This paper argues that the liberalization of capital inflows in a small open economy with a financial system dominated by banks may provoke a soft budget constraint distortion, because large amounts of funds become available at relatively low cost. International investors internalize the risk of accumulation of losses by the banking system only when the risk premium is sufficiently high so as to determine a positive probability that banks will default. This explains why crises occur when massive losses have already been accumulated. In this context, international investors’ incomplete information about the types of projects financed by the domestic banking system leads to crises with very similar dynamics, even if the banks are only illiquid, because a temporary increase in the cost of funds may drive illiquid banks to insolvency. This mechanism may explain contagion among countries that are equally rated by international investors but that have different investment opportunities. Finally, the implications of different institutional arrangements for financial stability are examined. In particular, the main source of soft-budget constraint problems in emerging markets is the limited number of lenders and boom-bust cycles may arise even if the central bank does not guarantee deposits.
