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Liquidity Insurance in a Financially Dollarized Economy

In: Financial Markets Volatility and Performance in Emerging Markets

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  • Eduardo Levy Yeyati

Abstract

Unlike the financial dollarization (FD) of external liabilities, the dollarization of domestic financial assets (domestic FD) has received comparatively less attention until very recently, when it has been increasingly seen as a key source of balance sheet exposure. This paper focuses on a complementary %u2013and often overlooked%u2013 angle of domestic FD: the limit it imposes on the central bank as domestic lender of last resort, and the resulting exposure to dollar liquidity runs. The paper discusses the incidence of FD on banking crisis propensity, shows that FD has been an important motive for self insurance in the form of international reserves, and highlights the moral hazard associated with centralized reserve accumulation. Next, it illustrates the authorities%u2019 belated recourse to suspension of convertibility in two recent banking crises (Argentina 2001 and Uruguay 2002). Finally, it argues for a combined scheme of decentralized reserves (liquid asset requirements on individual banks) to limit moral hazard, and an ex-ante suspension-of-convertibility clause (%u201Ccircuit breakers%u201D) to reduce self-insurance costs while limiting bank losses in the event of a run.

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This chapter was published in:

  • Sebastian Edwards & Márcio G. P. Garcia, 2008. "Financial Markets Volatility and Performance in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number edwa05-1.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 4778.

    Handle: RePEc:nbr:nberch:4778

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    1. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    2. Tito Cordella y Eduardo Levy Yeyati, 2005. "A (New) Country Insurance Facility," Business School Working Papers, Universidad Torcuato Di Tella newcountryins, Universidad Torcuato Di Tella.
    3. Roberto Chang & Andres Velasco, 1997. "Financial fragility and the exchange rate regime," Working Paper, Federal Reserve Bank of Atlanta 97-16, Federal Reserve Bank of Atlanta.
    4. De Nicolo, Gianni & Honohan, Patrick & Ize, Alain, 2003. "Dollarization of the banking system : good or bad?," Policy Research Working Paper Series 3116, The World Bank.
    5. Aizenman, Joshua & LEE, JAEWOO, 2005. "International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence," Santa Cruz Department of Economics, Working Paper Series qt44g3n2j8, Department of Economics, UC Santa Cruz.
    6. Eduardo Levy Yeyati, 2006. "Financial dollarization: evaluating the consequences," Economic Policy, CEPR;CES;MSH, CEPR;CES;MSH, vol. 21(45), pages 61-118, 01.
    7. Rajan, Raghuram G. & Tokatlidis, Ioannis, 2005. "Dollar Shortages and Crises," MPRA Paper 832, University Library of Munich, Germany.
    8. De la Torre, Augusto & Levy Yeyati, Eduardo & Schmukler, Sergio L., 2003. "Living and dying with hard pegs : the rise and fall of Argentina's currency board," Policy Research Working Paper Series 2980, The World Bank.
    9. Shah, Parth J, 1997. " The Option Clause in Free-Banking Theory and History: A Reappraisal," The Review of Austrian Economics, Springer, Springer, vol. 10(2), pages 1-25.
    10. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262033348, December.
    11. Eduardo Levy Yeyati & Tito Cordella, 2004. "Country Insurance," IMF Working Papers 04/148, International Monetary Fund.
    12. Gianni De Nicoló & Patrick Honohan & Alain Ize, 2003. "Dollarization of the Banking System," IMF Working Papers 03/146, International Monetary Fund.
    13. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 11-90, Wharton School Rodney L. White Center for Financial Research.
    14. Carlos O. Arteta, 2003. "Are financially dollarized countries more prone to costly crises?," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 763, Board of Governors of the Federal Reserve System (U.S.).
    15. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries," IMF Working Papers 06/229, International Monetary Fund.
    16. Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, American Finance Association, vol. 58(2), pages 867-894, 04.
    17. Eduardo Levy Yeyati & Alain Ize & Miguel A. Kiguel, 2005. "Managing Systemic Liquidity Risk in Financially Dollarized Economies," IMF Working Papers 05/188, International Monetary Fund.
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