• Exchange rates and currency crises

Exchange rates and currency crises

One explanation of the banking crisis in Argentina in 2001 is that idiosyncratic, random shocks affecting the solvency of individual banks caused depositors to withdraw savings, causing panic which then spread throughout the system. An alternative explanation is that fundamental aspects of the whole system led economic agents to perceive the economy as having become riskier.

The paper examines the crisis and tests these explanations by studying the determinants of deposit withdrawals during 2000-02, using an econometric model. The first explanation would suggest that characteristics of individual banks would tend to be the most important factors causing depositors to "flee" the system by withdrawing their deposits, whereas the second would suggest that "macro fundamentals" (characteristics of the whole system) would be more important.

It finds that:

• characteristics of individual banks do not explain the behaviour of deposits, except for the interest rate offered by each bank on deposits and the return on equity, suggesting that the crisis was unlikely to have originated in weak fundamentals of specific banks
• banks offering higher interest rates on deposits were subject to higher withdrawals, possibly because the interest rate was taken as an indicator of the strength of the bank, so that depositors were more likely to flee from those banks that had to pay higher interest rates to retain deposits
• "macro fundamentals" were very significant in explaining changes in bank deposits; in particular, higher devaluation risk (as measured by the difference between peso and dollar interest rates), declining liquidity in the whole banking system, and short term foreign credit lines all had a negative impact on deposits
• the highly dollarised loan portfolios of banks, and the large proportion of public debt in banks’ asset portfolios induced depositors to flee from the Argentine banking system as they perceived that their solvency was worsening.

On the basis of these findings, the paper argues that the regulatory framework built up during the 1990s had important weaknesses in controlling excessively risky credit expansion by financial institutions. It suggests policy recommendations, including:

• regulations should make depositors aware of the higher risk involved in foreign currency deposits, since the Central Bank is not able to act as a lender of last resort in these cases
• restrictions should be introduced on bank lending in foreign currency
• the sovereign debt risk of banks’ asset portfolios should be controlled.

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