Real Dollarization, Financial Dollarization, and Monetary Policy

This paper explores the interaction of real dollarization (dollar indexing of wages), financial dollarization (dollar denomination of financial contracts) and monetary policy in a general equilibrium model with real shocks. Real dollarization is avoided as long as the home monetary authorities perform optimally (i.e., they maximize local welfare). Instead, dollarization increases when central banks perform poorly, and even more so when the correlation between domestic and external shocks is high, since in this case the (presumably optimal) foreign monetary policy guarantees a better level of protection against macroeconomic uncertainty. While real dollarization contributes to financial dollarization, important asymmetries between the two arise.

Prudential Responses to De Facto Dollarization

We develop a theoretical framework that encompasses four distinct motives for dollarization and discuss appropriate policy responses to help contain dollarization and its attendant risks. "Moral hazard" dollarization provides a clear case for prudential policy activism, including through the introduction of currency-specific prudential norms. However, prudential reform will have only a limited impact on dollarization when the main culprits are fear of floating and lack of monetary credibility. In such cases, a concerted and comprehensive reform agenda, including market oriented and institutional reforms, would be needed to shift the balance of risks in favor of the peso. While quantitative limits on dollarization could also be used to speed up dedollarization, risks could be high.

Managing Systemic Liquidity Risk in Financially Dollarized Economy

This paper evaluates ways to protect highly dollarized banking systems from systemic liquidity runs (such as the ones that took place recently in Argentina, Uruguay, and Paraguay). In view of the limitations of available (private or official) insurance schemes, and the distortions introduced by central bank lending of last resort (LOLR), the authors favor decentralized liquid foreign asset requirements on dollar deposits, supplemented by a scheme of “circuit breakers.” The latter combines the use of limited dollar liquidity to ensure the convertibility of transactional deposits with a mechanism that automatically limits the convertibility of dollar term deposits once triggered by a predetermined decline in banks’ liquidity.

Containing systemic risk : paradigm-based perspectives on regulatory reform

Financial crises can happen for a variety of reasons: (a) nobody really understands what is going on (the collective cognition paradigm); (b) some understand better than others and take advantage of their knowledge (the asymmetric information paradigm); (c) everybody understands, but crises are a natural part of the financial landscape (the costly enforcement paradigm); or (d) everybody understands, yet no one acts because private and social interests do not coincide (the collective action paradigm). The four paradigms have different and often conflicting prudential policy implications. This paper proposes and discusses three sets of reforms that would give due weight to the insights from the collective action and collective cognition paradigms by redrawing the regulatory perimeter to internalize systemic risk without promoting dynamic regulatory arbitrage; introducing a truly systemic liquidity regulation that moves away from a purely idiosyncratic focus on maturity mismatches; and building up the supervisory function while avoiding the pitfalls of expanded official oversight.Debt Markets,Emerging Markets,Financial Intermediation,Banks&Banking Reform,Labor Policies

Implicancias de la dolarización parcial para el régimen de metas de inflación: Un análisis basado en la literatura sobre dolarización

Clasificación JEL:

Regulatory reform : integrating paradigms

The Subprime crisis largely resulted from failures to internalize systemic risk evenly across financial intermediaries and recognize the implications of Knightian uncertainty and mood swings. A successful reform of prudential regulation will need to integrate more harmoniously the three paradigms of moral hazard, externalities, and uncertainty. This is a tall order because each paradigm leads to different and often inconsistent regulatory implications. Moreover, efforts to address the central problem under one paradigm can make the problems under the others worse. To avoid regulatory arbitrage and ensure that externalities are uniformly internalized, all prudentially regulated intermediaries should be subjected to the same capital adequacy requirements, and unregulated intermediaries should be financed only by regulated intermediaries. Reflecting the importance of uncertainty, the new regulatory architecture will also need to rely less on markets and more on"holistic"supervision, and incorporate countercyclical norms that can be adjusted in light of changing circumstances.Debt Markets,Banks&Banking Reform,Emerging Markets,Labor Policies,Financial Intermediation

Risk absorption by the state: when is it good public policy ?

The global financial crisis brought public guarantees to the forefront of the policy debate. Based on a review of the theoretical foundations of public guarantees, this paper concludes that the commonly used justifications for public guarantees based solely on agency frictions (such as adverse selection or lack of collateral) and/or un-internalized externalities are flawed. When risk is idiosyncratic, it is highly unlikely that a case for guarantees can be made without risk aversion. When risk aversion is explicitly added to the picture, public guarantees may be justified by the state's natural advantage in dealing with collective action failures (providing public goods). The state can spread risk more finely across space and time because it can coordinate and pool atomistic agents that would otherwise not organize themselves to solve monitoring or commitment problems. Public guarantees may be transitory, until financial systems mature, or permanent, when risk is fat-tailed. In the case of aggregate (non-diversifiable) risk, permanent public guarantees may also be justified, but in this case the state adds value not by spreading risk but by coordinating agents. In addition to greater transparency in justifying public guarantees, the analysis calls for exploiting the natural complementarities between the state and the markets in bearing risk.Debt Markets,Banks&Banking Reform,Access to Finance,Insurance&Risk Mitigation,Labor Policies

Financial development : structure and dynamics

This paper analyzes the bright and dark sides of the financial development process through the lenses of the four fundamental frictions to which agents are exposed -- information asymmetry, enforcement, collective action, and collective cognition. Financial development is shaped by the efforts of market participants to grind down or circumvent these frictions, a process further spurred by financial innovation and scale and network effects. The analysis leads to broad predictions regarding the sequencing and convexity of the dynamic paths for a battery of financial development indicators. The method used also yields a robust way to benchmark the financial development paths followed by individual countries or regions. The paper explores the reasons for path deviations and gaps relative to the benchmark. Demand-related effects (past output growth), financial crashes, and supply-related effects (the quality of the enabling environment) all play an important role. Informational frictions are easier to overcome than contractual frictions, not least because of the transferability of financial innovation across borders.Debt Markets,Economic Theory&Research,Emerging Markets,Access to Finance,Banks&Banking Reform

Benchmarking financial development

Capitalizing on recent improvements in the availability of cross-country financial sector data, this paper proposes a standard methodology for benchmarking the policy component of financial development. Systematic controls are introduced to isolate main structural country characteristics and a principal components analysis is used to help identify a parsimonious set of ten"core"outcome indicators from a broader set of twenty seven potential indicators covering different dimensions of development in both financial institutions and financial markets. Such a broad-based approach helps reveal important determinants and regularities of the process of financial development. The paper also identifies some of the main data gaps that will need to be filled to allow further progress in financial benchmarking looking forward.Debt Markets,,Emerging Markets,Economic Theory&Research,Access to Finance

Financial dollarization

This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries. Policy implications are explored.Departamento de Economí