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leading to a flight to the U.S. dollar and a run on banks, banks need to pay off their dollar liabilities falling due at par. In the absence of an asset price adjustment that restore equilibrium through an exchange rate overshoot (as would be the case for local currency deposits), convertibility may not be sustainable or credible unless liquid dollar liabilities are backed by sufficient liquid dollar assets abroad. Instead, banks may run out of dollar liquid reserves and central banks of international reserves to provide dollar liquidity support.3 When this happens, deposit contracts may need to be broken and disruptive or confiscatory measures taken, thereby validating creditors' fears and justifying the run.

Liquidity and solvency crises are clearly interrelated. By undermining the solvency of borrowers and banks, the credit risk deriving from a large devaluation heightens the risk of deposit withdrawals by concerned depositors, whether in anticipation of or as a reaction to the devaluation.

To test for the existence of dollarization-specific vulnerabilities, we run cross-country regressions of banks' exposure to solvency and liquidity risk on dollarization. We used a semi-log specification to allow for nonlinearities, controlled for changes in underlying macro volatility, and used a standard instrumental variable method to control for potential reverse causality. As regards solvency risk, we consider two measures: the Z-index (Z) computed with 1995-2000 data, and the 2001 ratio of the nonperforming loans to total loans (NPL).<sup>38</sup> As controls for macroeconomic volatility, we use the MVP determinants of dollarization taken individually. Results show that the deposit dollarization ratio has a clear negative impact on both solvency proxies<sup>39</sup> (Table 5).

36 While under a floating exchange rate regime, central banks could in principle provide liquidity support in local currency against dollar deposit withdrawals, the impact on the exchange rate of such support is likely to be explosive, unless dollar deposits are converted at a fixed exchange rate (i.e., the terms of deposit contracts are not respected).

> 37 Nonlinearities arise from the boundedness of the dollarization variable, that is a percentage. Linear specifications yield the same qualitative results, but their explanatory power is significantly lower than semi-log specifications.

38 The Z index is a proxy of the probability of insolvency of a firm germane to measures of "distance to default." It measures systemic risk potential when aggregated for a set of systemically important banks. It is defined as the ratio (ROA+K)/S, where ROA is the return on assets, K is the equity capital-to-asset ratio, and S is the standard deviation of returns on assets. Thus, a larger value of Z indicates a smaller risk profile, which can be attained by improving efficiency (increasing ROA), greater diversification (decreasing S), or lower leverage (increasing K) (see, for example, De Nicol6 (2000) and De Nicol6 et al., (2003)). The Z-index data are taken from De Nicol6 et al., (2003).

> 39 Arteta (2003) finds that the probability of a banking crisis is not significantly affected by dollarization. However, his sample, as well as his methodology, are not comparable with ours.