Liquidity and Twin Crises

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 banks 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 banks B/S (dollars)
• Roll over if

Assets Liabilities
D L
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)

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Equilibrium (p, e)
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Alternative Equilibrium (p, e)
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Tight Monetary PolicyScenario 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 PolicyScenario II

• Downward spiral

Low p Foreclosure

Foreclosure Low e
15
Scenario II Downward Spiral
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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