Highlights of the International Conference on Financial Cycles

HIGHLIGHTS International Conference on Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

Sydney, Australia 8–9 September 2016

HIGHLIGHTS International Conference on Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience Organized by the Asian Development Bank in collaboration with the Institute of Global Finance, University of New South Wales and sponsored by the Reserve Bank of Australia and Bloomberg Sydney, Australia 8–9 September 2016

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Message from the Asian Development Bank ...... vii Message from the Institute of Global Finance ...... viii

Conference Highlights ...... 1 Opening Session ...... 3 Session 1: Financial, Commodity, and Business Cycles: Linkage and Transmission of Risks in Asia .. 5 Session 2: Financial Interconnectedness, Spillovers and Contagion, Propagation Mechanisms, and the Implications for Systemic Risks in Asia ...... 6 Day 1 Policy Panel ...... 7 Session 3: (Financial Authorities Session): Financial Network Analysis for Systemic Risks and Lessons Learnt from the Systemic Risks and Interconnectedness ...... 10 Session 4: Financial Globalization, Regional Financial Integration and Stability, Predictive Indicators of Vulnerability in Asia ...... 13 Day 2 Policy Panel ...... 14 Closing Session ...... 17

Contents | v vi Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

vi | Conference Highlights Message from the Asian Development Bank

n behalf of the Asian Development Bank, I would like to thanks all the participants to this very important Conference on Financial Cycles, Systematic Risk, Interconnectedness, and Policy Options for OResilience. I am delighted that the conference has been organized by ADB’s Economic Research and Regional Cooperation Department with the Institute of Global Finance, University of New South Wales.

The conference will form the foundation for one of ADB’s flagship publications, the Asian Economic Integration Report 2017, by strengthening our understanding of the mechanisms and channels of systemic risks build up and spread across different financial networks. In today’s era of globalized finance, we have seen how episodes of financial crisis and its spillovers have destabilized domestic, regional, and global financial systems. In our highly interconnected global financial world, resilience cannot be achieved by individual countries or one region alone. The conference provided a venue for fruitful discussion among members of the academia, central bankers, regulators, and international financial institutions to build resilience and safeguard stability in the region.

I particularly want to thank our keynote speakers, Professor Robert Engle of the New York University Stern School of Business, a Nobel Laureate in Economics, and Stijn Claessens of the Board of Governors of the US Federal Reserve System. I would like to thank all our distinguished panelists and presenters for responding to our call for papers and related research. It is encouraging to see your enthusiasm to dissect ﬁnancial vulnerabilities and study policy options in light of the increased regional and global ﬁnancial interconnectedness.

I would like to express my special appreciation to the honorable Philip Lowe, Governor of the Reserve Bank of Australia (RBA), for taking part in this conference, and for the RBA’s sponsorship of this conference, together with Bloomberg.

Again, I want to thank all participants representing academia, governments, ﬁnancial authorities, and international ﬁnancial organizations from Asia and around the world, for your support and knowledge contributions. It was a very productive and successful two days.

Bambang Susantono Vice-President for Knowledge Management and Sustainable Development Asian Development Bank

Contents | vii viii Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

Message from the Institute of Global Finance

n behalf of the Institute of Global Finance, UNSW Business School, I thank all participants and guests of the International Conference on Financial Cycles, Systemic Risk, OInterconnectedness, and Policy Options for Resilience. I hope our international guests were able to appreciate the city of Sydney.

The financial landscape has changed since the recent global financial crisis. Significant steps have been taken to address some of the factors that could ensure greater financial resilience globally, regionally and nationally.

One of the significant challenges of our generation is to manage an increasingly interdependent and interconnected global financial system that could pose significant financial risk, in the wake of another major financial crisis.

This conference is not a one-off event butrather part of a process of study, analysis and data mining of a major project that started several months ago with the aim of understanding the financial challenges and opportunities facing Asian countries, as policy makers and market participants attempt to understand those factors that could mitigate systemic risk and financial instability in the wake of another major financial crisis.

It has been an honor to work alongside the Asian Development Bank to have brought you this program which included so many eminent professionals from the regional and international ﬁnancial community. We are also grateful for the support and sponsorship of the Reserve Bank of Australia and Bloomberg for this conference.

Global financial stability and prosperity is one of the most significant issues of our times. The importance of examining the forces that both promote and challenge stability and prosperity locally, regionally and internationally cannot be overstated. By collaborating across organizations and nations, it is my hope that we will cultivate financial systems that will encourage long- term global prosperity.

I trust that the conference had been stimulating and enjoyable, and provided you with the opportunity to build beneﬁcial academic, corporate and social networks. Thank you for contributing to the success of this conference.

Fariborz Moshirian Director, Institute of Global Finance viii | Conference Highlights Conference Highlights

he global financial crisis highlighted that unbridled financial flows have potential to build up systemic risk and the spread of instability in an era of globalized finance and tightly This conference interconnected financial institutions. When emerging economies are poorly regulated and supervised, financial deepening can lead gathered leading Tto excessive risk-taking and high leverage, amplifying the effects of financial academics, central cycles on economic stability. Financial interconnectedness can also lead to systemic risks and financial contagion if failure or distress in one or more bankers and financial financial institutions causes repercussions throughout domestic, regional, and global financial systems. regulators, and

The global financial crisis has prompted regulators and supervisory international financial authorities around the world to develop new models and tools to analyze financial networks and to assess risks associated with financial cycles organizations, to and interconnectedness as they attempt to safeguard monetary and financial stability. discuss the theory, practices, and This conference gathered leading academics, central bankers and financial regulators, and international financial organizations, to discuss the theory, policy implications practices, and policy implications of financial interconnectedness for systemic risk and financial stability. Among many interesting and relevant of financial presentations delivered over two days, the highlights were keynote lectures by Professor Robert Engle of the New York University Stern School of interconnectedness Business, a Nobel laureate in economics, Stijn Claessens, Senior Adviser of the Board of Governors of the United States Federal Reserve System, and for systemic risk and Professor Viral Acharya of the New York University Stern School of Business. financial stability. The conference emphasized the importance of having in place sound macroprudential policies, a comprehensive regulatory and supervisory framework, and an increasing degree of regional financial integration.

ContentsCCoonntteennttss | 1 2 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

Finding the right balance is key for a country’s (or a region’s) financial and economic performance and resilience. Choosing the right policy responses during good and bad times requires a sound understanding of the nature of financial cycles. One finding is that while financial cycles do co-move to a certain extent with business cycles, they tend to be longer. The pronounced degree of interconnectedness of the global economy underpins that financial and economic resilience cannot be safeguarded by national policies alone. Greater coordination and cooperation, both within regions and globally, is needed.

2 | Conference Highlights Opening Session

he opening session comprised many welcoming remarks and Shang-Jin Wei a keynote address. Professor Fariborz Moshirian started by Chair pointing out three major aspects that are important for enhancing Former Chief Economist and resilience in an increasingly interconnected economic and Director General financial world: (i) corporate governance of financial institutions, Asian Development Bank T(ii) sharing of financial data such as for developing early warning systems, and OPENING REMARKS (iii) global governance. Fariborz Moshirian Director, Institute of Global Finance

Lowe’s talk underlined that financial stability is a global issue and thus WELCOME AND INTRODUCTORY REMARKS requires global efforts. Therefore, it is important to learn from one another’s Philip Lowe experiences dealing with poor asset quality, liquidity management, and Governor-Designate, Reserve Bank of Australia foreign currency exposure to enhance the resilience of global financial systems. Moreover, one needs to learn more about the financial cycle as WELCOME AND INTRODUCTORY REMARKS such, and about optimal policy responses during times of boom and bust. Bambang Susantono Lastly, it is crucial to understand the underlying driving forces of systemic Vice-President, Asian Development Bank risk and how to respond to it. Addressing these issues requires an effective KEYNOTE ADDRESS: INTERCONNECTEDNESS balance of supervision and regulation. AND PROSPECTS FOR GLOBAL FINANCIAL STABILITY Nobel Laureate Professor Robert Engle Vice-President Bambang Susantono pointed out that risks for the global New York University financial system have increased due to heightened uncertainties in advanced economies, sharp declines in oil and commodity prices, and slower growth in emerging markets coupled with spillovers arising from moderation in economic growth in the People’s Republic of China (PRC). This can also have important ramifications for financial stability in Asia, especially during times of increased financial interconnectedness both within the region and globally. Consequently, increased financial interconnectedness and its associated risks highlight the growing role that regional institutions and cooperation can play through providing support for monitoring of macroeconomic and financial conditions, and by providing assistance in times of need.

Finally, the opening session was completed with the highlight of a keynote address by Nobel Laureate Professor Robert Engle, who talked about Interconnectedness and Prospects for Global Financial Stability. Professor Engle presented the concept of SRISK as a measure to determine the capital needed for a firm to survive during a financial crisis. He noted that SRISK depends on liabilities, equity, and the degree of interconnectedness of a firm, and also quantifies the firm’s capital shortfall. Professor Engle said

Opening Session | 3 4 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

aggregate SRISK in Asia has increased recently, mainly as a result of a fall in equity prices, and also during the weeks following the decision of voters in the United Kingdom to leave the European Union. He said Brexit has caused a substantial increase of SRISK of Europe as the value of liabilities has increased, the value of equity holdings has declined, and the level of interconnectedness has gone up. Professor Engle also mentioned that Brexit The biggest risks also resulted in a transitory increase in global volatility. The biggest risks for global financial stability mentioned in the talk were for global financial slow global growth prospects, in particular in Asia (especially the PRC) and stability mentioned Europe. Professor Engle also highlighted challenges associated with recent developments in commodity markets. He said it is, therefore, very important in the talk were to take the action necessary to stimulate global growth, and added that this cannot be achieved through monetary policy alone, but needs to be slow global growth accompanied by expansionary fiscal policies. prospects, in particular During the following sessions, current research papers addressing questions related to financial cycles, systemic risk, interconnectedness, and policy in Asia (especially the options for resilience were presented and openly discussed. It is worth mentioning that a lot of the work that has been presented was still work in PRC) and Europe. progress. This implies that the results presented during the conference may possibly change in the course of future revisions of the papers.

4 | Conference Highlights SESSION 1: Financial, Commodity, and Business Cycles: Linkage and Transmission of Risks in Asia

Li Yang Chair UNSW Business School

PRESENTATIONS: Foreign Investment, Regulatory Arbitrage and the Risk of US Financial Institutions W. Scott Frame, Federal Reserve Bank of Atlanta Atanas Mihov, Federal Reserve Bank of Richmond his session addressed the role of regulatory and supervisory Leandro Sanz, Federal Reserve Bank quality, domestic foreign-currency bond markets, and global of Richmond (Presenter) credit cycles, while focusing on the linkages and channels for the Discussant: Jean-Pierre Fenech, transmission of risk in Asia. Monash University Exchange Rate Dynamics, US Interest TThe ﬁrst talk highlighted that the quality of banking regulation Rate and Sovereign Bond Prices in and supervision is relevant for the international subsidiary locations of US Emerging Markets Po-Hon Chau, Chinese University bank holding companies (BHCs). In particular, US BHCs are more likely to of Hong Kong operate subsidiaries in countries with weak regulation and supervision, which Cho-Hoi Hui, Hong Kong Monetary may lead to potentially dangerous consequences. The discussion included Authority (Presenter) Chi-Fai Lo, Chinese University of Hong Kong debate about whether this observed pattern could be driven by the existence Discussant: Cyn-Young Park, of tax heavens with poor regulatory and supervisory quality. Asian Development Bank

The second presentation provided evidence that dollar-denominated Foreign Booms and Domestic Busts Ambrogio Cesa-Bianchi, Bank of England sovereign bonds in emerging markets are directly inﬂuenced by the dynamics Fernando Eguren Martin, Bank of England of exchange rates. The strong relationship between emerging markets’ (Presenter) sovereign risk and exchange-rate stability suggests that both governments Gregory Thwaites, Bank of England Discussant: Eugenio Cerutti, International and investors might be better served by issuing debt in local currencies, Monetary Fund and letting investors hedge these risks in currency markets. The discussion addressed the role that domestic monetary policy could play in both amplifying and mitigating the risks associated with exchange rate dynamics. Another point discussed was whether a long-end risk premium of the interest rate term structure of the US dollar is an important factor in the pricing of sovereign bonds.

Empirical evidence that (i) banking crises are correlated across countries, and (ii) there is a component of the global credit cycle in domestic credit growth was presented by the last speaker. This calls for an investigation of the role of credit growth in the rest of the world in affecting domestic financial stability conditions. Results provided evidence of the existence of spillovers that financial developments in one country can create for others, highlighting the importance of international co-ordination of financial and macroprudential policies. The discussion focused on the prominent role that exchange rate volatility can play in supplementing these findings.

Contents | 5 6 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

SESSION 2: Financial Interconnectedness, Spillovers and Contagion, Propagation Mechanisms, and the Implications for Systemic Risks in Asia

Chairs: Shang-Jin Wei Former Chief Economist and Director General Asian Development Bank

Ed Johnson Bureau Chief for Sydney Bloomberg News

PRESENTATIONS: he second session began with a keynote lecture on the real Keynote Presentation (Video effects of nonconventional monetary policy measures and Presentation): Whatever it Takes: The Real Effects of Unconventional was followed by academic presentations on financial cycles, Monetary Policy interconnectedness and contagion. Professor Viral Acharya, New York University Stern School of Business TFocusing on the European experience, the keynote lecture Coherent Financial Cycles for G-7 highlighted the importance of adequately capitalized banks for proper Countries: Why Extending Credit transmission of nonconventional monetary policy. Extremely loose monetary can be an Asset Yves S. Schüler, European Central Bank policy has had only moderate effect on the real economy as funds have been (Presenter) channelled predominantly into unproductive sectors. This disappointing Paul P. Hiebert, European Central Bank outcome for Europe over almost a decade is related to an unhealthy banking Tuomas A. Peltonen, European Systemic sector. Healthy (i.e., sufficiently capitalized) banks are a necessity for the Risk Board Discussant: Ju Hyun Pyun, Korea University proper transmission of unconventional monetary policy measures. For the Business School case of Europe, regardless of regular stress-tests, its banks’ balance sheets have long been troubled and do not seem to be improving. Recent surges in The Changing International Network of Sovereign Debt and Financial nonperforming loans and bank insolvencies in Italy and in some periphery Institutions economies should alarm European policymakers and regulators into taking Mardi Dungey, University of Tasmania bold action to assure that their banks are adequately recapitalized. This is (Presenter) John Harvey, University of Tasmania essential for Europe not to experience another “lost decade.” Vladimir Volkov, University of Tasmania Discussant: Filip Zikes, Federal Reserve Board The first paper of the session touched upon the topic of identifying, characterizing, and evaluating financial cycles for Group of Seven (G7) Bad Bad Contagion Juan Miguel Londono-Yarce, Federal countries. Despite the prominence of curbing financial cycles as a policy Reserve Board objective, the research literature on the measurement of financial cycles Discussant: Mardi Dungey, University remains in its infancy—particularly compared with research on business of Tasmania cycles. This study aims at filling this knowledge gap. It finds that financial cycles are on average twice as long as business cycles, indicating a possible disconnect between financial and business cycles. At the same time, there is substantial heterogeneity in national financial and business cycles across G7 countries.

Results also indicate that consideration to how credit and asset prices move in tandem can strongly improve the ability to identify periods of vulnerability prior to systemic banking crises; especially the joint movement of credit and house prices. The paper concludes that policies targeting ﬁnancial cycles (such as macroprudential policies) can complement existing traditional

6 | Conference Highlights economic policy measures, and it highlights the need for a broad scope in ﬁnancial stability surveillance. The subsequent discussion focused on the interaction of ﬁnancial cycles across countries and with the business cycle.

The second talk was related to recent academic work that has emphasized how the interconnectedness of financial institutions across borders contributes to the “robust-but-fragile” nature of the financial system. In particular, the presented paper develops a global empirical network of financial institutions which incorporates both their links with each other and their links through investments in sovereign debt. It finds that for most shocks, the system is resilient and will dissipate risk through the network, but that in some cases, large shocks—or a coincidence of many small ones—can The discussion here cause the network of institutions to act in such a way that the transmission of the shock is amplified, making the system fragile. Accordingly, it is focused on the important to understand changing relationships in the international financial network over periods of crisis. Although it is well observed that international need to develop financial institutions have become more connected during periods of stress, this has been achieved by the formation of increasing numbers of weaker richer, multilayered links between institutions at the same time as stronger links are being networks which dissolved. Therefore, it is imperative that regulators understand both the changing numbers and strength of linkages to practically assess systemic encompass many of risk. The discussion here focused on the need to develop richer, multilayered networks which encompass many of the possible sources of interconnection the possible sources between financial institutions. of interconnection The last presentation of the session addressed the issue of contagion, and noted that although contagion usually has a negative connotation, there between financial is very little empirical evidence in the literature to support such assertions. This paper aims at filling this gap by showing the downside component of institutions. contagion in international stock markets and its negative implications for financial stability. It proposes a measure for the occurrence and severity of global contagion as the proportion of international stock markets that simultaneously experience unexpected returns beyond a certain threshold. The paper also shows that episodes of bad contagion are followed by a significant and economically meaningful deterioration of financial stability conditions: a decrease in bank index stock prices, an increase in spreads on Natalie Oh the credit-default swaps of banks (which protect against banks defaulting Chair UNSW Business School on their bonds), an increase in SRISK, and a reduction of capital-to-assets ratios. The discussion addressed the role of exchange rate movements in KEYNOTE SPEECH: propagating contagion. Financial Cycles and Crisis in Asia Stijn Claessens, US Federal Reserve Board

Panelists: Day 1 Policy Panel Perry Warjiyo, Deputy Governor Bank Indonesia The keynote lecturer underpinned the importance of analyzing macrofinance channels jointly rather than treating them separately. The Cyn-Young Park, Director Asian Development Bank global financial crisis has shown that financial markets actually matter both in originating and propagating shocks. Therefore, it is crucial to understand Stijn Claessens the nature of financial cycles and their interplay with the business cycle. Federal Reserve Board

Session 2 | 7 8 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

The academic literature already addresses underlying propagation mechanisms of financial cycles amplifying real economic shocks, both from a theoretical and an empirical point of view. However, only a few theories explain how financial cycles arise independently. Therefore, it is important to increase the understanding of the endogenous nature of financial cycles in order to choose the right policy options. Likewise, it is important to develop a deeper understanding of how to measure financial cycles, as the different methodologies proposed do not necessarily always lead to the same results.

One of the main lessons is that financial cycles can be of much longer duration than business cycles. Business cycles typically last for 6 to 8 years, while financial cycles can last 10 to 20 years, with particular long periods of boom and higher volatility. Therefore, contraction phases of financial cycles are deeper than those for business cycles. Recessions associated with contractions of the financial cycle tend to be more severe, but not all recessions coincide with financial cycle troughs. Moreover, there is a high coincidence of financial cycle peaks with subsequent cycles.

Regarding recent ﬁnancial developments in the region, it was pointed out that overall credit has grown rapidly in emerging Asia over the past few years, which is mainly associated with rising corporate sector credit. However, household debt and nonperforming loans in the region have been rising recently. While bank capitalization generally is strong in emerging Asia, banks’ current market valuations suggest some concerns about their proﬁtability.

8 | Conference Highlights Another lesson is that financial cycles and crises recur, often even in waves, and are hard to prevent and predict. One should focus instead on improving crisis management mechanisms. Both financial and debt restructuring— Even though it including of sovereign debt—can play an important role. In this vein, it is particularly important to thoroughly assess all banks before their re- may take time and capitalization during a crisis. Even though it may take time and resources, it resources, it is crucial is crucial to differentiate between “good” and “bad” banks in the course of managing crisis. to differentiate The ever-changing financial landscape and its impact on the movement of between “good” and business and financial cycles were debated during the panel discussion. The view was that rapid credit expansion has accelerated through a more diverse “bad” banks in the landscape, which is likely to develop further in the future. course of managing The panel pointed out that while the Asia and Pacific region is better prepared to weather financial crisis, maintaining adequate tools for crisis crisis. management is important. In particular, the instrument of macroprudential policies was viewed as essential because history tells us that exchange-rate flexibility does not suffice to manage the financial cycle; and one may also consider the instrument of capital controls. Effectively, implementation of macroprudential policies requires a sound understanding of the determinants and transmission channels of macrofinancial linkages and the financial cycle. The credit-to-GDP ratio, for instance, turned out to be a good indicator for financial cycles, which typically last longer than the growth cycles. Broader credit cycles that also include other instruments such as debt last shorter than narrower credit cycles (bank lending). Apart from the credit cycle, it is also important for policymakers to understand and monitor the housing cycle, the capital flow cycle, and the corporate and household leverage cycle. Furthermore, panelists noted that a deeper understanding of “boom and bust” in global commodity markets is necessary. Regarding regional policy coordination, it was pointed out that while policy coordination for macroprudential policies may be cumbersome, it is still very important to promote cooperation among central banks and to enhance the exchange of knowledge within the region.

Session 2 | 9 10 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

SESSION 3: FINANCIAL AUTHORITIES Financial Network Analysis for Systemic Risks and Lessons Learnt from the Systemic Risks and Interconnectedness

resentations in the third session of the conference touched Stijn Claessens Chair upon countries’ experiences in dealing with systemic risks and an US Federal Reserve Board elevated degree of interconnectedness. It consisted of five talks from Asian financial authority officials. KEYNOTES/PRESENTATIONS: Takuo Komori, Deputy Commissioner, Financial Services Agency, Japan PDuring the first presentation, the high degree of interdependencies In-Chang Song, Deputy Minister, Ministry of between Japan and the rest of Asia was noted. Throughout recent years, Strategy and Finance, Republic of Korea Japan intensified its engagement in Asia by almost doubling the exposure of Shigeto Nagai, Director General, Bank of Japan Japanese banks to Asian developing countries since 2010. Moreover, it was Meghan Quinn, Head of Financial System shown that Japan did not reduce its engagement in the region during the Division, Australian Treasury global financial crisis as opposed to the Asian financial crisis of 1997–1998, Bambang P. S. Brodjonegoro, Minister, Ministry of National Development Planning, during which Japanese banks reduced their activities. Increased foreign Indonesia exchange reserves, as well as the safety net provided by the Chiang Mai Initiative, contributed to Asia’s enhanced resilience resulting in less severe exposure to external shocks during the global financial crisis. Furthermore, long-lasting low interest rates in Japan provided incentives for domestic banks to increase engagement in foreign markets to generate profits. Lastly, the important role of supervisors to monitor financial soundness, watching global developments, foreign liquidity management and establishing early warning system was highlighted.

The second speaker focused on the experience of the Republic of Korea in dealing with systemic risk and interconnectedness. The main points were:

10 | Conference Highlights First, its financial sector has demonstrated procyclicality, which has built up systemic risks and sometimes has led to financial crises. Second, volatility of external capital flows has been the country’s biggest source of systemic risk. Third, systemic risks arising from financial interconnectedness have relatively been low, but still require careful monitoring. Fourth, and more generally, a variety of policy efforts are required to mitigate systemic risks. This also underpins the important role of international cooperation.

The third talk addressed the banking landscape in Japan and Asia as a whole, and the risks associated with foreign currency funding in particular. The role Regarding risks of Japanese banks in the region has increased in importance over the past associated with few years. Japanese banks account for the largest proportion of international bank claims in emerging Asia and the Paciﬁc, which have risen substantially, foreign currency followed by PRC banks, whose international claims have increased six fold in the past 6 years. Of the banks increasingly active regionally, Japanese ones funding, it was pointed are the dominant players. While such a surge in interconnectedness yields many efficiency gains, it also poses risks, such as ﬁnancial contagion through out that Japanese common and concentrated creditors. Moreover, international bank claims are often held by foreign banks’ branches (as opposed to subsidiaries). This banks are generally in turn leads to challenges for local regulators, because it is the responsibility of the host country to monitor risks. resilient to short-

Regarding risks associated with foreign currency funding, it was pointed out term stress in foreign that Japanese banks are generally resilient to short-term stress in foreign currency funding, as currency funding, as they hold sufficiently liquid assets to cover outflows that would be expected under a stress situation. However, an increase in the cost they hold sufficiently of US dollar funding underpins the growing need for local currency funding in the whole region. This is particularly important for economies that do liquid assets to cover not hold large foreign exchange reserves. The integral role of international coordination in mitigating the risks associated with foreign funding was outflows that would pointed out. For instance, the establishment of foreign currency swap lines at market rates among six major central banks in the aftermath of the be expected under a global financial crisis has turned out to be effective. Cross-border collateral arrangements, allowing domestic banks to use collateral from other central stress situation. banks can mitigate balance of payment risks.

The fourth talk featured Australia’s experience in ensuring financial stability, both during times of “peace” and episodes of financial distress. It was stressed that the Australian banking sector has performed remarkably well over the past two decades. This was partly due to favorable fiscal conditions in 2007, but also since Australia’s flexible exchange rate regime turned out to be effective in reacting to external shocks. Furthermore, flexible labor markets, fiscal policy measures, independent and robust regulators, good monetary policy credibility, prudential regulation, and adequate liquidity management were mentioned as important contributors to success. Especially, the importance of continual reevaluation of the financial environment during good and bad times, combined with an effective coordination, turned out to be indispensable. In particular, since Australia’s coordination body, the Council of Financial Regulators, consists of only four

Session 3 | 11 12 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

key regulating agencies, this allows for a timely and coordinated response to The severity of the changing financial conditions. The last presentation centered on the case of Indonesia. The severity of the Asian financial crisis in Asian financial crisis in 1997–1998 resulted in Indonesia and other Asian 1997–1998 resulted in economies being better prepared for the global financial crisis. The fact that in 2009 the Indonesian economy was still growing at an annual growth rate Indonesia and other of 4% underlines this observation. Still, capital flow volatility, particularly capital outflows, represents a major concern today. Indonesia has introduced Asian economies tax amnesties to encourage investors to send capital back to Indonesia. Furthermore, existing liquidity constraints that dampen growth were being better prepared mentioned and substantiated by the context of a loan to GDP ratio of only for the global financial 40% (compared to 200% in Singapore, for example). During the subsequent discussion, measures on how to direct and manage crisis. capital flows to emerging market economies were addressed. The possibility of enriching Asian financial markets with new instruments, other than bonds and equities, was mentioned as one way to attract more capital. However, balancing the “right amount of inflows” is also important. While in the past, capital inflows were generally considered advantageous to receiving economies, today the risks associated with massive capital inflows are better known. Therefore, macroprudential policy measures such as assuring a foreign exchange liquidity cover ratio are important tools to mitigating these risks. Lastly, the importance of good policy making during the good times was once again highlighted. Even though it might be cumbersome from a political economy perspective, “peace time” regulation is not less important than policy reactions during times of crisis.

12 | Conference Highlights SESSION 4: Financial Globalization, Regional Financial Integration and Stability, Predictive Indicators of Vulnerability in Asia

he second session of Chris Adam the second day of the Chair conference consisted of Associate Dean and the Deputy Director two empirical studies, Institute of Global Finance, UNSW Business School investigating the effects Tof systemic risk-taking of banks and PRESENTATIONS: the transmission of real estate shocks Systemic Risk-taking at Banks: Evidence from the Pricing of Syndicated Loans through multinational banks. Di Gong, University of International Business and Economics (Presenter) The ﬁrst talk provided empirical Wolf Wagner, Rotterdam School of evidence for banks’ risk-taking in Management Discussant: Christina Bui, University the United States arising from “too- of Technology Sydney many-to-fail” public guarantees. While desirable from the ex-post viewpoint The Transmission of Real Estate Shocks through Multinational Banks of safeguarding the stability of the Ata Can Bertay, World Bank ﬁnancial system, these guarantees Discussant: Adalbert Winkler, Frankfurt School are likely to create distortions ex-ante. Estimation results suggest that of Finance and Management bailout subsidies due to public guarantees in systemic crises are sizable, pointing toward a considerable moral hazard problem arising from “too-many-to-fail” guarantees.

Although the sample covers the United States banking sector only, the moral hazard problem of systemic risk-taking is likely to be applicable for the Asia and Paciﬁc region as well. For instance, banks in the PRC are taking excessive systemic risk by expanding exposure to the housing market in the real estate boom. Mortgages comprised 95% of new loans in July 2016 while the housing prices skyrocketed in major cities, which could cause a dangerous bubble. Extra capital surcharges for ﬁnancial institutions that take on excessive correlated risks could be a remedy, as it enhances the capital buffer of those banks and punishes and discourages systemic risk-taking at the same time. The discussion addressed the question of distinguishing systemic risk-taking behavior during normal times from behavior observed throughout crisis periods.

Session 4 | 13 14 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

The second paper investigated the response of credit supply of foreign banks KEYNOTE SPEECH: in response to real estate price changes in home countries (i.e., where the

Financial Resilience and Policy parent banks reside). Empirical results suggest that multinational banks Recommendations: Stressing Financials transmit real estate shocks to their foreign bank subsidiaries’ credit supply. in the Asia Pacific Region More specifically, a 1% decrease in real estate prices in the home country leads to a 0.2%–0.3% decrease in the credit growth of the foreign subsidiary. Speaker: Nobel Laureate Professor Robert Engle, New York University Stricter home country banking regulation reduces the size of the effect. Also, the effect is only significant during crisis (as opposed to booms), suggesting Chair: Bambang Susantono, Vice-President, an asymmetric response. Asian Development Bank

Panelists: Moreover, cultural and geographical proximity to the home country leads Bambang P. S. Brodjonegoro, Minister to less severe transmission of real estate shocks. The last finding seems Ministry of National Development Planning, Indonesia especially relevant to ADB member countries during times of increased regional integration. Specific policy recommendations arising from the Perry Warjiyo, Deputy Governor, Bank findings about the transmission channels were debated in the discussion that Indonesia followed the presentation. Cyn-Young Park, Director Asian Development Bank Day 2 Policy Panel Meghan Quinn, Head of Financial System Division, Australian Treasury The Day 2 Policy panel started with a keynote speech by Nobel laureate Professor Robert Engle, on “Financial Resilience and Policy Recommendations: Stressing Financials in the Asia Pacific Region.” Professor Engle highlighted the importance of regular bank stress-tests to gauge the financial sector’s resilience and for their prudent use in shaping policy actions. One of the risks Professor Engle mentioned was the occurrence of an endogenous financial spiral caused by firms collectively selling assets to deleverage their balance sheets. This in turn might yield downward price pressure on all assets held by firms, leading to increased systemic risk. As a result, firms are even incentivized to sell more assets, which reinforce the financial downward spiral. It is the regulators’ task to carefully assess these risks and, if needed, to take mitigating action such as the recapitalization of banks.

The session continued with a policy panel, which focused on lessons learned from past crises to guide today’s policy choices and challenges. Panelists discussed the relevance of strengthening bank capital, banking consolidation, regulation, and supervision, and the need for an appropriate policy mix

14 | Conference Highlights between monetary policy and macroprudential measures, exchange flexibility, and capital flow management measures, along with the significance of the interplay between monetary and fiscal policy, the development of local-currency bond markets, and the role of regional safety nets during times of financial integration. It was emphasized that strengthened bank capital and consolidation of the banking sector can lead to greater financial stability. The Indonesian example in 1997–1998 shows that banking deregulation The Indonesian without proper regulation and supervision can result in too many and too poorly capitalized banks, especially small ones. This, in turn, can example in 1997–1998 exacerbate financial vulnerabilities—both endogenously and exogenously— as the failure of one bank, even a small one, can cause tensions in financial shows that banking markets. In this vein, the debate on the effect of higher capitalization of banks on economic growth was introduced. Panelists pointed out that most deregulation without of the economic literature suggests that higher capitalization increases proper regulation and economic growth, while banks generally see it as hindering growth. supervision can result Panelists said strengthening financial regulation, banking stress tests, capital in too many and too surcharges or countercyclical capital buffers, especially on Domestically poorly capitalized Systemically Important Banks (DSIBs) would ensure the banking system banks, especially is sound and thus contribute to financial stability. They highlighted small ones. the important role of a central bank in safeguarding financial stability. Based on Indonesia’s experience, a policy mix between inflation targeting and macroprudential policies that support financial stability, and a mix of exchange rate flexibility and capital flow management measures to deal with volatilities of capital flows was suggested as the right policy approach. In this regard, the importance of understanding interactions between microprudential and macroprudential policies was stressed. Panelists emphasized the important role of macroprudential policies and crisis prevention mechanisms, and also stressed the right policy mix between fiscal and monetary policy. One policy recommendation was to not only rely on monetary stimulus during turbulent times, but also to make use of expansionary fiscal policies, as long as there is sufficient fiscal space available. Such a measure can lift the pressure from the monetary stimulus. In this vein, effective and close coordination among all domestic financial authorities with different mandates in the economy is all the more important. Session 4 | 15 16 Ň Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

Furthermore, panelists underlined the need for international cooperation. National mechanisms and domestic policies alone are not sufficient to ensure financial stability, as demonstrated by the occurrences of previous crises. In an interconnected world, cooperation is paramount. The need is amplified Furthermore, panelists by the risks associated with ever-growing interconnectedness and spillovers. As part of regional initiatives, enhancing effective surveillance of regional underlined the need macrofinancial conditions and deepening regional capital markets, especially through the development of local currency bond markets were recommended. for international The importance of establishing effective regional mechanisms for liquidity support in time of crisis was also raised. As successful examples for cooperation. international cooperation, the cases of ASEAN+3 Macroeconomic Research Office (AMRO) and Chiang Mai Initiative Multilateralization (CMIM) were brought up.

However, panelists also mentioned that the current CMIM format may not be sufficient to provide confidence to the markets, and it remains untested. CMIM only consists of callable capital; no capital was actually paid in. Furthermore, it was argued that a merger of CMIM and AMRO could be considered to make regional financial safety nets more effective. Another view regarding further deepening of the regional crisis prevention and resolution architecture was that one needs to first gain a sounder understanding of interconnectedness. As to financial interconnectedness and regional responses, it was recommended that individual economies should ensure their own financial systems with a cooperative framework. A panelist also explained that the Association of Southeast Asian Nations (ASEAN) has already laid out the ASEAN Banking Integration Framework and set up a “cross-border supervisory reporting system between specific ASEAN economies.” While it was pointed out that deepening regional capital markets, especially through the development of local currency sovereign and corporate bond markets can strengthen regional financial resilience, it also entails certain risks. For instance, liquidity in Indonesia’s sovereign debt markets quickly dried up in the face of external headwinds and Asia’s liquid local currency bond markets can be associated with faster moving capital flows in the region.

16 | Conference Highlights Closing Session

uring the closing remarks, Shang-Jin Wei identiﬁed the CLOSING REMARKS:: concepts of interconnectedness, international ﬁnancial cycles, and systemic risk as the major topics discussed in the Shang-Jin Wei conference. Moreover, the interdependencies between these Former Chief Economist and Director General concepts were mentioned. Wei stressed the relevance of Asian Development Bank Dbringing together policymakers and researchers, as this conference achieved.

Wei noted that the diverse topics discussed at the conference highlighted that policymakers need to be equipped with a wide range of skills, while researchers tend to be far more specialized. On the one hand, it is critical to have experts in academia to produce high quality research. On the other hand, it is important to account for essential cross-dimensions while conducting research that is useful for policymaking. In particular, Wei pointed out that to develop a sound understanding of the topics discussed at the conference, one has to take into account both the ﬁnance side and the open economy macro side. Otherwise, he said, one risks missing out relevant details about the transmission channels.

Lastly, Wei mentioned that one should not underestimate the beneﬁts that crises generate, especially from a long-term perspective. It must not be the aim to extinguish every single crisis, since crisis often provides a way to overcome political economy resistance, which eventually leads to welfare- improving reforms.

Contents | 17

Highlights: International Conference on Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience

Jointly organized by the Asian Development Bank Economic Research and Regional Cooperation Department and the Institute of Global Finance - University of New South Wales, the conference gathered leading academics, central bankers and financial regulators, and international financial organizations and discussed the theory, practices, and policy implications of financial interconnectedness for systemic risk and financial stability.

About the Asian Development Bank

ADB’s vision is an Asia and Paciﬁc region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to a large share of the world’s poor. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration.

Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.

About the Institute of Global Finance

Based at the University of New South Wales, Sydney, the Institute of Global Finance (IGF) is housed at Australia’s leading business school: the UNSW Business School. The IGF has collaborated and published joint research with a number of international institutions, such as the BIS, the IMF and the World Bank. The IGF collaborates with New York University’s Volatility Institute. The IGF’s work with the NYU Volatility Institute focuses on banks’ systemic risk, global financial stability and financial institutions. The IGF is currently working with business and finance organizations such as PwC, KPMG and BlackRock and collaborates with international institutions such as the Asian Development Bank and the World Bank, with the aim of providing cutting edge research with policy applications for the finance industry and policy makers. Another objective of the IGF is the promotion of global financial prosperity through financial policies which contribute to greater global financial and regional resilience and enhancement of the process of regional and global financial integration.