Global Moral Hazard, Capital Account Liberalization and the 'Overlending Syndrome'

Because of deposit insurance, banks maximize the value of the option implicit in the deposit contract by investing in high-yield high-risk projects. In the presence of barriers to international capital flows, low risk developed countries are associated with narrow intermediation margins and low deposit rates. After a relaxation of restrictions on international lending, banks in low-risk developed countries benefit from investing funds captured in home markets at low deposit rates, in higher risk projects in emerging economies, even if these projects command lower expected returns. The associated credit expansion, in turn, has a negative impact on investment returns and bank profitability in the borrowing country, even when foreign funds are intermediated through domestic banks. In this context, expectations of a financial rescue not only further stimulate international lending, but may also discriminate in favor of foreign banks. The results provide an alternative explanation for the expansion in international bank lending to emerging economies during the 1990s, its resilience to the Mexican crisis of December 1994, and its adverse impact on banking sector fragility in recepient countries