Central bank vulnerability and the credibility of its commitments: a value-at-risk approach

ABSTRACT A loss of solvency increases central bank vulnerability, reducing the credibility of its commitments to defend a nominal regime, including an exchange rate peg. This paper develops a methodology for assessing central bank solvency and exposure to risk. The measure, based on value-at-risk, is frequently used to evaluate commercial risk. It is emphasized that the ability to sustain nominal commitments cannot be gauged by focusing only on selected accounts (such as the volume of foreign exchange reserves), but requires a comprehensive solvency and vulnerability analysis of the monetary authorities' complete portfolio (including off-balance-sheet operations). The measure suggested in the paper takes such a global approach and its disclosure could improve monitoring of sovereign solvency risk. In addition, a rationale is provided for a central bank policy of holding high equity to asset ratio and for instituting an international lender of last resort.