2015, leading to significant losses in export earnings for commodity exporters.

While commodity markets may be undergoing a transition to an era of low prices, such a sharp decline is not unprecedented. The large occurrence of commodity price shocks has led to a large number of studies analyzing the impact of lower commodity prices on various variables such as economic growth, debt, conflict, etc.

Adverse commodity price shocks can also contribute to financial fragility through various channels. First, a decline in commodity prices in commodity-dependent countries results in reduced export income, which could adversely impact economic activity and agents’ (including governments) ability to meet their debt obligations, thereby potentially weakening banks’ balance sheets. Second, a surge in bank withdrawals following a drop in commodity prices may significantly reduce banks’ liquidity and potentially lead to a liquidity mismatch. . If large enough, commodity price shocks can also adversely affect bank balance sheets by weighing on international reserves and increasing the risk of currency mismatches. Third, a decline in commodity prices can reduce commodity exporters’ fiscal performance (by lowering revenue), which in turn may push government to adjust their budgets to accommodate revenue shortfalls. Often this can happen in a disorderly manner through the accumulation of payment arrears to suppliers and contractors, who in turn are unable to adequately service their bank loans.

However, the literature lacks a systematic empirical analysis of the impact of negative commodity price shocks on the financial sector. The lack of evidence could be due to the lack of data on developing countries and the imprecise definition of the financial fragility, which is difficult to quantify.

Financial fragility can be defined as the increased likelihood of a systemic failure in the financial system, for which the most obvious indicator would be a systemic banking crisis. A less dramatic definition of financial fragility could capture the sensitivity of the financial system to relatively small shocks.

That said, the corresponding indicator(s) would be relatively more complex and not obvious to construct. The closest existing empirical analysis in the literature examines the impact of terms of trade shocks on the occurrence of banking crises. The lack of empirical evidence is rather surprising given the growing awareness of financial stability issues in many countries, and the close link between commodity markets and the financial sector.

Using a large sample of commodity exporters among developing economies, this paper highlights that negative commodity price shocks tend to weaken the financial sector and can lead to banking crises. The paper attempts to fill a gap in the empirical literature by analyzing the impact of adverse commodity price shocks on the fragility of the financial sector and has three main findings.

First, negative shocks to commodity prices tend to weaken the financial sector and increase the probability of banking crises, with larger shocks having more pronounced impact. More specifically, negative commodity price shocks increase nonperforming loans and bank costs, reduce the provisions to non-performing loans and bank profits (return on assets and return on equity).

Second, these detrimental effects are more common in countries with poor quality of governance, high public debt, and low financial development but are less common in countries under IMF-supported programs, holding sovereign wealth funds (SWF), implementing macro-prudential policies, and with a diversified export base.

Third, GDP growth, fiscal performance (fiscal deficit and government revenue), savings, and debt in foreign currency are the main transmission channels of commodity price shocks to the financial sector.