Exchange Rate Stability and Financial Stability

Historical evidence reveals no monocausal explanation for banking crises, including one which would emphasize the maintenance of a currency peg. To some extent this follows from the standard textbook wisdom: whether fixed or flexible exchange rates are preferable depends on the source of disturbances. If threats to the stability of the banking system come from the “outside,” there is a case for exchange rate flexibility to discourage the banks from relying excessively on external sources of finance and to enhance the capacity of the domestic authorities to act as lenders of last resort. Conversely, if the main threats to the stability of the banking system emanate from “inside” (e.g., erratic monetary policies at home), there is an argument for attempting to peg the exchange rate in order to discipline domestic policymakers and vent shocks via the external sector. From this point of view, it is no surprise that there is no simple correlation between the exchange rate regime and the prevalence of banking crises.