In°ation Risk and Portfolio Allocation in the Banking System

This paper proposes theory and evidence on the relationship between in°ation and the bank's portfolio allocation. The proposed idea rationalized what Rodriguez (1992) pointed out with respect to the Central Bank of Argentina, behaving as a "borrower of ̄rst resort", where banks reallocated their investment from the private sector to government bonds. A main component of in°ation costs is the misallocation of resources, this paper shows a channel through the reallocation of credits, where the credit market for the private sector trend to disappear. Theoretically, this paper studies the behavior of risk-neutral ̄nanciers in a world in which monitoring costs, and limited liability on the part of ̄rms leads to credit rationing equilibria. In light of the well established relation between in°ation and changes in relative prices, the theoretical model rationalizes the relationship between in°ation and the allocation of capital in the banking system. Empirically, it looks at the dynamic behavior of the composition of bank's assets in Argentina between 1983 and 1998, which shows a robust relationship between relative price variability and bank's allocation in government denominated assets.