Endogenous Deposit

This paper explores sources of deposit dollarization unrelated to standard moral hazard arguments. We develop a model in which banks choose the optimal currency composition of their liabilities. We argue that the equal treatment of peso and dollar claims in the event of bank default can induce banks to attract dollar deposits above the socially desirable level. The distortion arises because dollar deposits are the only source of default risk in the model, but dollar depositors share the burden of the default with peso depositors. The incentive to dollarize is reinforced by common banking system safety nets such as deposit and bank insurance. Our findings suggest that regulators in bi-currency economies would potentially benefit by departing from the currency-blind benchmark and differentiating among currencies in a way that prevents undesirable currency mismatches.). We are grateful to Miguel Broda, Rudi Dornbusch, Augusto de la Torre, and Roberto Rigobon for their helpful comments. We also benefited from suggestions of seminar participants at MIT, the Federal Reserve Bank of New York, Universidad Di Tella, and LACEA (2000). All remaining errors are our own. The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System.