Bank risk-taking in emerging economies: Empirical evidence and theory

This article empirically studies the impact of foreign shocks on bank risk-taking in emerging economies. We use a country panel model for the 2001–2017 period. Using several measures of bank risk-taking, financial openness and foreign debt participation, we find if anything that the lower the financial openness in an economy, the higher the likelihood that the foreign monetary policy rate increases bank risk-taking and that the foreign debt participation reduces bank risk-taking. To provide an intuition of these results, we develop a simple small open economy model with banks facing foreign borrowing limits and taking excessive risk. The novel result is that, when the foreign borrowing limit binds, a lower foreign interest rate reduces excessive bank risk-taking. Since the foreign borrowing limit binds, the lower foreign rate does not boost bank credit but reduces bank default probability, which diminishes bank incentives to take excessive risk. Similarly, greater access to the international credit markets reduces excessive bank risk-taking.