Hot Money Inflows and Bank Risk-Taking: Germany from the 1920s to the Great Depression

What is the impact of hot capital inflows on bank risk-taking? In an increasingly financially globalised world this question becomes especially relevant. However few authors have examined it in detail empirically, despite repeated crises in Latin America, East Asia and the Eurozone from the 1980s to the 2010s. In this paper, we collect individual bank data on one of history’s most striking examples of a “supply push†in foreign funds: the great inflow of capital from the developed world to Germany in the second half of the 1920s. Bank by bank we examine its effects on decisions related to leverage, lending and liquidity. The specificities of the time period – the Dawes Plan of 1924 as well as the relative absence of a Too-Big-to-Fail environment, which we document through extensive historiographical analysis – allow us to mitigate endogeneity concerns. We develop a three-step approach in which we run panel regressions including only months of falling interest-rate spreads, and apply a two-stage least-squares model in which initial bank size is used as an instrument. In all our models our results tend to converge: while capital inflows did not seem to impact banks’ liquidity decisions, their impact on leverage was non-negligeable. This paper’s results thus call for extra prudential oversight whenever cross-border banking flows increase significantly.