Capital Mobility in a Second Best World - Moral Hazard with Costly Financial Intermediation
UCSC Dept. of Economics Working Paper No. 491
29 Pages Posted: 29 Oct 2001
There are 2 versions of this paper
Capital Mobility in a Second Best World - Moral Hazard with Costly Financial Intermediation
Capital Mobility in a Second Best World -- Moral Hazard with Costly Financial Intermediation
Date Written: May 2001
Abstract
This paper studies financial integration in the presence of moral hazard, where banks may mitigate excessive risk by costly monitoring. We show that a drop in banks' cost of funds, less efficient intermediation technology, higher macroeconomic volatility, and a more generous deposit insurance raise the riskiness of projects in a competitive equilibrium. Overborrowing would arise even in the absence of deposit insurance in circumstances where the cost of risk monitoring is high, the banks' cost of funds is relatively low, and macroeconomic volatility is high. Reforming an inefficient banking system and improving its operation is a precondition for successful financial integration.
JEL Classification: F15, F2, F34
Suggested Citation: Suggested Citation