Short-term debt and international banking crises

After the liberalization of financial markets in the 1980s many developing countries experienced large amount of foreign capital inflows, in particular, in the term of short-term debts. In the Asian countries, many economists believe that this kind of short-term debts is one of the major causes for the Asian financial crises that happened in the late 1990s. Thus, the Asian financial crises called into question the role of foreign short-term debts in the banks’ liquidity situation. The first essay explores how a bank run can occur when a bank takes into account short-term capital inflow from abroad. In the model, it is more efficient to meet short term liquidity needs this way than by holding liquid domestic assets; therefore, the bank’s portfolio at the beginning of the period will be more illiquid than in the baseline closed economy case. However, this illiquidity makes the domestic banks extremely vulnerable to bank runs. More interestingly, the cause of a domestic bank run in this model is the pessimistic expectations of the foreign investors regarding other foreigners’ willingness to lend. I show conditions under which a “bad” equilibrium exists in which pessimistic foreign investors withhold their investments making a bank run the equilibrium strategy for domestic agents and making those viii expectations self-fulfilling. The second essay extends the analysis to study on optimal contracts. In this essay I investigate a mechanism design question: What should be the optimal contract in the presence of the possibility of a sunspot-triggered bank runs? With a specific CRRA utility function, I find that the equilibrium of the model never involves bank runs with positive probability. Even if foreign lenders anticipated a bank run with positive probability and charged a correspondingly higher interest rate, it would be optimal for the domestic bank to write a contract and make a portfolio plan that avoids runs. In the third essay, I examines the effects of monetary policy in Korea. The model takes into account the openness of the economy and the structural break in monetary policy that occurred in Korea after the 1997 financial crisis, which is important for the Korean economic situation of recent periods. The principal finding in this paper is that the CD rate is most significant instrument, as the consequences are consistent with expectations of monetary policy.Economic