1

Liquidity and Twin Crises

Hyun Song ShinLondon School of Economics

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Twin Crises

• Banking crisis combined with currency crisis

– Korea 1997– Mexico 1994– Germany 1931

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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

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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

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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)

Assets Liabilities

p D/e

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Foreign Banks

• Foreign creditor bank’s B/S (dollars)

– Roll over if–

Assets Liabilities

D L

iDpe

,~ Ui

7

Foreclosures by Foreign Creditor Banks

pe

f

1

D D

kpea

8

Domestic Asset Price as Function of Exchange Rate

e

p

p

xbp

ep

Dpe

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)

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Equilibrium (p, e)

p

e

p

pg

xbp

e

pe

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Alternative Equilibrium (p, e)

p

e

p

pg

xbp

e

pe

12

Tight Monetary PolicyScenario I

• High interest rate– Raises costs of speculation– Increases attractiveness of holding Won

• Asset price falls, but stabilizes

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Scenario I: Stabilization

p

e

p

pg

xbp

e pe

14

Tight Monetary PolicyScenario II

• Downward spiral

Low p Foreclosure

Foreclosure Low e

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Scenario II: Downward Spiral

p

e pg

e pe

A

B

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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

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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

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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