Abstract
Currency crises that coincide with banking crises tend to share at least three elements. First, banks have a currency mismatch between their assets and liabilities. Second, banks do not completely hedge the associated exchange rate risk. Third, there are implicit government guarantees to banks and their foreign creditors. This paper argues that the first two features arise from bank's optimal response to government guarantees. We show that guarantees completely eliminate banks' incentives to hedge the risk of a devaluation. Our model also articulates one reason why governments might be tempted to provide guarantees to bank creditors. Guarantees lower the domestic interest rate and lead to a boom in economic activity. But this boom comes at the cost of a more fragile banking system. In the event of a devaluation, banks renege on foreign debts and declare bankruptcy.
Original language | English (US) |
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Pages (from-to) | 1151-1193 |
Number of pages | 43 |
Journal | European Economic Review |
Volume | 45 |
Issue number | 7 |
DOIs | |
State | Published - 2001 |
Funding
We are grateful to Kellogg's Banking Research Center for financial support. Burnside thanks the Hoover Institution for its support through a National Fellowship. We thank Marco Bassetto, Ariel Burstein, Jonathan Eaton, Larry Jones, Leora Klapper, Deborah Lucas, David Marshall, Paolo Pesenti, Rob Vigfusson, an anonymous referee, and seminar participants at Georgetown, Harvard, Hoover, the IMF, the 1999 UTDT Workshop in International Economics and Finance, the Northwestern University Summer Macroeconomics Workshop, and ISOM for useful comments. The opinions in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago or the World Bank.
Keywords
- Fixed exchange rate regimes
- Government guarantees
- Hedging
ASJC Scopus subject areas
- Finance
- Economics and Econometrics