High Real Interest Rates, Guarantor Risk, and Bank Recapitalizations

Abstract

The author sets out a methodology for analyzing episodes of high real interest rates in emerging market economies. He reviews the literature on what determines spreads in deposit rates and loan rates. Then he links the causes of interest rate spreads by explicitly modeling the incentive effect of a government deposit guarantee on the behavior of depositories, banks, and firms. The premise: begin with accounting identities that decompose the deposit spread and loan spread into several components. The relative importance of the components can be measured to discover the sources of the high real rates. The results suggest that the expected exchange rate depreciation and credit quality of borrowers are among the most important determinants of high real rates. A government guarantee on deposits affects both the deposit and the loan spread by altering marginal incentives. Although high real rates may signal financial distress, standard recapitulation mechanisms may not improve the situation. The behavior of real interest rates depends on the account unit that has been chosen for financial transaction. High real interest rates often occur when an economy is close to widespread debtor default. If high real interest rates are a financial sector distress symptom, then high real rates will incorporate expectations of a breakdown in the government's enforcement of financial contracts, in addition to other factors the author addresses.