Comments on Chapter 8

Adrián Armas, Eduardo Levy Yeyati, and Alain Ize
Published Date:
July 2006
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Julio de Brun

The authors have embarked on the ambitious and welcome task of adapting the recommendations of the Basel Committee on Banking Supervision to the problems arising in highly dollarized economies. The result is a comprehensive set of recommendations that should be taken into account by supervisors in emerging economies facing the particular issues raised by dual currencies.

The chapter’s contributions are also contrasted with the results of a survey conducted among seventeen countries about supervisory practices in relation to the problems of dollarization. This survey shows that supervisory practices focus on foreign exchange and liquidity risks, with less effort being made to address currency-induced credit risk. This result is not unexpected, given that liquidity risks and foreign exchange positions have been traditionally addressed by regulation, while currency-induced credit risk has received attention only more recently, following the significant impact on banks’ financial statements of the large changes in currency values during the 1980s and 1990s.

The chapter is organized around the three risks associated with dollarization in financial systems: foreign exchange, credit and liquidity risks. I would like to focus these brief comments on two aspects of the analysis: the appropriate determination of the ‘risk-free’ position in foreign currency and the instruments available to deal with many of the recommendations concerning credit and liquidity risks.

Position in foreign currency

Regarding the definition of a ‘risk-free’ position in foreign currency, the authors prefer to protect the CAR instead of the level of bank’s capital expressed in domestic currency. The traditional definition of a position in foreign currency, which is assets net of liabilities in foreign currency, is related to the second definition. If assets in foreign currency are equal to liabilities, changes in the nominal exchange rate have no impact on the capital of the bank, when denominated in domestic currency. However, the authors show that the CAR is affected negatively in the event of an exchange rate depreciation, given that the nominal value of the dollar assets rises, while the value of equity remains constant.

Indeed, if the goal of the supervisor is to isolate the CAR from movements in the exchange rate (in fact, in highly dollarized economies the sensitivity of the CAR to movements in the exchange rate is very high if the positions are closed), then the regulation should define the ‘risk-free’ position in a slightly different way. In this case, a position in foreign currency is neutral from the point of view of the CAR, not if assets net of liabilities in foreign currency equal zero, but if they equal instead the net worth of the bank multiplied by the share of foreign currency assets over total assets. Under that rule, in the event of variations in the exchange rate, the net worth of the bank will change due to the difference between assets and liabilities in foreign currency in the amount exactly needed to match the increase in the value of assets, so that the CAR remains constant.

However, I am not convinced that the goal of the supervisor should be to stabilize the CAR with regard to variations in the exchange rate. If the CAR was initially high enough with respect to the minimum thresholds determined by the regulation to resist the impact of a devaluation of the currency, the regulator should not consider exchange rate fluctuations to be a problem. And if for the same reason the CAR falls below the minimum established, it should not be a problem very different from those related to other causes of fluctuations in the CAR.

The argument of the authors is valid in terms of volatility. Probably no other factor can have the same major impact on the CAR as changes in the value of the currency if a large portion of a bank’s assets are dollarized. However, stabilizing the CAR against exchange rate fluctuations could introduce greater volatility in returns, which should also be a cause for concern for the supervisor.

Finally, from a general economic viewpoint rather than from that of a supervisor, the goal of de-dollarization is precisely to introduce incentives to close positions in foreign currency. From this perspective, it might be difficult to justify a bought position, as the positions of financial agents in the market are often considered to be an important signal for the rest of the economy.

At the end of the day, this discussion is more philosophical than practical. In highly dollarized economies banks often work with bought positions in foreign currency, not because of concerns about the CAR but for different reasons. In highly dollarized economies, the dollar has in great part replaced the local currency as a unit of account. Economic agents therefore try to maintain the value of the net worth in dollars, not in domestic currency. This is especially true for foreign banks, which for reasons of consolidation are usually required to concern themselves with results in foreign currency. Under this framework, a closed position in foreign currency means, in the case of a positive net worth, a bought position in domestic currency, which is ‘risky’ if the unit of account is the dollar or other foreign currency. Instead, having a bought position in foreign currency, when allowed, closes their position in domestic currency and reduces the volatility of the CAR to changes in the value of domestic currency.

Liquidity and currency-induced credit risk

While I basically share the views of the authors and their treatment of liquidity and currency-induced credit risks, I would like to mention the limitations that bank officials and supervisors usually face when dealing with market risks, in particular with exchange rate volatility.

The authors recommend a great effort on the part of the banks to assess the sensitivity of their borrowers to fluctuations in exchange rates and interest rates. They also suggest that internal policies be defined with the aims of reducing exposure to customers facing currency mismatches and helping to reduce the currency mismatches of borrowers by offering hedging products and internalizing appropriately the risks of operating in different currencies. It is difficult not to share this view. However, this is easier said than done. One of the consequences of dollarization is precisely the virtual nonexistence of markets for domestic currency. The great proportion of assets denominated in foreign currency is the counterpart of the liability structure of banks, which in turn reflects the dominance of the foreign currency in non-financial sector portfolios. In that sense, the reduction of the vulnerability that high dollarization brings to the banking system must go hand-in-hand with policies that encourage the development of the domestic currency market. The construction of a yield curve for domestic currency through an active public debt management policy is the first step in that direction.

Regarding the development of capabilities to deal with currency-induced credit risk and liquidity risks, both at the bank and supervisory levels, the first step is to focus on the implementation of stress tests applied to the loan portfolio, and to assess its sensitivity to variations in the real exchange rate. These results should be used to feed banks’ models of cash flows under assumptions that are common to all banks. At this stage, in which a lot of trial and error will be involved in the process of developing capabilities, the availability of comparable results under a common methodology is a preferred goal that overcomes the eventual risk of interpreting the common parameters as signals given by the supervisory agency. In any case, this misleading interpretation can be avoided if a clear separation is established between the supervisor and the monetary authorities.

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