Prudential Capital Controls and Risk Misallocation: Bank Lending Channel

I identify a novel impact of managing capital flows in emerging markets: Prudential capital controls encourage domestic firms to take more dollar liabilities. This occurs because banks in emerging markets have a fundamental risk problem: households save partially in dollars while firms borrow in local currency. Absent capital controls, banks hedge the associated currency risk with foreign investors. When capital controls are present, banks respond by lending in dollars to domestic firms. I exploit heterogeneity in the strictness of capital controls across Peruvian banks to provide causal evidence of this mechanism and show that it has sizable effects on employment.