Optimal International Reserves of the CNB with Endogenous Probability of Crisis

In this paper we expand the model of optimal reserves assuming an exogenous probability of crisis proposed in Čeh and Krznar (2008), in order to analyse not only holding reserves as an instrument for self-insurance against crisis, but also reserve accumulation for crisis prevention. The benefit of holding reserves as self-insurance in the model assuming an exogenous probability of crisis arises from the mitigation of the adverse effects of the crisis on the level of consumption, and, consequently on the welfare of the economy. On the other hand, the benefit of holding reserves for crisis prevention stems from reduced probability of a crisis breaking out, which depends on the reserve level. Given this two-sided cause-and-effect connection between reserves and the probability of crisis, the model of optimal reserves with endogenous probability of crisis has no analytical solution. Therefore, we applied the value function iteration method in order to work out a numerical solution of the model. For plausible parameter values, the model of optimal reserves with endogenous probability of crisis better explains reserve accumulation in the case of Croatia during the last ten-year period. The conclusion about whether Croatia has enough reserves to mitigate the adverse effects of a crisis, or even prevent a crisis similar to that in 1998/1999, depends on the parent banks’ reaction to the crisis. Only in a “more favourable” scenario, in which parent banks assume the role of lenders of last resort, does the Croatian National Bank hold enough reserves for self-insurance and the prevention of a potential future crisis.