## Assessing Banking and Currency Crisis Risk in Small States: An application to the Eastern Caribbean Currency Union

_IMF Working Papers, November 19, 2021_

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## Bibliographic details
- Authors: Carlo Pizzinelli, Kotaro Ishi, Tariq Khan
- Published: November 19, 2021
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513599861.001

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### Summary
- Study objective: Complement the early warning signals literature by studying the determinants of banking and currency crises for small states and currency boards.
- Dataset and model: Builds on the crisis dataset by Laeven and Valencia (2020) and estimates a binominal logit model to identify the determinants of crises.
- Case study: Applies models to the Eastern Caribbean Currency Union (ECCU).
- Core conceptual result: Both external and domestic fundamentals matter in predicting crisis likelihood; small states and fixed exchange rate regimes are more sensitive to these fundamentals compared to larger economies.
- Specific result for currency boards: Keeping a high level of the foreign reserve cover—the “backing ratio” defined as official foreign reserves as a share of central bank demand liabilities—is critical to reduce the likelihood of both banking and currency crises.
- Conditional effect: The backing ratio is particularly important during years of global economic downturn.

### Methods and Scope
- Empirical approach: Estimation of a binominal logit model using the Laeven and Valencia (2020) crisis dataset.
- Application: Model results applied to the ECCU as a case study.
- Focus variables: External fundamentals, domestic fundamentals, exchange rate regime classification (including currency boards and conventional pegs), and the backing ratio metric.

### Key Findings
- Both external and domestic fundamentals are important predictors of banking and currency crisis likelihood.
- Small states and fixed exchange rate regimes exhibit greater sensitivity to those fundamentals than larger economies.
- For currency board economies:
  - A high backing ratio (official foreign reserves as a share of central bank demand liabilities) substantially reduces the likelihood of banking and currency crises.
  - The protective effect of the backing ratio is especially strong during global economic downturns.

### Policy Implications and Recommendations
- For small states and fixed exchange rate regimes:
  - Strengthen monitoring of both external and domestic fundamentals as early warning indicators of crisis risk.
- For currency board economies:
  - Maintain a high backing ratio (official foreign reserves relative to central bank demand liabilities) to lower the probability of banking and currency crises.
  - Prioritize reserve accumulation and reserve management practices that preserve the backing ratio, particularly to buffer against global downturns.

*Carlo Pizzinelli, Kotaro Ishi, and Tariq Khan. "Assessing Banking and Currency Crisis Risk in Small States: An application to the Eastern Caribbean Currency Union", IMF Working Papers 2021, 276 (2021), accessed 9/16/2026, https://doi.org/10.5089/9781513599861.001*

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_Source: https://www.imf.org/en/publications/wp/issues/2021/11/19/assessing-banking-and-currency-crisis-risk-in-small-states-509664_