| In the 1990s, Bolivia embarked upon a process of economic and financial reform after having achieved a sustained period of macroeconomic stability. During the period, the banking sector underwent significant changes as new regulation followed the dramatic growth in financial intermediation. This paper explores whether depositor-based market discipline could play an important role in determining banks' lending behavior and regulatory policy. Using data from Bolivian banks, we study the heterogeneity of deposit interest rates premia and net flows across banks despite the existence of an implicit deposit insurance. We trace this heterogeneity to fundamental attributes of banks (i.e. measures of asset quality and leverage) determining the risk exposure of deposits to the possibility of bank default. To understand depositors' response to banks' financial conditions given the opaque nature of bank asset quality, we develop an private information model of bank asset and liability management. The model helps explain the heterogeneity of deposit interest rates and flows across banks in the context of asymmetric information between depositors and bank insiders in the presence of partial deposit insurance. We show the existence of a separating equilibrium in the market for bank debt where “good” banks incur the opportunity cost of holding a large fraction of low-risk, liquid assets as a mechanism to differentiate themselves from “bad” banks. In return, “good” banks obtain lower financing costs and a higher share of deposit flows. To complement the analysis, we present empirical evidence supporting the presence of adverse selection in the market for bank debt in Bolivia. |
