This paper examines the effects that capital inflows have on the financial system in a Diamond-Dybvig environment. Here, an adverse-selection problem arises where short-term capital has the incentive to enter the domestic banking system while long-term capital chooses to stay out. Then, short-term capital flows limit the insurance function of banks. As short-term inflows increase, a threshold is reached beyond which it becomes optimal to restrict capital inflows. In addition, if the quantity of inflows is unknown, a banking crisis may occur as short-term inflows become large. In spite of this, restricting capital inflows may not be optimal at all times, since the cost of doing so may be greater than the detriment of allowing them in. My model is a two asset, open economy version of Diamond and Dybvig, where two types of agents are introduced. Agents are either domestic or foreign depositors. They have access to the same savings and production technologies, and share the same preferences, but differ only in the time they learn their idiosyncratic withdrawal demand. Domestic agents are the standard Diamond-Dybvig agent in the sense that they are uncertain about their liquidity needs at the time they deposit their endowments in banks. Foreign agents, on the other hand, know their liquidity preference at the time they are born. This paper then examines the effect that foreign agents have on entering the demand deposit contract offered by domestic banks. Banks arise endogenously in this environment as a coalition of domestic agents to provide two services. They provide insurance among ex-ante identical agents who need to consume at different times, and they prevent suboptimal liquidation of assets. However, when banks are not able to distinguish domestic from foreign deposits, an adverse-selection problem arises. That is, short-term inflows have the incentive to join the financial system while long-term capital does not. Further, as short-term capital flows in, a moral hazard problem emerges, where foreigners exploit the bank's service of liquidity provision at the expense of domestic depositors. Implementing a self-selection constraint in this case fully thwarts liquidity provision, and thus may or may not be preferred, depending on the relative size of short-term flows. In addition, if the quantity of capital inflows is unknown, then for sufficiently large short-term flows, a banking crisis occurs. In this case, both services banks provide, liquidity provision and prevention of costly liquidation, are lost. A constraint that produces a separating contract will prevent banking crises. In spite of this, preventing crises by restricting capital flows may not be optimal at all times, since the cost of doing so may be greater than the expected loss in allowing crises to occur with positive probability.
