Fixed Exchange Rates and Banking Crises: When Does the Former Prevent the Latter?

Because monetary policy is constrained in fixed exchange rate regimes, banks should expect fewer money-financed bailouts and therefore manage their risks more carefully when exchange rates are fixed than when they are flexible. It follows that we should observe fewer banking crises in countries with formal currency pegs. The 1990s however are littered with occurrences of banking crises in countries with fixed exchange rates. This paper asks whether banks in those countries could have adopted excess risk expecting money-financed bailouts or whether their pegs discouraged such moral hazard-type risks. Copyright 2009 The Author Journal compilation 2009 Banca Monte dei Paschi di Siena SpA.