Capital Flows, Institutions, and Financial Fragility

This paper studies how international capital flows are transmitted from the banking sector to the real sector in a bank-based open economy. The analysis centers on the role of institutions and domestic policies in reducing moral hazard problems and on determining the net benefit of international capital flows to a country. We develop a model that incorporates market imperfections (e.g., moral hazard problems) at the bank, corporate and international levels. The three layers of problems and international capital flows reinforce one another to amplify the boom-bust cycle. We calibrate the model using data from Thailand because Thailand experienced a financial crisis in 1997-1998 and subsequently undertook major policy reforms specifically designed to strengthen its financial institutions and system. The results from the estimation suggest that institutional reforms can be successful at alleviating some moral hazard problems. Specifically, improvements in banking supervision and foreign investors' risk estimation substantially reduces bailout costs and output losses. In contrast, austerity measures hurt, rather than help, the economy since the cost from the overall output decline outweighs the benefit from the lower bailout costs. These findings provide specific recommendations to policy makers considering financial reforms in the wake of the recent global debt crisis