Liquidity Insurance in a Financially Dollarized Economy

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.