Financial Liberalization and Banking Crises: The Role of Capital Inflows and Lack of Transparency

Financial Liberalization and Banking Crises: The Role of Capital Inflows and Lack of Transparency

Mariassunta Giannetti

Series number :

Serial Number: 
109/2005

Date posted :

December 01 2005

Last revised :

October 30 2018
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Keywords

  • Banking crises • 
  • Capital inflows • 
  • Transparency • 
  • capital requirements

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.

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