Why is Financial Stability Essential for Key Currencies in the International Monetary System?

Lambert: Because, corrupt as we are, where else are you going to put your money?

Linda Goldberg, Vice President of International Research at the Federal Reserve Bank of New York, Signe Krogstrup, Assistant Director and Deputy Head of Monetary Policy Analysis, Swiss National Bank; Member of the World Economic Forum’s Global Agenda Council on the International Monetary System, John Lipsky, Distinguished Visiting Scholar at the School of Advanced International Studies, John Hopkins University, and Hélène Rey, Professor of Economics, London Business School and CEPR Research Fellow. Originally published at VoxEU.

Could the dollar lose its status as the key international currency for international trade and international financial transactions, and if so, what would be the principal contributing factors? Speculation about this issue has long been abundant, and views diverse. After the introduction of the euro, there was much public debate about the euro displacing the dollar (Frankel 2008). The monitoring and analysis included in the ECB’s reports on “The International Role of the Euro” (e.g. ECB 2013) show that the international use of the euro mainly progressed in the years prior to 2004, and that it has largely stalled since then. More recently, the euro has been displaced by the renminbi as the debate’s main contender for reducing the international role of the dollar (Frankel 2011).

This debate has mainly argued in terms of ‘traditional’ determinants of international currency status, such as country size, economic stability, openness to trade and capital flows, and the depth and liquidity of financial markets (Portes and Rey 1998). Considerations regarding the strength of country institutions have more recently been added to the list. All of these factors influence the ability of currencies to function as stores of value, to support liquidity, and to be accepted for international payments. Inertia also plays a role (e.g. Krugman 1984, Goldberg 2010), raising the bar for currencies that might uproot the status quo.

We argue here – building on discussions we began during the World Economic Forum Summit on the Global Agenda 2013 – that the rise in global financial-market integration implies an even broader set of drivers of the future roles of international currencies. In particular, we maintain that the set of drivers should include the institutional and regulatory frameworks for financial stability. The emphasis on financial stability is linked with the expanded awareness of governments and international investors of the importance of safety and liquidity of related reserve assets. For a currency to have international reserve status, the related assets must be useable with minimal transaction-price impact, and have relatively stable values in times of stress. If the risk of banking stress or failures is substantial, and the potential fiscal consequences are sizeable, the safety of sovereign assets is compromised exactly at times of financial stress, through the contingent fiscal liabilities related to systemic banking crises. Monies with reserve-currency status therefore need to be ones with low probabilities of twin sovereign and financial crises. Financial stability reforms can – alongside fiscal prudence – help protect the safety and liquidity of sovereign assets, and can hence play a crucial role for reserve-currency status.

The broader emphasis on financial stability also derives indirectly from the expanded awareness in the international community of the occasionally disruptive international spillovers of centre-country funding shocks (Rey 2013). We argue that regulatory reforms can play a role in influencing these spillovers. Resilience-enhancing financial regulation of global banks can help reduce the volatility of capital flows that are intermediated through such banks.

On financial stability and reserve-currency status

International reserve assets tend to be provided by sovereigns, notably due to the fiscal capacity of the state and the credibility of the lender of last resort function of the central bank during liquidity crises (see also De Grauwe 2011 and Gourinchas and Jeanne 2012). Systemic financial events can be accompanied by pressures on the government budget, however. While provision of a fiscal backstop to the banking sector is not the best ex ante approach to policy, fiscal support will tend to be forthcoming if the risk and estimated welfare costs of a systemic fallout are otherwise deemed too high. Yet, banking sector risks – and inadequate capacity within the banking sector to absorb these risks – can end up exceeding a government’s ability to provide a credible fiscal backstop without adversely affecting the safety of its sovereign assets. The fiscal consequences of bailouts may result in increased sovereign risk and the loss of safe-asset status, with implications for the status of the currency in question in the international monetary system.

To increase the likelihood that sovereign assets remain safe during systemic events, the sovereign can undertake financial and fiscal reforms that decouple the fiscal state of the sovereign from banking crises. Such reforms should achieve, in part, a reduction in the likelihood of and need for bailouts through increased resilience and loss absorption capacity of the financial system, and by ensuring sufficient fiscal space for credible financial-sector support (see also Obstfeld 2013).

Reform initiatives

A number of current reform initiatives already take steps in this direction. These include:

  • Reforms to bank capital and liquidity regulation, which reduce the likelihood that financial institutions, and notably systemically important ones (SIFIs), become distressed;
  • Initiatives that seek to counteract the procyclicality of leverage, and to strengthen oversight; and
  • Recovery and resolution regimes for distressed systemically important financial institutions (SIFIs) are being improved.

Importantly, initiatives are underway to improve recovery and resolution in the international context. While a global agreement on cross-border bank resolution is currently not in place, bilateral agreements among some pairs of countries are being forged ex ante to facilitate lower-cost resolution ex post.

  • Further, the resilience of the system as a whole is being strengthened, to better contain the systemic externalities of funding shocks. Examples include:The strengthening of the resilience of central counterparties and other financial market infrastructures; and
  • The foreign-currency swap arrangements among central banks to provide access to foreign-currency funding liquidity at times when market prices of such liquidity are punishingly high.

Nevertheless, the financial system contains vulnerabilities – globally, as well as in individual currency areas. The negative sovereign-banking feedback loop may be weakened in many countries, but has not been fully severed. Moreover, reforms are not necessarily evenly implemented across countries. Fiscal capacities to provide credible backstops of the financial sector during stress vary widely. The consequences of recent reforms for the future of key international currencies are therefore open. Scope remains for countries vying for reserve-currency status to use the tool of financial stability reform to protect the safety and liquidity of their sovereign assets from the contingent liabilities of financial systemic risk.

Financial stability reforms matter for spillovers and capital flows

International capital flows yield many advantages to home and host countries alike. Yet the international monetary system still faces potential challenges stemming from unanticipated volatility in flows, as well as occasionally disruptive spillovers of shocks in centre-country funding conditions to the periphery. With the events around the collapse of Lehman Brothers, disruption in dollar-denominated wholesale funding markets led to retrenchment of international lending activities. Capital flows to some emerging-market economies then recovered with a vengeance as investors searched for yield outside the countries central to the international monetary system, where interest rates were maintained at the zero lower bound. After emerging markets were buoyed by the influx of funds, outflows and repositioning occurred when markets viewed some of the expansionary policies in the US as more likely to be unwound.

While macroprudential measures – and in extreme cases, capital controls – are some of the policy options available for addressing the currently intrinsic vulnerabilities of some capital-flow recipient periphery countries (IMF 2012), we point out that these vulnerabilities can also be addressed in part by financial stability reforms in centre countries. Consider, for example, the consequences of the regulatory reforms pertaining to international banks that are currently being proposed or implemented. Improvements in the underlying financial strength and loss-absorbing capacity of global banks could have the beneficial side-effect of reducing some of the negative spillovers associated with unanticipated volatility in international banking flows – especially those to emerging and developing economies. Empirical research suggests that better-capitalised financial institutions, and institutions with more stable funding sources and stronger liquidity management, adjust their balance sheets to a lesser degree when funding conditions tighten (Gambacorta and Mistrulli 2004, Kaplan and Minoiu 2013). The result extends to cross-border bank lending (Cetorelli and Goldberg 2011, Bruno and Shin 2013).

While financial stability reforms may reduce the externalities of centre-country funding conditions, they retain the features of international banking that promote efficient allocation of capital, risk sharing, and effective financial intermediation. By enhancing the stability of global institutions and reducing some of the amplitude of the volatility of international capital flows, they may address some of the objections to the destabilising features of the current system.

Cross-border capital flows that take place outside of the global banking system have recently increased relative to banking flows (Shin 2013). Regulation of global banks does very little to address such flows, and may even push more flows toward the unregulated sector. At the same time, however, regulators are considering non-bank and non-insurer financial institutions as potential global systemically important financial institutions (Financial Stability Board 2014).


We have argued that the policy and institutional frameworks for financial stability are important new determinants of the relative roles of currencies in the international monetary system. Financial stability reform enhances the safety of reserve assets, and may contribute indirectly to the stability of international capital flows. Of course, the ‘old’ drivers of reserve currencies continue to be influential. China’s progress in liberalising its capital account, and structural reforms to generate medium-term growth in the Eurozone – as examples of determinants of the future international roles of the renminbi and the euro relative to the US dollar – will continue to influence their international currency status. Our point is that such reforms will not be enough. The progress achieved on financial stability reforms in major currency areas will also greatly influence the future roles of their currencies.

Editor’s note: The views expressed in this column are those of the individual authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve System, or the Swiss National Bank. This column is based on discussions by the authors during the Summit on the Global Agenda 2013 from 18–20 November in Abu Dhabi, United Arab Emirates, as part of the dialogue of the World Economic Forum’s Global Agenda Council on The International Monetary System. The views expressed in this piece should not be taken to represent the views of the World Economic Forum or the participants of the entire Council.


Bruno, Valentina and Hyun Song Shin (2013), “Cross-Border Banking and Global Liquidity”, Manuscript, Princeton University.

Cetorelli, Nicola and Linda Goldberg (2011), “Global Banks and International Shock Transmission: Evidence from the Crisis”, International Monetary Fund Economic Review, 59(1): 41–76.

De Grauwe, Paul (2011), “The Governance of a Fragile Eurozone”, CEPS Working Document 346, May.

ECB (2013), “The International Role of the Euro”, Report by the European Central Bank. 

Financial Stability Board (2014), “Consultative Document: Assessment Methodologies for Identifying Non-Bank Non-Insurer Systemically Important Financial Institutions”. 

Frankel, Jeffrey (2008), “The euro could surpass the dollar within ten years”, VoxEU.org, 18 March. 

Frankel, Jeffrey (2011), “The rise of the renminbi as international currency: Historical precedents”, VoxEU.org, 10 October. 

Gambacorta, Leonardo and Paolo Emilio Mistrulli (2004), “Does bank capital affect lending behavior?”, Journal of Financial Intermediation, 13: 436–457.

Goldberg, Linda (2010), “What is the status of the international roles of the dollar?”, VoxEU.org, 31 March. 

Gourinchas, Pierre-Olivier and Olivier Jeanne (2012), “Global safe assets”, BIS Working Paper 399, December.

Gourinchas, Pierre-Olivier, Emmanuel Farhi, and Hélène Rey (2011), Reforming the International Monetary System, CEPR eBook, 19 September. 

IMF (2012), “The Liberalization and Management of Capital Flows: An Institutional View”, IMF Board Paper, November.

Kapan, Tümer and Camelia Minoiu (2013), “Strength in Lending: Strong balance sheets help banks sustain credit to the economy during crises”, Finance and Development, September. 

Krugman, Paul R (1984), “The International Role of the Dollar: Theory and Prospect”, in John F O Bilson and Richard C Marston (eds.), Exchange Rate Theory and Practice, University of Chicago Press. 

Obstfeld, Maurice (2013), “On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability”, Monetary and Economic Studies, Bank of Japan, November.

Richard Portes and Hélène Rey (1998), “The emergence of the euro as an international currency”, Economic Policy, 13(26): 305–343. 

Rey, H (2013) “Dilemma not Trilemma: The global financial cycle and monetary policy independence”, Paper presented at the Jackson Hole Symposium, August (revised version forthcoming as a CEPR Discussion Paper). 

Shin, Hyun Song (2013), “The Second Phase of Global Liquidity and Its Impact on Emerging Economies”, Remarks at the 2013 Federal Reserve Bank of San Francisco Asia Economic Policy Conference.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Chauncey Gardiner

    Well crafted and reassuring piece, and only four authors…

    Headline question: “Why is financial stability reform essential for key currencies in the international monetary system?”

    A: Could it be that a key, but unstated reason is because of the fragility of the global financial system due to the magnitude of the derivatives exposures of the transnational TBTFs? “Financial stability” serves to freeze the status quo with its current set of direct and indirect beneficiaries, including the so called “shadow banks”.

    Q: … and why have those derivatives exposures along with related law giving super-priority to derivatives in bankruptcy been created?

    A: Um, good question. But it is reassuring to learn that six years after the collapse of Lehman, at least “financial stability reform” initiatives are already underway.

    1. Jim Haygood

      Four cooks seem to have whipped up a pretty thin gruel, replete with the usual exhortations … ‘neither a borrower nor a lender be’ … oops, wrong author.

      They don’t even mention the politicization of the dollar with arbitrary fines against America’s ennemis du jour — sanctions which can strike just as suddenly and shockingly as a financial crisis.

      Five-word summary: pick the cleanest dirty shirt.

      1. Lambert Strether Post author

        That’s better than my intro, and I’m glad somebody else boiled it down in exactly the same way. I also wonder about the timing of the piece.

        Frankly, it feels to me like important factions plural (note the CEPR and the Fed) are laying down a marker of some kind, but I’m not au courant enough with that stratum of our society to know what the marker is, or who is supposed to read it. T

        1. jgordon

          Jim Rickards says that he’s been sitting in on meetings with various international powers that be players where they are actively planning for the collapse of the usd as the reserve currency–the replacement, of sorts, being special drawing rights from the IMF.

          According to Jim, in the 2008 the large financial institutions lost credibility and so the sovereigns stepped in to save them, putting their own credibility at risk in the process. The crisis/collapse coming up will lead to a sovereign crisis where the the sovereigns have lost credibility and so some international authority(s) will step in putting international credibility on the line. And finally the international authorities may lose credibility in the next crisis after the imminent one, and at that point the international monetary system may have to adopt some medium of exchange that has no counter-party risk, simply because there is no longer any credibility in the system at all. Jim calls this ongoing process “kicking the can up the stairs”.

          Honestly, Jim Rickards makes a hell of a lot of sense to me, whereas most of these other pseudo intellectuals I hear pontificating about economic/monetary theory sound like to me that they have no idea what they’re talking about and they’re blowing smoke out their ass.


          1. Banger

            Rickards is right–SDRs have been seen as a final backstop for some time now. But monetary policy is overwhelmingly political and, for the moment, IMF, sovereign funds and major banks are all pledged to maintain the status quo until the men with guns decide otherwise which is unlikely any time soon in the emergent rogue/gangster economy.

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