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Section III, dollarization itself largely arises as protection against risk and, absent externalities and moral hazard, does not call for prudential reform. A case for imposing tighter, currency-specific, prudential requirements to limit the risks of dollarization would thus have to be based on a finding that the level of dollarization, though privately optimal, was socially excessive.

The presence of moral hazard is particularly clear, as the systemwide nature of the risks related to dollarization creates a herd-effect in regard to indirect exchange rate risk arising through increased credit risk on foreign currency lending. Bank depositors that expect to be bailed out in the event of a catastrophic exchange rate depreciation will not require banks that lend in foreign currency to local currency earners pay a risk premium on their deposits. This, in turn, removes banks' incentives to limit the risk they take by intermediating in dollars or adequately provisioning against those risks. Instead, they are better off not to provision since it allows them to limit their losses in the event of a catastrophic depreciation (e.g., it enhances the option value of walking away). Bailout expectations similarly induce dollar borrowers to discount the real cost and risks of dollar borrowing. By penalizing the more prudent banks, competitive forces can help broaden across all banks the failure of at least some of the participants to fully internalize risk. Instead, the owners and other insiders of a bank which experiences widespread loan-losses associated with an exchange rate collapse can expect much more favorable treatment from the authorities in the crisis resolution phase if it has been in the company of many other banks facing the same risk. Knowing this, bankers will assume indirect credit risk more freely than they would in isolation.

Similar moral hazard failures affect banks' exposure to liquidity risk. The large international reserves held by central banks and abundant associated provision of liquidity support in the event of systemic runs provide free insurance benefits. Thus, banks have limited incentives to accumulate dollar liquidity on their own, if they know that all banks will be similarly affected and, hence, will need to be supported.<sup>4 2</sup> Instead, competitive pressures will tend to penalize those banks that set aside more liquidity or otherwise take measures to limit the liquidity of their liabilities.

Thus, a first objective of prudential reform is to level the playing field between the local currency and the foreign currency by ensuring that market participants adequately internalize dollarization risks. A secondary objective is to boost the capacity of dollarized financial systems to withstand liquidity or solvency shocks, thereby enhancing the scope for a more flexible and smoother monetary and foreign exchange policy. However, it should do so _without unduly constrainingfinancial development and repressing the needfor currency diversification._ This latter objective is likely to gain importance as financial systems across the world deepen and become more integrated.

Provided the necessary information and skills are available, a flexible regulatory approach, based on statistical risk management models such as value-at-risk, should thus be preferable to one based on discretionary application of administrative restrictions and quantitative

> 42 Gonzalez-Eiras (2000) provides direct evidence of such effects. He finds that the introduction in Argentina of a credit contingent line to expand liquidity support to banks led domestic banks to reduce their domestic liquidity relative to foreign banks (that were less dependent on such support due to their increased reliance on support from parent banks).