Financial liberalizations in emerging markets are often followed by reckless lending and severe banking crises. The identification of the causes of banks’ behavior is often difficult because financial liberalizations entail several contemporaneous changes. Competition in the banking sector increases, and, at the same time, the liberalization of the current account allows capital inflows.

The existing literature has mainly stressed the first of these changes: Among others, Hellmann et al. (2000) and Allen and Gale (2000) have analyzed how competition affects banks’ incentives to risk-taking. The argument goes as follows: Competition in the market for deposits increases banks’ cost of funds and gives an incentive to select riskier projects (to shift risk on depositors).