Endogenous Deposit Dollarization

This paper explores sources of deposit dollarization unrelated to standard moral hazard arguments. We argue that the equal treatment of peso and dollar claims on a bank in the event of default can induce banks to attract dollar deposits above the socially desirable level. The distortion arises because dollar depositors are the only source of default risk in the model, but they share the burden of the default with peso depositors as interest rates cannot be set contingent to the (unobserved) level of deposit dollarization. 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 should depart from the currency-blind benchmark and instead distinguish across currencies in a way that prevents undesirable currency mismatches, even in the absence of moral hazard related to the relaxation of market discipline.