The policy implication of our analysis is clear: if the presence of shortterm debt increases vulnerability, then policies to avoid short-term debt must reduce it. In particular, imagine that the domestic authorities required that all foreign borrowing by the bank were no less than two periods in maturity itat on.
Then, the optimal response by the bank would be to borrow the full / dollars in period 0, while holding b dollars of “reserves.” Under this arrangement the bank would not be vulnerable to creditor panic, because in period 1 it has no short term debt to roll over. Hence, the policy of banning short-term borrowing abroad is all gain and no pain.
The size of capital inflows
How does the gap between demandable debt in period 1 and total liquid resources in period 1 change with the amount of credit available from the rest of the world? Is is true in this model that “larger” capital inflows aggravate bank fragility? Is this effect also a function of the maturity of the capital inflows?
There is a basic sense in which financial vulnerability is a function of the size of the credit limit /, and hence of the size of the total inflows. Consider the case of a run on short-term external debt considered in the preceding subsection. Such an outcome can only take place if indeed the bank is a debtor and not a creditor in period 1. A bit of algebra readily shows that d is given bv
Notice, however, that a larger / can make a crisis possible (in the sense that it can make z+++ change from negative to positive) only when the bank contracts short term debt in period 0. But in the cases of only long-term debt, the size of / cannot affect the vulnerability to a crisis (that is, it cannot make or z++ change sign.) In this sense, it is not simply the ready availability of foreign loans that poses a danger, but a large loan volume contracted at short maturities.
This conclusion fits well with the finding by Sachs, Tornell and Velasco (1996b) that the maturity of capital inflows was a helpful predictor of vulnerability to the Tequila effect, while the size of those inflows was not. Notice also that if capital controls lengthen average maturity but do not affect loan volumes, as Valdes-Prieto and Soto (1996) and Cardenas and Barrera (1997) find they do, then such policies are effective in reducing vulnerability.