Discussion Paper Details

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Title: On the Causes of Overlending: Are Guarantees on Deposits the Culprit?

Author(s): Mariassunta Giannetti

Publication Date: September 2003

Keyword(s): bank-firm relationships, banking crises, bond markets, guarantees on deposits and transparency

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: Conventional wisdom holds that overlending problems and banking crises in open economies are provoked by investor moral hazard, which is caused in turn by guarantees on deposits. This Paper shows that this is not necessarily the case: guarantees on deposits may even limit the losses banks accumulate. In the model, banks may rationally accumulate bad loans if international investors have incomplete information on firm profitability and initially provide funds at low cost. In equilibrium, international investors rationally require a risk premium and banks stop renewing bad loans, only when a substantial amount of losses has been accumulated. This feature of the equilibrium does not depend on whether or not there are guarantees on deposits. Transparency and bond market development can eliminate overlending problems and prevent banking crises.

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Bibliographic Reference

Giannetti, M. 2003. 'On the Causes of Overlending: Are Guarantees on Deposits the Culprit?'. London, Centre for Economic Policy Research.