Essays on banking and foreign exchange market instability
Financial intermediation has been associated with several risks. We study sunspot panics, information-based bank runs, contagion, uncertainty about consumption time preference, twin crises and a number of policies attempting to resolve these issues. We offer a basic model where sunspot panics and information-based bank runs co-exist. This framework can be used to evaluate a number of policies. We examine closely the policy of suspension of deposit convertibility and observe a trade-off regarding its implementation. Although suspension eliminates sunspot panics, it presents important drawbacks in an environment vulnerable to information-based bank runs, thus generating a dilemma for policy makers. It removes the advantage of discretionary liquidation of long-term technologies when portfolio returns are expected to be extremely low, and eliminates the signalling property of suspension that continuation of investment is beneficial, which can mitigate the spread of contagion. We offer an alternative solution, with discretionary rules accounting for every possible state of the economy. Studying uncertainty about consumption time preference, we demonstrate that partial suspension is welfare improving on the outcome of full suspension. Nevertheless, in the absence of limitations preventing the formation or the efficient operation of an inter-bank market, borrowing and lending among intermediaries will be the optimal solution. In demonstrating this, we make sure we respect the sequential service constraint that necessitates redemption obligations to be honoured in a first-come first-served basis. Opening up the economy, by the addition of a foreign exchange market and by assuming a fixed exchange rate regime, we study the possibility of twin crises. We abstract from foreign capital as the source of instability and focus on the role of domestic depositors. Speculative opportunities in the currency markets can result in banking crises, while banking crises can lead to betting against the exchange rate regime. Suspension of convertibility can limit funds for speculation, but at the expense of depositors' welfare, thus raising a dilemma for policy makers.