DP2901 Dollarization, Bailouts and the Stability of the Banking System

Author(s): Douglas M Gale , Xavier Vives

Publication Date: July 2001

Keyword(s): moral hazard , banking crisis , lender of last resort , liquidity , IMF

JEL(s): E58 , F30 , G28

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP2901.asp

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. Dollarization is preferable 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. A very severe moral hazard problem could make dollarization undesirable, however. 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.