This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank's balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries. Policy implications are explored. JEL Classification Numbers: E52, F36, F41, G11Keywords: Dollarization, financial intermediation, asset substitution Author's E-Mail Address: aize@imf.org, ely@utdt.edu 1 The paper benefited from comments received on an earlier version and during IMF seminar presentations. We are indebted to Tomás

De Nicol6, Honohan, and Ize assess the benefits and * Dollarization is likely to promote financial risks associated with dollarization of the banking system.deepening only in a high inflation environment. The authors provide novel empirical evidence on the * Financial instability is likely higher in dollarized determinants of dollarization, its role in promoting economies. financial development, and on whether dollarization isThe authors discuss the implications of these findings associated with financial instability. They find that:for financial sector and monetary policies. * The credibility of macroeconomic policy and the quality of institutions are both key determinants of crosscountry variations in dollarization.This paper-a joint product of Finance, Development Research Group, and the Monetary and Financial Systems Department, International Monetary Fund-is part of a larger effort to examine institutional determinants of financial development and stability. Copies of the paper are available free from the World Bank,

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This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank's balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries. Policy implications are explored. JEL Classification Numbers: E52, F36, F41, G11Keywords: Dollarization, financial intermediation, asset substitution Author's E-Mail Address: aize@imf.org, ely@utdt.edu 1 The paper benefited from comments received on an earlier version and during IMF seminar presentations. We are indebted to Tomás

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.