Working Paper: CEPR ID: DP4055
Authors: Mariassunta Giannetti
Abstract: Conventional wisdom holds that overlending problems and banking crises in open economies are provoked by investor moral hazard, which is caused in turn by guarantees on deposits. This Paper shows that this is not necessarily the case: guarantees on deposits may even limit the losses banks accumulate. In the model, banks may rationally accumulate bad loans if international investors have incomplete information on firm profitability and initially provide funds at low cost. In equilibrium, international investors rationally require a risk premium and banks stop renewing bad loans, only when a substantial amount of losses has been accumulated. This feature of the equilibrium does not depend on whether or not there are guarantees on deposits. Transparency and bond market development can eliminate overlending problems and prevent banking crises.
Keywords: bank-firm relationships; banking crises; bond markets; guarantees on deposits; transparency
JEL Codes: F34; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| guarantees on deposits (G28) | accumulation of bad loans (G21) |
| incomplete information (D89) | investor behavior (G41) |
| investor behavior (G41) | risk premium (G19) |
| risk premium (G19) | accumulation of bad loans (G21) |
| guarantees on deposits (G28) | moral hazard (G52) |
| transparency and bond market development (G10) | overlending problems (F65) |