Working Paper No. 43
By Prasanna Gai
This paper develops an information based theory of international bank lending that is compatible with the LDC debt story of the 1970s and 1980s and emphasises the importance of market structure as a factor contributing to financial crises. A feature of the market for sovereign loans, hitherto neglected, has been the leadership role played by a small group of major international "money-centre" banks and their subsequent influence over a much larger grouping of smaller, "regional" banks. Lending behaviour amongst such creditor heterogeneity is captured using a signalling model that takes into account the in complete information environment created by sovereign risk. Our main finding is that the "herd-like" behaviour of the late 70s and early 80s may have, in part, been generated by large money-centre banks seeking to capitalise on their ability to influence the inferences and actions of their smaller rivals'.