Bank-Firm Relationships and Contagious Banking Crises

Abstract

This paper shows that in an open economy a banking system with close bank-firm relationships may be easily subject to contagious banking crises, because it is difficult to distinguish between and main bank relationships. There is cronyism if banks renew loans to insolvent projects and, as a consequence, accumulate losses. On the other hand, banks could be only temporarily illiquid because they lend to projects in temporary difficulties that would be solvent in the long run (main bank relationship). I show that, if international investors cannot distinguish the bank type, the distinction between crony capitalism and main bank relationships becomes very fuzzy. In fact, incomplete information provokes a uniformly low equilibrium interest rate in the aftermath of the liberalization of capital flows, when the lending boom starts, and an apparently sudden increase in the cost of funds, which causes the defaults of insolvent banks. Even if illiquid banks do not default immediately, so revealing that they are not insolvent, the temporary increase in the interest rate burden may drive them to insolvency and make them default after a few periods. This model can explain sequences of bank defaults within a country, even if the insolvent banks were very few ex ante, as well as sequences of banking crises among countries that are equally rated by international investors, but indeed differ in the ex ante solvency of their banking system.