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Liquidity Insurance in a Financially Dollarized Economy

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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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12345.

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Date of creation: Jun 2006
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Publication status: published as Liquidity Insurance in a Financially Dollarized Economy , Eduardo Levy Yeyati. in Financial Markets Volatility and Performance in Emerging Markets , Edwards and Garcia. 2008
Handle: RePEc:nbr:nberwo:12345

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  1. 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.).
  2. 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.
  3. 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.
  4. Eduardo Levy Yeyati, 2005. "Financial Dollarisation: Evaluating The Consequences," Business School Working Papers, Universidad Torcuato Di Tella findollarisation, Universidad Torcuato Di Tella.
  5. Tito Cordella & Eduardo Levy Yeyati, 2005. "A (New) Country Insurance Facility," IMF Working Papers 05/23, International Monetary Fund.
  6. Joshua Aizenman & Jaewoo Lee, 2005. "International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence," NBER Working Papers 11366, National Bureau of Economic Research, Inc.
  7. 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.
  8. 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.
  9. Tito Cordella & Eduardo Levy Yeyati, 2004. "Country Insurance," Business School Working Papers, Universidad Torcuato Di Tella countryinsurance, Universidad Torcuato Di Tella.
  10. 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.
  11. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  12. 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.
  13. Raghuram G. Rajan, 2004. "Dollar Shortages and Crises," NBER Working Papers 10845, National Bureau of Economic Research, Inc.
  14. 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.
  15. Gianni De Nicoló & Patrick Honohan & Alain Ize, 2003. "Dollarization of the Banking System," IMF Working Papers 03/146, International Monetary Fund.
  16. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries," IMF Working Papers 06/229, International Monetary Fund.
  17. 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.
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