1 Liquidity and Twin Crises Hyun Song Shin London School of Economics

2 Twin Crises Banking crisis combined with currency crisis –Korea 1997 –Mexico 1994 –Germany 1931

3 Policy Dilemma High interest rates –Raise cost of speculation –Increase attractiveness of holding domestic currency High interest rates –Lower asset values –Lower net asset value of domestic banking system –Precipitate run by foreign creditor banks

4 Mark to Market Accounting Transparency –Ex ante incentives, moral hazard –Measurement of counterparty risk But measurement implies actions –Reacting to price changes –Amplifying price changes –Measuring counterparty risk determines counterparty risk

5 Twin Crisis as Liquidity Black Hole Korean bank’s balance sheet (in won) –p is price of domestic asset –D is dollar liability to foreign bank –e is exchange rate (high e = strong won) AssetsLiabilities pD/e

6 Foreign Banks Foreign creditor bank’s B/S (dollars) –Roll over if – AssetsLiabilities DL

7 Foreclosures by Foreign Creditor Banks

8 Domestic Asset Price as Function of Exchange Rate

9 Two Equations in (e, p) Domestic asset market equilibrium Foreign exchange market equilibrium –Short term flows influence exchange rate –Evans and Lyons (2002), Lyons (2001)

10 Equilibrium (p, e)

11 Alternative Equilibrium (p, e)

12 Tight Monetary Policy Scenario I High interest rate –Raises costs of speculation –Increases attractiveness of holding Won Asset price falls, but stabilizes

13 Scenario I: Stabilization

14 Tight Monetary Policy Scenario II Downward spiral Low pForeclosure Low e

15 Scenario II: Downward Spiral

16 Determinants of Twin Crises Liquidity and duration of assets –determines interest sensitivity of p –real estate low liquidity, high duration Currency mismatch of banking sector B/S –counterparty risk (central bank reserves at risk) –Discretion of central bank LOLR function limited by reserve holding

17 Ex Ante and Ex Post Ex ante policy to prevent twin crises –limit currency mismatch of (national) consolidated balance sheet limit dollar carry trades limit corporate leverage Ex post crisis management –tight money can be counterproductive –freedom of manoeuvre for LOLR activity

18 Liquidity as a Public Good Some ex ante incentive to hold liquid assets But not all externalities will be internalized –Sub-optimal liquidity –Public good provision –Liquidity requirement as a Pigouvian tax