CAPITAL FLOWS AND BANKING SYSTEM FRAGILITY
Financial intermediation in emerging economies is almost always bank-dominated: that is, the bulk of capital inflows is channeled through the domestic banking system. Concern about the linkages and interactions among domestic financial institutions and foreign investors arises from the fact that they have played a crucial role in most of the key financial events in the developing world during the last several decades. As most of the flows intermediated through the domestic banking system are short run flows dependant on portfolio decisions, their effects on the banking system depend on the factors that affect those decisions. The instability of bank deposits has been studied in the literature, and “contagion” runs have been the main factor identified in banking crises: Uncertainty about the soundness of the banking sector generates a preference for liquidity. Then, the “first-come, first-served” process whereby deposits are paid out to depositors starts a run. Following this same line of thinking, this paper focuses on banking crises stemming from a change in international financial market conditions or from agent fear of a possible devaluation. Whatever the reason for withdrawals, banks face a so-called liquidity risk, the inability to obtain funding to satisfy current obligations. Bank balance sheets show the true nature of this problem.