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Bank Risk-Taking in a Small Open Economy

Jorge Pozo
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Jorge Pozo: Banco Central de Reserva del Perú

No 2019-016, Working Papers from Banco Central de Reserva del Perú

Abstract: I develop an open economy model with banks facing foreign borrowing limits. The interaction of banks' limited liability and deposit insurance leads banks into socially excessive risk-taking, which involves credit volume and not the type of credit. The novel result is that, under a realistic calibration, a lower foreign interest rate reduces the excessive bank risk-taking. Since the foreign borrowing limit is binding, this lower rate does not boost banks' credit, but rather decreases it, since for a given capital the lower rate reduces the default probability of banks, which diminishes their risk-taking incentives. Through the same mechanism, a greater access to the international credit markets reduces the excessive risk-taking by banks. Hence, less banking regulation to achieve socially efficient risk-taking is required after a foreign rate reduction and a higher foreign borrowing limit.

Keywords: Macroprudential policies; financial stability; monetary policy and bank risk-taking. (search for similar items in EconPapers)
JEL-codes: E44 E52 F41 G01 G21 G28 (search for similar items in EconPapers)
Date: 2019-12
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-opm
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