Dollarization, Bailouts, and the Stability of the Banking System

43 Pages Posted: 13 Jul 2001

See all articles by Xavier Vives

Xavier Vives

University of Navarra - IESE Business School; Universitat Pompeu Fabra (UPF); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Douglas M. Gale

New York University (NYU) - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: February 2001

Abstract

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

Vives, Xavier and Gale, Douglas M., Dollarization, Bailouts, and the Stability of the Banking System (February 2001). EFA 2001 Barcelona Meetings. Available at SSRN: https://ssrn.com/abstract=276655 or http://dx.doi.org/10.2139/ssrn.276655

Xavier Vives (Contact Author)

University of Navarra - IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

HOME PAGE: http://wwwapp.iese.edu/faculty/facultyDetail.asp?lang=en&prof=xv

Universitat Pompeu Fabra (UPF) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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