Banking System, International Investors and Central Bank Policy

Abstract

This paper studies the lending process in financial systems dominated by banks and examines the role of expectations and fundamentals in explaining banking and balance-of-payments crises. The excessive credit expansion to unprofitable projects that often follows the liberalization of capital movements is explained by a "soft budget constraint distortion", due to the large availability of funds at low cost in the early phase of the financial liberalization. Insolvent banks default when the interest rate at which international investors offer deposits becomes so high that it is no longer convenient to renew loans to insolvent projects. In this case, the central bank intervenes printing money and validates international investors' expectations of depreciation, which made the cost of funds rise. However, incomplete information about the type of projects financed by the banking system may lead to crises with very similar dynamics, even if banks are just illiquid, because a temporary increase in the cost of funds may drive illiquid banks to insolvency. This mechanism explains contagion among countries that are equally rated by international investors, but have different investment opportunities. Finally, the implications of different institutional arrangements for financial stability are taken into account. In particular, I find that the main source of soft-budget constraint problems in emerging markets is the lack of lenders and that this problem may arise, even if the central bank does not offer guarantees on deposits.

JEL Classification: F34, F42, G21, E44