Hedging and financial fragility in fixed exchange rate regimes

Currency crises that coincide with banking crises tend to share at least th ree elements. First, banks have a currency mismatch between their assets an d liabilities. Second, banks do not completely hedge the associated exchang e rate risk. Third, there are implicit government guarantees to banks and t heir foreign creditors. This paper argues that the first two features arise from banks' optimal response to government guarantees. We show that guaran tees completely eliminate banks' incentives to hedge the risk of a devaluat ion. Our model also articulates one reason why governments might be tempted to provide guarantees to bank creditors. Guarantees lower the domestic int erest 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, b anks renege on foreign debts and declare bankruptcy. (C) 2001 Elsevier Scie nce B.V. All rights reserved.