Central Bank Balance Sheets and the Transmission of Financial Crises

Abstract

Central banks usually “park” their foreign exchange reserves in safe or highly liquid foreign assets. The paper illustrates that when central banks invest instead in risky foreign assets, then domestic banking crises can cause a crisis in the market for the foreign asset and vice versa. The paper takes its motivation from Asian central banks’ recent appetite for US government agency-debt securities such as those issued by Fannie Mae and Freddy Mac.