Reserve accumulation and financial crises: From individual protection to systemic risk

- Conventional view: Central banks׳ reserves reduce probability of financial crises.
- New perspective: The persistent accumulation of reserves creates systemic risk.
- Reserve-accumulating countries generate a negative externality.
- We integrate this externality in a model of reserve demand: optimal level is lower.
- Calibration shows that these considerations may lower optimal reserves by 45%.

This paper provides a new perspective on the relationship between countries׳ international reserve holdings and financial crises: while the “local” view holds that reserves may prevent domestic crises, it overlooks that the accumulation of reserves relaxes the financing constraint of the reserve currency country and may cause a financial crisis in the centre, which is transmitted globally. According to this “global” view reserve accumulation might destabilize the international financial system. Since the crisis affects all countries alike, the accumulation of reserves imposes a negative externality on non-accumulating countries.We integrate this idea in a theoretical model of the optimal amount of reserves and illustrate the gap between local and global optimality: the consideration of systemic risk lowers the demand for reserves. Moreover, if a supranational authority determines the optimal level of reserves, it internalizes the negative externality and accumulates fewer reserves. A macroprudential tax on reserve hoardings might implement the socially optimal solution. Our calibration analysis shows that these considerations are economically significant: they lower the optimal amount of reserves in the benchmark case by 45%.