Hedging and financial fragility in fixed exchange rate regimes

Craig Burnside*, Martin Eichenbaum, Sergio Rebelo

*Corresponding author for this work

Research output: Contribution to journalArticle

99 Scopus citations

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 languageEnglish (US)
Pages (from-to)1151-1193
Number of pages43
JournalEuropean Economic Review
Volume45
Issue number7
DOIs
StatePublished - Jun 23 2001

Keywords

  • Fixed exchange rate regimes
  • Government guarantees
  • Hedging

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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