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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 –and often overlooked– 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’ 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 (“circuit breakers”) to reduce self-insurance costs while limiting bank losses in the event of a run.

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Bibliographic Info

Paper provided by Universidad Torcuato Di Tella in its series Business School Working Papers with number liquid.

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Length: 36 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:udt:wpbsdt:liquid

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  1. Shah, Parth J, 1997. " The Option Clause in Free-Banking Theory and History: A Reappraisal," The Review of Austrian Economics, Springer, vol. 10(2), pages 1-25.
  2. Eduardo Levy-Yeyati, 2004. "FINANCIAL DOLLARIZATION: Evaluating the consequences," Econometric Society 2004 Latin American Meetings 184, Econometric Society.
  3. Rajan, Raghuram G. & Tokatlidis, Ioannis, 2005. "Dollar Shortages and Crises," MPRA Paper 832, University Library of Munich, Germany.
  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 Center for International Economics, Working Paper Series qt44g3n2j8, Center for International Economics, UC Santa Cruz.
  6. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers 11-90, Wharton School Rodney L. White Center for Financial Research.
  7. Tito Cordella & Eduardo Levy Yeyati, 2004. "Country Insurance," Business School Working Papers countryinsurance, Universidad Torcuato Di Tella.
  8. Roberto Chang & Andres Velasco, 1997. "Financial fragility and the exchange rate regime," Working Paper 97-16, Federal Reserve Bank of Atlanta.
  9. Tito Cordella & Eduardo Levy Yeyati, 2006. "A (New) Country Insurance Facility," International Finance, Wiley Blackwell, vol. 9(1), pages 1-36, 05.
  10. Eduardo Levy Yeyati & Augusto de la Torre & Sergio Schmukler, 2003. "Living and Dying with Hard Pegs: The Rise and Fall of Argentina´s Currency Board," Business School Working Papers catorce, Universidad Torcuato Di Tella.
  11. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries," IMF Working Papers 06/229, International Monetary Fund.
  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  13. Gianni De Nicoló & Patrick Honohan & Alain Ize, 2003. "Dollarization of the Banking System," IMF Working Papers 03/146, International Monetary Fund.
  14. 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.
  15. Carlos O. Arteta, 2003. "Are financially dollarized countries more prone to costly crises?," International Finance Discussion Papers 763, Board of Governors of the Federal Reserve System (U.S.).
  16. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262033348, December.
  17. Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, vol. 58(2), pages 867-894, 04.
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