NBER WORKING PAPER SERIES LIQUIDITY INSURANCE IN A FINANCIALLY DOLLARIZED ECONOMY. Eduardo Levy Yeyati

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1 NER WORKING PAPER SERIES LIQUIDITY INSURANCE IN A FINANCIALLY DOLLARIZED ECONOMY Eduardo Levy Yeyati Working Paper NATIONAL UREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA June 2006 The author wishes to thank Marco onomo, Alejandro Werner and participants at the December 2005 NER Inter-American Seminar on Economics in Rio de Janeiro for their helpful comments, and Ramiro lázquez and Luis Casanovas for their outstanding research assistance. The paper is forthcoming in Strengthening Global Financial Markets, (Sebastian Edwards and Marcio Garcia, eds.,), University of Chicago Press. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National ureau of Economic Research by Eduardo Levy Yeyati. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

2 Liquidity Insurance in a Financially Dollarized Economy Eduardo Levy Yeyati NER Working Paper No June 2006 JEL No. G2, F3 ASTRACT 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. Eduardo Levy Yeyati Universidad Torcuato Di Tella Miñones 2177 (1428) uenos Aires ARGENTINA ely@utdt.edu

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12 e maxπ { R } = r L r D C LAR ) ). C % $( - C = ([ rl rf ] F( R ) [( 1+ rl )( 1+ θ ) rl ][ 1 F( R )] ) R 1 ( rd rf ) xdf( x) + [( 1+ rl )( 1+ θ ) rd ] xdf( x) 0 R * %- C R r L r f FR 1 r L 1FR 0 & ('.%. $( *! 2 '# $( *.'*! *2 #& & (''% R* % R = F 1 1 ( ) [ + ( ) ] rl rf 1 1+ rl θ R R R ') > 0 ; < 0; > 0. θ r r L f < ) +1' % % *. )) '' ( r 1 ( )( ) + r L < 1+ r < 1+ rl 1+ θ ( $.+ & 9' & (% '' ( ) %*.. )- C = ([ rl rf ] F( R ) ( r rl )[ 1 F( R )]) R R 1 ( rd rf ) xdf( x) + ( r rd ) xdf( x) 0 R ') C R = ( r r ) F( R ) + ( r r ) F( R ) L f L [ 1 ] = 0. R / '(. %. + 11

13 R = F 1 ( ) < R, rl r f [ 1 ( r r )] + L 1, ( % + ' *! #'( ' '%*! R < R < 1#& '% %) % * * ' &'. % % (% '- C = ( rl rf ) F( R ) ( r rl )[ F( R + R ) F( R )] [( 1+ rl )( 1+ θ ) ( 1+ rl )][ 1 F( R + R )]) R R + R 1 ( rd rf ) xdf( x) + ( r rd ) xdf( x) + [( 1+ rl )( 1+ θ ) ( 1+ rd )] xdf( x) 0 R R + R [( 1+ rl )( 1+ θ ) ( 1+ r )][ 1 F( R + R )] R ) C R = + ( r r ) F( R ) + ( r r ) F( R + R ) F( R ) L ( 1 + r ) θ[ 1 F( R + R )] = 0 L f L [ ] ) &*& * R ) * % 9& ). R R %! < 0& < 0#+ J R r *&) ('! 2 #'( E & ) ( * ( + $' &) % ' ( % - '' '% & %( (. '' -1% &%) ' 2!& & * $#+1 &) % ( ' ( & % * % & '' %& ' R R R R J1&% & θ > 0 ; r < 0; r > 0+ L f 12

14 +(& 2 &%** R ('! r = 0 = 1&% r f ( % #+& 9( * ) '& ' )*.! %. # '' + &) %% ' & '( '%* * M ' &. % + & ' % &( ** &(( & + A & $ ( * % ( 9! & $ %( ) % 2 #& ) % ' ' "% %) (..+ F) & ' &) $+! ( (%% &' %' +? '( ) %'*&)(%% 1 p & ' %* ( +5 '(' %' * R '( %* &.) ' ( & 9 2 %* ' CLAR ( R ) > 0CLAR+ = 0+ / ' % %*' *& (( '! %2( #+ A.%'& *. '* (& % & ' * ' M! '*%)* )*(#+? $ () ( ( ' 9!'*. % $ ) % % #& ( ' % (! %%# ( +1 * 1 '!8#+ 13

15 +F &'(' ' ' (6!%) #) $( pr L r r f & r Lp r p+ & (%% ' ) %M & %M(% '% ) - maxπ R, p e = p ( r r C ) L D ) e π R C = p R = 0 e p π = r L r D C + C rl p 1 = 0. rl p ) p R = 2 2 C 2 R C rl R = R R r p L 0 r L C < 0& 0& p 2 C R r L 2 R = F 2 ( R + R ) θ[ 1 F( R + R )] > 0. & % ) + - ((* % *2 (6! % ' *. % *%(#+5 & 2 C R R '( - = [( 1+ r ) θ ( r r )] F ( R + R ) > 0 L L p R = p 2 2 C R R C = rl R R R rl p 0, ) ' 2*!&&) #+?? +!8#( ' '( 14

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17 ( * ('% ) '.% R (' ) - maxw { R} ') e W R e = = + 0 R α 1 α ( 1 R) df( x) + [ 1 R ( 1+ θ )( x R) ] df( x) 0 R R 1 ( 1+ rf )( R x) df( x) ( 1+ rf + ρ)( 1 x) df( x) 0 α 1 1 [ α( 1 R) ( 1+ rf )] F( R) + θ α 1 R ( 1+ θ )( x R) R α 1 [ ] df( x) = 0 1'( '( (' ( $ %+?? & ( $! +*+& ( & * θ#& ( )( * * + '(*19+ 19& ) & ( %(' 2 ( ' + 9 &.%'& e π α 1 ( R ) = 0 r r = α( 1 R ) r = C( R ) > 0. L D f %)*!&& ( ' # ( * *, ( ) '+ '& (()%* ' %* $( *+1& 2 ( - & & % ) ' &. ' ( ' & (''& '. ( *+ %"%&#$ <) '( (!& R ( ( R) α 1??/ & '('( %* &% '. '*((+F) & '& (.% ( '( ( '* '.!)( 2*% # * '*+ 16

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

30 28 (!#!#!?#!D#!8#!#!J#!# <M )" F*" )" F*" )" F*" )" F*" /++, / /,+05 / //1, /,62555 //4, /,62555 &;! &7! &8! &<:! &;! &6:! &88! &<<! ///,555 ///3555 ///,555 ///2555 //// ///1555 & &! &! &! &! &! 'R*( /,+6555 /,+6555 / / &76! &;;! &7! &79! , ,,555 7//4/ 740+,555 //,2 7//.0 &<<<! &;6! &88! &99:! &7:! &<:! &9! &9! K% 8 AA 8 D 8J D 8J ? +8 +?J + +D +?? +D <?? 8 J 8 J ( '( =>+1 * $ + )" % ) ( ( * L+ 9% ( +Z*LCZZ*8LCZZZ*L 29

31 3)#!#!#!?#!D#!8#!#!J#!# * ' /2 / /,01555 /,00555 /+2455 /,06555 /.//555 /,4/55 /,4+55 &6! &:9! &:9! &9! &:8! &:8! &;! &7! ///,555 //// //// //// ///.555 ///.555 ///3555 ///2555 &! &! &! &! &! &! &! &! 'R*( /+3/555 / / /,/+555 / / /.,/555 /.,/555 &77! &87! &8;! &78! &<! &<! &7! &7! //// ///,555 ///+5 ///1555 ///.555 ///.555 ///3555 ///2555 &! &! &! &! &! &! &! &! 7// //+155 &:! &:! $R %R*( ///1 &:! 7//+/ 7///0 ///6 ///6 &<! &<! &8! &8! 10 crisis _ i /++.5 /,4.555 = i 0 &;6! &99! (RR //+/5 //,2555 &:! &<! , / /555 7+/6,,555 7+/6/,555 &868! &66! &6! &:8! &77:! &78! &;7! &76! K% 8? J8 J J J D +?? +?J +?J +?8 +?8 < A ( '( =>+1 * $ + 9% ( +Z*LCZZ*8LCZZZ*L 30

32 (+ 31

33 (,# 14% 12% 10% 8% 6% 4% 2% 0% * ( ' '' ' ' ( % 8&'J) (( '( + 32

34 (. 8( )9 ( : ; 9 > +/= e( total_reserves_gdp X ) e( total_reserves_gdp X ) e :; 9 < +/= e-17 e( dollar_dep_gdp X ) coef = , (robust) se = , t = e( dollar_dep_gdp X ).2 coef = , (robust) se = , t =.55 33

35 (1 ( Argentina (September 2000-December 2001) 60,000 8,000 50,000 7,000 System Time Deposits (left axis) 6,000 Million U.S. Dollars 40,000 30,000 20,000 Exchange Rate Risk (right axis) [4.996] 5,000 4,000 3,000 asis Points 2,000 10,000 1,000 0 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 0 Uruguay (December 2001-July 2002) 12,000 Argentina's suspension of convertibility 5,000 4,500 10,000 4,000 Million U.S. Dollars 8,000 6,000 4,000 Time Deposits (left scale) Exchange rate risk (right scale) 3,500 3,000 2,500 2,000 1,500 asis Points 2,000 1, Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Exchange rate risk is the devaluation implicit in the 12-month forward (NDF) for Argentina, and the (annualized) peso-dollar interest rate differential on time deposits for Uruguay. Source: Levy Yeyati, Martinez Peria and Schmukler (2005). 34

36 Index of Deposits (=100 in December 2000) 110 (2!) Dollar Deposits Peso Deposits Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Source: De la Torre, Levy Yeyati and Schmukler (2003). 35