Victoria Miller

Central bank reactions to banking crises in fixed exchange rate regimes

Abstract Until recently, speculative attacks and banking crises have been largely treated as separate phenomena. However, the recent experiences of several Southern Cone countries indicates that banking difficulties can lead to a currency crises if in combatting them, the central bank adopts policies which are inconsistent with the fixed exchange rate regime. The paper illustrates how this can be the case and discusses what are the policy responses available to central banks that face banking crises in fixed exchange rate regimes.

Domestic bank runs and speculative attacks on foreign currencies

Abstract The paper extends the international-transmission-of-financial-crisis literature by illustrating how a domestic bank run can cause a speculative attack on foreign currencies. The idea is that when domestic banks invest abroad, a domestic bank run will give way to a repatriation of foreign capital. If the repatriation causes a depletion of the foreign central banks foreign exchange reserves, then the foreign currency will be devalued. As such a devaluation will render domestic banks insolvent, in the rational equilibrium, domestic bank runs will (1) cause a speculative attack on the foreign currency and (2) be self-justified.

Exchange rate crises with domestic bank runs: evidence from the 1980s

Abstract The Sherman Silver Purchase Act of 1890 led to inflation fears and a series of flights from the dollar. In spite of these runs, the dollar was never devalued. The question remains: why? Grilli (1990) argues that it was the Treasurys ability to borrow that prevented collapse. While this explains why the gold standard endured from 1894 to 1896, it does not explain why there was no successful attack before that time. The paper argues that the gold standard endured during 1893 because an internal drain of commercial bank funds stopped the external drain . A revised series of collapse probabilities is provided and shown to be zero during the internal drain.

Bank runs and currency peg credibility

Abstract It is shown that as a currency peg constrains a government’s ability to finance a bailout, bank runs are more likely in credible fixed exchange rate regimes than in those in which the central bank is less committed to its exchange rate. Within the context of the model and given the government responses to their respective banking crises during the period 1994–1995, the bank runs in Argentina and lack thereof in Mexico seem to be rational responses of depositors.

The timing and size of bank-financed speculative attacks

Abstract The recent epidemic of banking and currency crises has led researchers to consider the role that unhealthy banks may have in currency crises. The present paper, in contrast, investigates the anatomy of a currency crisis when banks are healthy enough to finance it. It is shown that when banks finance the crisis, an anticipated collapse occurs sooner and an unanticipated collapse is worse, than when banks do not increase credit during the crisis. The findings imply that restrictions on bank loan activities and careful management of bank balance sheet risks may lessen the severity of, or even prevent, a currency crisis.

Why a government might want to consider foreign currency denominated debt

Abstract As the real value of foreign currency denominated debt is not affected by domestic inflation, such debt eliminates the discretionary incentive to inflate. This in turn will reduce the expected and thus equilibrium rate of inflation. However, as foreign currency debt is affected by foreign inflation, such debt could be an attractive alternative to indexed bonds if the foreign country inflates when the domestic one would like to.

How a Bank Bailout may Increase Systemic Risk

In 2008–2009, the US government spent trillions of dollars to bailout its financial system and prevent insolvency due to a deterioration in domestic loan portfolios. The following dips in US bond prices suggest that global investors feared that the US was over-extending itself and might be unable to repay its debt with taxes rather than inflation. The paper illustrates that if uncertainty arises about a large governments ability to raise taxes to repay its debt, then a debt-financed bailout which initially restores bank health may inadvertently contribute to the financial systems ultimate demise if banks are important lenders to a foreign country that pegs its currency to the domestic money.

Fixed Exchange Rates and Banking Crises: When Does the Former Prevent the Latter?

Because monetary policy is constrained in fixed exchange rate regimes, banks should expect fewer money-financed bailouts and therefore manage their risks more carefully when exchange rates are fixed than when they are flexible. It follows that we should observe fewer banking crises in countries with formal currency pegs. The 1990s however are littered with occurrences of banking crises in countries with fixed exchange rates. This paper asks whether banks in those countries could have adopted excess risk expecting money-financed bailouts or whether their pegs discouraged such moral hazard-type risks.

The Information Content in Bank Currency Mismatches in Fixed Exchange Rate Regimes

Banks tend to leave their currency exposures uncovered in fixed and “intermediate” exchange rate regimes. The paper asks why this is the case. There are three possible explanations: First, hedges are costly and the currency peg is credible; Second, financial markets are incomplete and so hedging instruments are unavailable; or third, hedges are costly and banks expect a bailout should currency gyrations threaten their solvency. The paper demonstrates that the third argument is not time consistent and therefore that uncovered currency exposures reflect currency peg credibility or financial incompleteness and not moral-hazard risk taking.