Dollarization, Bailouts, and the Stability of the Banking System
43 Pages Posted: 13 Jul 2001
Date Written: February 2001
We examine the trade-offs associated with the move to dollarization from the perspective of the stability of the banking system in a small open economy. Central bank policy suffers from time-inconsistency when facing a banking crisis: A bailout is optimal ex post but ex ante it should be limited to control moral hazard. Dollarization provides a credible commitment not to help at the cost of not helping even when it would be ex ante optimal to do so. It is found that in the presence of moral hazard, dollarization is good when the costs of establishing a reputation for the central bank are high, monitoring effort by the banker is important in improving returns, and when the cost of liquidating projects is moderate. However, a very severe moral hazard problem could make dollarization undesirable. The paper makes also a contribution of independent interest: the integration of the banking instability and moral hazard views of crisis. The results obtained are applied to assess the desirability of dollarization in a range of countries and the potential role of the IMF as International LOLR.
Keywords: Moral hazard, banking crisis, lender of last resort, liquidity, IMF
JEL Classification: E58, F30, G28
Suggested Citation: Suggested Citation