Ms. Corinne C Delechat, Ms. Camila Henao Arbelaez, Ms. Priscilla S Muthoora, and Svetlana Vtyurina
Banks’ liquidity holdings are comfortably above legal or prudential requirements in most Central American countries. While good for financial stability, high systemic liquidity may nonetheless hinder monetary policy transmission and financial markets development. Using a panel of about 100 commercial banks from the region, we find that the demand for precautionary liquidity buffers is associated with measures of bank size, profitability, capitalization, and financial development. Deposit dollarization is also associated with higher liquidity, reinforcing the monetary policy and market development challenges in highly dollarized economies. Improvements in supervision and measures to promote dedollarization, including developing local currency capital markets, would help enhance financial systems’ efficiency and promote intermediation in the region.
. Section VI provides robustness checks, and Section VII concludes the paper.
II. A C onceptual B ackground : T he M odel
The model illustrates in a minimalist fashion that firms change their liquidityholdings through changes in bank loans and CP issues upon monetary policy shocks and that inventories and liquid assets are substitutes in liquidity management. Based on a partial equilibrium approach, we present a simple model that describes firms, banks, and the Federal Reserve (“Fed”), but leaves the rest of the economy unspecified. The model is a
Mr. Eduardo Levy Yeyati, Mr. Alain Ize, and Miguel A. Kiguel
so far are unlikely to go away in the foreseeable future.
Second, the paper discusses whether the liquidity buffer should be held in a centralized or decentralized manner, a question that has been barely addressed in the literature. With the help of a stylized example, we show that, in the absence of LARs, centralizing reserves at the central bank introduces an agency cost leading to suboptimal dollar liquidityholdings and an implicit subsidy to dollar intermediation. By contrast, decentralized holdings (through the imposition of LARs) help internalize the