Central Bank Vulnerability and the Credibility of Commitments : A Value-at-Risk Approach to Currency Crises

The 1990s currency debacles revitalized the search for early warning and forward-looking indicators of financial vulnerabilities. This paper contributes to this task by proposing an approach to assess central bank solvency and to examine the factors putting it at risk, and by refining the concepts relevant for solvency analysis of central bank portfolios. It postulates that a loss of solvency increases central bank financial vulnerability and leads to credibility losses regarding its ability to defend a nominal regime, including exchange rate pegs. The methodology proposed for appraising central banks' financial vulnerability is based on Value-at-Risk (VaR), a concept developed to assess commercial risk. While central banks cannot commercially fail, they behave equivalently if they forsake their commitment to an announced nominal regime. Since a default in central bank commitments would arise from the increased vulnerability caused by solvency losses, solvency measures, such as VaR, are good forward-looking indicators of possible credibility crises. The paper analyzes risks derived both from traditional central bank operations and from off-balance sheet positions, including foreign exchange forwards and financial sector guarantees. Methodological and policy implications are derived. Main factors putting central bank solvency at risk are the volatilities of the exchange rate, of expected exchange rate changes, of international interest rates, of country risk coefficients, and of the magnitudes of the corresponding positions exposed. Therefore, central banks with positions implying high VaR face difficulties in defending rigorous nominal commitments and should not attempt to peg their currencies. Alternatively, if fixing the rate is deemed essential, the central bank should diminish its portfolio's risk exposure and vulnerability in order to reduce the likelihood of credibility crises. Available data and technology permits the tracking of central-bank VaR measures along the lines suggested here. We claim that this indicator, if disclosed to institutions and investors can reduce the likelihood of contagion and improve the monitoring of sovereign risk