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Endogenous deposit dollarization

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  • Christian Broda
  • Eduardo Levy Yeyati

Abstract

This paper explores sources of deposit dollarization unrelated to standard moral hazard arguments. We develop a model in which banks choose the optimal currency composition of their liabilities. We argue that the equal treatment of peso and dollar claims in the event of bank default can induce banks to attract dollar deposits above the socially desirable level. The distortion arises because dollar deposits are the only source of default risk in the model, but dollar depositors share the burden of the default with peso depositors. The incentive to dollarize is reinforced by common banking system safety nets such as deposit and bank insurance. Our findings suggest that regulators in bi-currency economies would potentially benefit by departing from the currency-blind benchmark and differentiating among currencies in a way that prevents undesirable currency mismatches.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 160.

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Date of creation: 2003
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Handle: RePEc:fip:fednsr:160

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Keywords: Bank deposits ; Foreign exchange ; Currency convertibility;

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  1. Obstfeld, Maurice, 1998. "The Global Capital Market: Benefactor or Menace?," Center for International and Development Economics Research, Working Paper Series qt3kn3n2s8, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  2. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1998. "Prospective Deficits and the Asian Currency Crisis," NBER Working Papers 6758, National Bureau of Economic Research, Inc.
  3. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 2001. "Hedging and financial fragility in fixed exchange rate regimes," European Economic Review, Elsevier, vol. 45(7), pages 1151-1193.
  4. Michael P. Dooley, 1997. "A Model of Crises in Emerging Markets," NBER Working Papers 6300, National Bureau of Economic Research, Inc.
  5. Thomas, Lee R, 1985. "Portfolio Theory and Currency Substitution," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 17(3), pages 347-57, August.
  6. Sahay, Ratna & Vegh, Carlos, 1995. "Dollarization in transition economies: Evidence and policy implications," MPRA Paper 20490, University Library of Munich, Germany.
  7. Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
  8. Martin Uribe, 1995. "Hysteresis in a simple model of currency substitution," International Finance Discussion Papers 509, Board of Governors of the Federal Reserve System (U.S.).
  9. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
  10. Adam Bennett & Eduardo Borensztein & Tomás J. T. Baliño, 1999. "Monetary Policy in Dollarized Economies," IMF Occasional Papers 171, International Monetary Fund.
  11. G. G. Garcia, 1999. "Deposit Insurance," IMF Working Papers 99/54, International Monetary Fund.
  12. Girton, Lance & Roper, Don E, 1981. "Theory and Implications of Currency Substitution," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 13(1), pages 12-30, February.
  13. Pablo Guidotti & Carlos A. Rodríguez, 1992. "Dollarization in Latin America: Gresham's Law in Reverse?," CEMA Working Papers: Serie Documentos de Trabajo. 81, Universidad del CEMA.
  14. Sergio L. Schmukler & Luis Serven, 2002. "Pricing Currency Risk: Facts and Puzzles from Currency Boards," NBER Working Papers 9047, National Bureau of Economic Research, Inc.
  15. Demirguc, Asli & Detragiache, Enrica, 2000. "Monitoring Banking Sector Fragility: A Multivariate Logit Approach," World Bank Economic Review, World Bank Group, vol. 14(2), pages 287-307, May.
  16. Carlos A. Végh Gramont & Ratna Sahay, 1995. "Dollarization in Transition Economies," IMF Working Papers 95/96, International Monetary Fund.
  17. Alexander Kyei, 1995. "Deposit Protection Arrangements: A Survey," IMF Working Papers 95/134, International Monetary Fund.
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