Academic journal article Journal of Money, Credit & Banking

Endogenous Deposit Dollarization

Academic journal article Journal of Money, Credit & Banking

Endogenous Deposit Dollarization

Article excerpt

IN MANY EMERGING markets domestic financial intermediation is carried out in two (or more) currencies. Since the dollar is generally the main foreign currency of choice, this phenomenon has been named financial dollarization in the literature. Financial dollarization can take several forms, including foreign borrowing (domestic banks or local firms borrowing directly from abroad as in the case of Thailand and Indonesia in the 1990s or Chile and Argentina in the early 1980s) and deposit dollarization (domestic asset holders saving locally in foreign-currency deposits as in Turkey and Argentina in the 1990s).

While the issue of foreign borrowing has received attention in the literature (see Diaz-Alejandro, 1985, Burnside, Eichenbaum, and Rebelo, 2001b, Caballero and Krishnamurthy, 2002), (1) deposit dollarization has been almost completely neglected, (2) despite the evidence suggesting its empirical relevance in many emerging markets (see Balino, Bennett, and Borensztein, 1999). In principle there are reasons why domestic savers may prefer to save in dollars rather than in domestic currency (henceforth, for simplicity, the peso). Thomas (1985) and Ize and Levy-Yeyati (2003) explain the process of dollarization as an optimal portfolio choice by depositors. These models, however, ignore important aspects of the financial intermediation process such as the balance-sheet imbalances caused by currency mismatches. In this paper we abstract from the depositor's decision and focus on whether it may be in the best interest of banks in emerging markets to attract dollar deposits. By acquiring dollar deposits, banks face a trade-off between low dollar rates (i.e., low funding costs) and high default risks associated with currency mismatch. We are interested in examining under what conditions the former effect dominates the latter and whether these conditions induce excessive dollarization by banks. We also address the implications for bank regulators in emerging markets.

In our model, limited-liability banks choose the currency composition of their liabilities. They collect peso and dollar deposits from risk-neutral depositors to finance domestic projects with known peso returns. Depositors, in turn, do not observe the currency composition of bank deposits. Exchange rate risk is the sole source of uncertainty in the model. The presence of dollar deposits gives rise to a currency imbalance in the banks' balance sheet that implies that low exchange rate states (i.e., peso depreciations) are associated with bank insolvency. In this context, the loss-sharing policy between different types of deposits in the event of bank default is the key to distinguishing between the banks' and the central planner's valuation of dollar deposits.

We show that an equal treatment of peso and dollar deposits in the event of a bank liquidation (understood as the case in which the residual value of the bank is distributed on a pro rata basis among all depositors according to the value of their claims at the time of liquidation) creates an incentive for banks to dollarize. In this case, the cost for banks of funding their investment using dollar relative to peso deposits increases as the peso depreciates. Risk-neutral depositors price this benefit of dollar deposits into lower dollar rates relative to peso rates. However, due to limited-liability, banks do not pay the higher costs of dollar deposits in the event of default and thus find it cheaper to finance their projects through dollar funding. We show that this effect leads to excessive deposit dollarization relative to a central planner's choice.

Our paper differs from the foreign borrowing literature cited above in the causes underlying dollarization. In Caballero and Krishnamurthy (2002), the incentive for firms to issue excessive dollar debt arises from the interaction between the value of dollar collateral and the presence of financial constraints. In Burnside, Eichenbaum, and Rebelo (2001b) and Dooley (1997), the free insurance provided by the government induces banks to borrow from abroad. …

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