Banks and cross-border capital flows: Policy challenges and regulatory responses

Markus K Brunnermeier, José De Gregorio, Philip R. Lane, Hélène Rey, Hyun Song Shin 07 October 2012

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The textbook case for financial integration is well known. It allows capital to flow from capital-rich to capital-poor economies, where returns should be higher. These flows complement limited domestic saving in capital-poor countries and reduce their cost of capital, boosting investment and growth. Financial integration may also be a buffer against shocks and carry “collateral” or indirect benefits to do with managerial and organisational expertise, or better governance of local firms. Some allowance for a slower pace of financial integration was sometimes made for developing or emerging economies, citing their weaker institutions and more limited capacity to absorb and benefit fully from the inflows of capital, but the ideal of full capital account convertibility should still served as the North Star that emerging economy policymakers should navigate by, even if they steer close to land initially so as to avoid the perils of the open ocean that only advanced economy ships can navigate safely.

However, the subprime crisis in the US and capital flow reversals and the banking crisis in Europe, have shaken faith that even advanced economies can harness the benefits of greater financial flows and deepening without incurring costs (Allen et al. 2011). The advanced-countries that have been swept up first by the subprime crisis and now by the Eurozone crisis are not the stereotypical emerging economies with weak institutions. Spain, for example, ranks high on traditional yardsticks of financial development such as the ratio of commercial bank assets to GDP, or of financial integration such as cross-border liabilities as a proportion of GDP. And yet, those same measures of financial integration and development that were held up as yardsticks of progress have turned out instead to be the engines of financial distress as capital flow reversals have gathered pace in Europe. In contrast, it has been the emerging economies with what were presumed to have ‘weak’ institutions and underdeveloped financial markets that have best weathered the storm.

These topsy-turvy outcomes have been disorienting for those who believed in the desirability of moving toward the ideal of liberalised, open financial markets in incremental steps.

The Committee for International Economic Policy and Reform of which we are a part (whose members are listed below) has just issued a report (CIEPR 2012) that takes stock of the traditional case for financial liberalisation and offer our perspective on which principles have withstood the test of recent events and which ones now need re-thinking. In our 2011 report, Rethinking Central Banking, we made the case for a broader mandate for central banks and for monetary policy coordination. In this year’s report, we lay out a complementary framework for cross-border banking flows and for improved regulatory coordination.

The traditional policy prescription is that the benefits of capital flows can be reaped by removing the impediments to unfettered capital movements one by one. However recent experience, especially the capital flow reversals in Europe, has shown that even advanced economies may be vulnerable to the unintended consequences of capital account liberalisation when the procyclicality inherent in capital flows is not adequately addressed.

The procyclicality of capital flows can in principle be addressed through coordinated global regulation and globally coordinated monetary policy. However, in practice such coordination is not straightforward to design or implement, even when the interests of countries overlap or are congruent. And even when coordination is globally optimal, it may generate tensions with the valued prerogative of national governance.

Given the obstacles to global coordination, countries may have little choice but to design frameworks that mitigate the risks of cross-border flows at the national level. We provide a number of recommendations from the perspective of nation policymakers.

Our main conclusions and recommendations are as follows:

  • The policymaker’s goal is to reap the benefits from cross-border capital flows while guarding against potential financial stability costs. Reaping the benefits requires, first and foremost, resisting vested interests that push for barriers to capital flows as a way of avoiding necessary structural reforms and fiscal adjustments. Good macroeconomic and structural policies form the bedrock of financial stability.
  • Guarding against financial instability starts with keeping track of the complete matrix of gross cross-border capital flows and gross external asset and liability positions. Focusing on net flows is not enough. The detailed features of national balance sheets, at the level of gross flows, determine whether financial integration promotes risk sharing across countries or increases financial contagion.
  • Persistent current-account imbalances pose financial stability risks and have implications for the sustainability of net external asset positions. Discussions of global rebalancing should be linked to the broader debate on capital flows, including specifically the connections between capital flows and financial stability, the procyclical nature of such flows, and the role of monetary policy spillovers in magnifying that procyclicality.
  • FDI and equity portfolio investment are conducive to increased international risk sharing and tend to be stabilising. In contrast, credit flows, which are not always conducive to efficient risk sharing, have a greater potential to be destabilising. Therefore, current biases in favour of debt financing over equity financing should be reduced.
  • Most cross-border capital flows are channelled through global banks and are heavily procyclical. The pro-cyclical nature of cross-border bank-intermediated credit flows has given rise to serious economic and financial instabilities. Effective regulation of cross-border banking is essential for domestic and global financial stability in a highly financially integrated world economy.
  • The organisational and financial structure of global banks is important for the transmission of imbalances and therefore requires careful regulatory attention. Banks that are funded by stable deposits or long-term funding pose the least risk. In contrast, banks that rely on short-term wholesale funding represent a greater risk, irrespective of whether they are domestically-owned or branches/subsidiaries of foreign banks.
  • Globally enforced financial regulation together with global monetary policy coordination can reduce distortions sufficiently to allow countries to reap the benefits of capital flows while limiting risks to stability. In practice, however, political realities are likely to complicate multilateral discussions of banking regulation, while monetary policy tends to be conducted with domestic rather than global imperatives in mind.
  • The incremental liberalisation of capital flows in the pursuit of the ideal of the frictionless first best outcome has not worked as advertised. The crisis in the EZ shows that the flaws with the incremental first best approach are not simply a result of underdeveloped or inadequate domestic institutions, as traditionally argued in the emerging market and developing country context.
  • Given the difficulties of attaining a unified global regulatory framework and efficiently coordinating monetary policies across countries, governments may need to resort to a Second Best approach in which they seek to actively manage capital flows. Macroprudential policies can play a key role in this process by imposing targeted regulations on banks engaged in cross-border activities.
  • Macroprudential policies should operate on both the asset side of a bank’s balance sheet, such as LTV and DTI caps, and the liability side, through devices such as levies on the non-core liabilities. These policies should attempt to influence balance sheet management by banks through instruments such as countercyclical capital requirements.
  • For the EZ, the First Best may still be attainable through sufficiently robust financial regulation together with banking integration. Full banking union with a single regulator, as has been proposed recently by the European Commission, would be an effective means to this end.

Alternatively, national banking systems that are conservatively regulated at the national level—for instance, through macro-prudential measures that limit banks’ reliance on short-term wholesale funding – would help moderate capital flows that could otherwise exacerbate procyclical behaviour and generate risks. But the middle ground of fragmented financial systems with unimpeded capital flows has been shown by recent events to be untenable.

Editor’s Note: Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses, published by the Brookings Institution, is the second annual report of the Committee for International Economic Policy and Reform (CIEPR), comprised of Markus Brunnermeier, Jose De Gregorio, Barry Eichengreen, Mohamed El-Erian, Arminio Fraga, Takatoshi Ito, Philip Lane, Jean Pisani-Ferry, Eswar Prasad, Raghuram Rajan, Maria Ramos, Helene Rey, Dani Rodrik, Kenneth Rogoff, Hyun Song Shin, Andres Velasco, Beatrice Weder di Mauro and Yongding Yu.

References

Allen, Franklin, Thorsten Beck, Wolf Wagner, Philip Lane, Dirk Schoenmaker, and Elena Carletti (2011), “Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies”, VoxEU.org, 20 June.

Committee for International Economic Policy and Reform (2012) Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses

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Topics:  International finance

Tags:  financial sector, banking sector

Edwards S. Sanford Professor at Princeton University

Professor of Economics, University of Chile

Whately Professor of Political Economy at Trinity College Dublin and CEPR Research Fellow

Professor of Economics, London Business School and CEPR Research Fellow

Princeton University and CEPR