Financial Liberalization and Banking Crises: The Role of Capital Inflows and Lack of Transparency
51 Pages Posted: 9 Dec 2005 Last revised: 31 Oct 2018
Date Written: December 1, 2005
This paper shows that the liberalization of capital inflows may undermine bank stability in emerging markets. After financial liberalization, uninformed international investors rationally provide large amounts of funds at low cost. This enables insolvent banks to accumulate bad loans. In equilibrium, when a substantial amount of losses may have been accumulated, solvent banks do not find it any longer optimal to issue debt at the interest rate that would compensate investors for risk. Investors anticipate this and stop holding bank debt. When the market for bank liabilities breaks down, insolvent banks default. I show that, because of wasteful investment, the liberalization of capital inflows may decrease aggregate welfare.
Keywords: Banking crises, Capital inflows, Transparency, Capital requirements
JEL Classification: G21, G28, F34
Suggested Citation: Suggested Citation