International Capital Inflows, Domestic Financial Intermediation, and Financial Crises under Imperfect Information

Abstract

A model of financial crises in emerging markets based on problems of agency in financial intermediation is developed. This model generates dynamic relationships between foreign capital inflows, domestic investment and domestic bank debt in an endogenous growth model. As a consequence of loan renegotiation between limited liability banks and firms, financial crises inevitably occur. Banking and currency crises are concurrent events under an exchange rate peg combined with deposit insurance and implicit government guarantees of foreign currency loans. The model links high pre-crisis growth rates, the accumulation of bank debt and increasing concentration of domestic lending and investment to the anticipation of contingent government insurance of private financial transactions. The dynamics of capital inflows and growth before and after a financial crisis are compared to the experience of the Asian crisis countries. We find evidence consistent with this agency model of domestic bank intermediation of foreign capital inflows under exchange rate pegs.