We calibrate a model of the optimal level of international reserves for emerging market countries. The model focuses on the optimization problem of a small open economy that is hit by crises, defined as a sudden stop in capital flows associated with a fall in ouput. We derive a formula for the optimal level of reserves and calibrate it using data on sudden stops in middle-income countries. The calibrated model can explain reserves of the order of magnitude observed in emerging countries.

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The paper describes the path of reserve requirements (RR) in the aftermath of bank runs as the outcome of an optimal policy decision. It develops a dynamic general equilibrium model of a small open economy characterized by three frictions. The results suggest that the path of RR depends on the shock the economy receives and the resulting impact on interest rates. The paper identifies factors that trigger banking crises in several countries, matching the facts with the model’s predictions.

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We assess the contribution of reserves vis-a-vis institutional variables in reducing the risk of crises. We find that the ratio of reserves to short-term debt robustly explains crises, even after controlling for financial development and political variables. We compute the optimal level of reserves for a set of emerging economies, finding that the current stocks of reserves are broadly consistent with an optimal selfinsurance policy under reasonable assumptions regarding the cost of a crisis.

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In a cross section of emerging markets and developing countries, we find that equity-like liabilities as a share of countries’ total external liabilities (or as a share of GDP) are positively and significantly associated with institutional quality. These results suggest that better institutional quality may help improve countries’ capital structures. The results might also provide an explanation for the observed correlation between institutional quality and the frequency of crises.

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We develop a model in which countries insure against shocks by subscribing to a credit-union - the IMF - or by accumulating reserves. We assess the impact of increasing heterogeneity of Fund members on its effectiveness as a provider of co-insurance. We find high-risk countries increasingly self-insure; the average size of Fund assistance rises; and regional Funds are likely to emerge as a second-line of co-insurance. We conclude that the Fund’s financial basis needs reconsidering.

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The paper highlights the increased dispersion in net external positions in recent years. It provides a simple accounting framework that disentangles the factors driving the accumulation of external assets and liabilities. It also examines the factors driving the foreign asset portfolio of international investors. Finally, it relates the empirical evidence to the current debate about the roles of portfolio balance effects and exchange rate adjustment in shaping the external adjustment process.

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