Global Moral Hazard, Capital Account Liberalization and the “Overlending Syndrome”

IMF Working Papers, July 1, 1999

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The removal of government guarantees in borrowing countries does not eliminate the moral hazard problem posed by the existence of deposit guarantees in lender countries.
After restrictions on international capital flows are lifted, banks in low-risk developed countries benefit from lending funds captured in home markets at low deposit rates to high-risk/high-yield projects in emerging economies, even though these projects command lower expected returns.
This behavior has a negative impact on bank profitability in the borrowing country, even when foreign funds are intermediated through domestic banks.
The results are consistent with the surge in international bank lending flows that led to recent banking crises in Asia.

Deposit guarantees in lender countries allow banks in those countries to capture funds at low deposit rates.
These banks then lend to high-risk/high-yield projects in emerging economies after capital account liberalization.
The transferred funds flow into projects that offer higher nominal yields but lower expected returns, creating an incentive misalignment (global moral hazard).
The practice reduces profitability for banks in the borrowing country, regardless of whether lending is direct or intermediated through domestic banks.

Capital account liberalization can trigger cross-border lending behavior that amplifies global moral hazard when lender-country deposit guarantees remain in place.
Removal of government guarantees in borrowing countries alone is insufficient to prevent adverse cross-border incentives created by lender-country deposit insurance.
The pattern of flows and incentives identified is consistent with the international bank lending surge associated with banking crises in Asia.

Subjects: Balance of payments, Banking, Capital account liberalization, Commercial banks, Deposit insurance, Deposit rates, Financial crises, Financial institutions, Financial sector policy and analysis, Financial services, Moral hazard
Keywords: bank profit, bank shareholder, Banking Crises, capital account, Capital Account Liberalization, Commercial banks, Deposit Insurance, Deposit rates, high-yield project, lender bank, loan issue, maximization problem, Moral Hazard, risk profile, WP

Global Moral Hazard, Capital Account Liberalization and the "Overlending Syndrome" - WP/99/100
- Global Moral Hazard, Capital Account Liberalization and the "Overlending Syndrome" - WP/99/100 (Markdown version)
- Global Moral Hazard, Capital Account Liberalization and the "Overlending Syndrome" - WP/99/100 (PDF)