Banks and Capital Inflows
AbstractThis paper examines the effects that capital inflows have on the financial system in a Diamond-Dybvig environment. Here, an adverse-selection problem arises where short-term capital has the incentive to enter the domestic banking system while long-term capital chooses to stay out. Then, short-term capital flows limit the insurance function of banks. As short-term inflows increase, a threshold is reached beyond which it becomes optimal to restrict capital inflows. In addition, if the quantity of inflows is unknown, a banking crisis may occur as short-term inflows become large. In spite of this, restricting capital inflows may not be optimal at all times, since the cost of doing so may be greater than the detriment of allowing them in. My model is a two asset, open economy version of Diamond and Dybvig, where two types of agents are introduced. Agents are either domestic or foreign depositors. They have access to the same savings and production technologies, and share the same preferences, but differ only in the time they learn their idiosyncratic withdrawal demand. Domestic agents are the standard Diamond-Dybvig agent in the sense that they are uncertain about their liquidity needs at the time they deposit their endowments in banks. Foreign agents, on the other hand, know their liquidity preference at the time they are born. This paper then examines the effect that foreign agents have on entering the demand deposit contract offered by domestic banks. Banks arise endogenously in this environment as a coalition of domestic agents to provide two services. They provide insurance among ex-ante identical agents who need to consume at different times, and they prevent suboptimal liquidation of assets. However, when banks are not able to distinguish domestic from foreign deposits, an adverse-selection problem arises. That is, short-term inflows have the incentive to join the financial system while long-term capital does not. Further, as short-term capital flows in, a moral hazard problem emerges, where foreigners exploit the bank's service of liquidity provision at the expense of domestic depositors. Implementing a self-selection constraint in this case fully thwarts liquidity provision, and thus may or may not be preferred, depending on the relative size of short-term flows. In addition, if the quantity of capital inflows is unknown, then for sufficiently large short-term flows, a banking crisis occurs. In this case, both services banks provide, liquidity provision and prevention of costly liquidation, are lost. A constraint that produces a separating contract will prevent banking crises. In spite of this, preventing crises by restricting capital flows may not be optimal at all times, since the cost of doing so may be greater than the expected loss in allowing crises to occur with positive probability.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society 2004 Latin American Meetings with number 272.
Date of creation: 11 Aug 2004
Date of revision:
Contact details of provider:
Phone: 1 212 998 3820
Fax: 1 212 995 4487
Web page: http://www.econometricsociety.org/pastmeetings.asp
More information through EDIRC
Financial Intermediation; Banking Crises; Capital Flows; Insurance Function of Banks;
Find related papers by JEL classification:
- D92 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Firm Choice and Growth, Financing, Investment, and Capacity
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-08-16 (All new papers)
- NEP-IFN-2004-08-16 (International Finance)
- NEP-MON-2004-08-16 (Monetary Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Roberto Chang & Andres Velasco, 1998. "Financial Crises in Emerging Markets," NBER Working Papers 6606, National Bureau of Economic Research, Inc.
- Bruce D. Smith, 2002. "Monetary Policy, Banking Crises, and the Friedman Rule," American Economic Review, American Economic Association, vol. 92(2), pages 128-134, May.
- Bencivenga, V.R. & Smith, B.D., 1988.
"Financial Intermediation And Endogenous Growth,"
RCER Working Papers
124, University of Rochester - Center for Economic Research (RCER).
- Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
- Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996.
"Currency Elasticity and Banking Panics: Theory and Evidence,"
Canadian Journal of Economics,
Canadian Economics Association, vol. 29(4), pages 828-64, November.
- Champ, B. & Smith, B.D., 1991. "Currency Elasticity and Banking Panics: theory and Evidence," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9109, University of Western Ontario, The Centre for the Study of International Economic Relations.
- Champ, B. & Snith, B.D. & Williamson, D.S., 1991. "Currency Elasticity and Banking Panics: Theory and Evidence," RCER Working Papers 292, University of Rochester - Center for Economic Research (RCER).
- Jacklin, Charles J., 1993. "Market rate versus fixed rate demand deposits," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 237-258, November.
- von Thadden, Ernst-Ludwig, 1997.
"The term-structure of investment and the banks' insurance function,"
European Economic Review,
Elsevier, vol. 41(7), pages 1355-1374, July.
- Ernst-Ludwig VON THADDEN, 1996. "The Term-Structure of Investment and the Banks' Insurance Function," Cahiers de Recherches Economiques du DÃ©partement d'EconomÃ©trie et d'Economie politique (DEEP) 9606, Université de Lausanne, Faculté des HEC, DEEP.
- Diamond, Douglas W & Dybvig, Philip H, 1983.
"Bank Runs, Deposit Insurance, and Liquidity,"
Journal of Political Economy,
University of Chicago Press, vol. 91(3), pages 401-19, June.
- Roberto Chang & Andrés Velasco, 2001. "A Model Of Financial Crises In Emerging Markets," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 489-517, May.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If references are entirely missing, you can add them using this form.