Alain Ize

Dollarization of the Banking System: Good or Bad?

This paper assesses the benefits and risks associated with dollarization of the banking system. We provide novel empirical evidence on the determinants of dollarization, its role in promoting financial development, and on whether dollarization is associated with financial instability. We find that: (a) the credibility of macroeconomic policy and the quality of institutions are both key determinants of cross-country variations in dollarization; (b) dollarization is likely to promote financial deepening only in a high inflation environment; and (c) financial instability is likely higher in dollarized economies. The implications of these findings for financial sector and monetary policies are discussed.

Dollarization of Financial Intermediation: Causes and Policy Implications

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, and policy implications are explored.

Central Banking Without Central Bank Money

Given the rapidly declining demand for central bank reserves and their gradual replacement in wholesale payments by alternative forms of money—clearinghouse moneyand treasury money—this paper discusses whether the complete extinction of base money could undermine monetary control. It argues that such concerns are misplaced since central banks can target interest rates and inflation even in the absence of base money. The paper explores implications for current and future central banking, including monetary and foreign exchange operations, lender of last resort, coordination between public debt and monetary management, and design of operating rules in currency boards.

Capitalizing Central Banks: A Net Worth Approach

This paper provides a simple, quantitative, net-worth-based approach to assessing the need for central bank capital. It derives a concept of “core capital” (a function of the central banks operating expenditures and the carrying cost of its international reserves) as the minimum capital needed by a central bank to ensure the credibility of its inflation target. The approach is illustrated with the published accounts of three loss-making central banks and selected accounting entries for a broader sample of central banks. Policy implications are explored. In particular, the paper argues that central bank capitalizations cannot be automatic and require instead a broad policy debate.

Financial Development in Latin America and the Caribbean: The Road Ahead

The financial systems of the Latin America and the Caribbean region (LAC) are at a crucial juncture. After a history of recurrent instability and crisis (a trademark of the region), they now seem well poised for rapid expansion. Since the last wave of financial crises that swept through the region in the late 1990s and early 2000s, financial systems in LAC have continued to gain in soundness, depth, and diversity. The size of banking systems has increased, albeit from a low base; local currency bond markets have greatly developed, both in volumes and in reach over the yield curve; stock markets have expanded; and derivative markets particularly currency derivatives have grown and multiplied. Institutional investors have become more important relative to banks, making the financial system more complex and diversified. Importantly, much progress has been made in financial inclusion, particularly through the expansion of payments, savings, and credit services to lower income households and microenterprises. As evidence of their new soundness and resiliency, financial systems in the region, except in some Caribbean countries, weathered the recent global financial crisis remarkably well. The progress in financial development in LAC no doubt reflects substantial improvements in the enabling environment, lower macroeconomic volatility, more independent and better-anchored currencies, increased financial liberalization, lower currency mismatches and foreign debt exposures, enhanced effectiveness of regulation and supervision, and notable improvements in the underlying market infrastructures (for example, trading, payments, custody, clearing, and settlement). This regional flagship report aims at providing such a stocktaking and forward looking assessment of the regions financial development. Rather than going into detail about sector-specific issues, the report focuses on the main architectural issues, overall perspectives, and interconnections. The value added of the report thus hinges on its holistic view of the development process, its broad coverage of the financial services industry (not just banking), its emphasis on benchmarking, its systemic perspective, and its explicit effort to incorporate the lessons from the recent global financial crisis.

Financial stability in dollarized economies

This paper addresses the challenges to prudential supervision in highly dollarized economies, where central banks and supervisors may be constrained in the use of standard money and financial policy tools. The study’s conclusions are the basis of an ongoing policy dialogue with IMF member countries, standard-setters in the financial area, and academia. The paper is part of the policy development work conducted by the IMF’s Monetary and Financial Systems Department.

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.

Capital Inflows in the Baltic Countries, Russia, and Other Countries of the Former Soviet Union: Monetary and Prudential Issues

Significant capital inflows were observed during the first half of 1995 in a number of FSU countries. This paper reviews the recent experience of those countries with significant inflows, examines policy responses in view of the current macroeconomic and institutional environment, discusses the use of monetary and prudential instruments to sterilize or discourage inflows, and reviews operational considerations for conducting sterilization operations.

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 states 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.

The conceptual foundations of macroprudential policy : a roadmap

This paper explores post-Lehman macroprudential regulation by interacting two types of market failures (principal-agent and collective action) with two cognition modes (unconstrained and constrained) in the context of aggregate risk. Four paradigms with orthogonal policy justifications are identified. In the first time consistency paradigm, regulation offsets the moral hazard implications of efficient but time inconsistent post-crisis bailouts. In the second dynamic alignment paradigm, it protects unsophisticated market participants by maintaining principal-agent incentives continuously aligned in the face of aggregate shocks. In the third collective action paradigm, regulation arises in response to the socially inefficient yet rational financial instability resulting from uninternalized externalities. The fourth collective cognition paradigm is grounded on the need to temper the mood swings that arise from bounded rationality or severe cognitive frictions in a rapidly changing, complex and uncertain world. These four rationales give rise to important tensions and trade-offs in the design of macroprudential policy.