Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses

Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses Committee on International Economic Policy and Reform SEPTEMBER 2012 Markus Brunnermeier Philip R. Lane Dani Rodrik José De Gregorio Jean Pisani-Ferry Kenneth Rogoff Barry Eichengreen Eswar Prasad Hyun Song Shin Mohamed El-Erian Raghuram Rajan Andrés Velasco Arminio Fraga Maria Ramos Beatrice Weder di Mauro Takatoshi Ito Hélène Rey Yongding Yu Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses Committee on International Economic Policy and Reform SEPTEMBER 2012 Markus Brunnermeier Philip R. Lane Dani Rodrik José De Gregorio Jean Pisani-Ferry Kenneth Rogoff Barry Eichengreen Eswar Prasad Hyun Song Shin Mohamed El-Erian Raghuram Rajan Andrés Velasco Arminio Fraga Maria Ramos Beatrice Weder di Mauro Takatoshi Ito Hélène Rey Yongding Yu Table of Contents Preface . iii Executive Summary . iv 1 . Introduction . 1 2 . Some Key Features Of Capital Flows . 6 3 . Policy Implications . 20 4 . Summary And Recommendations . 29 References . 32 Appendix A: Subsidiarization . 37 Appendix B: On Europe . 44 BANKS AND CAPITAL FLOWS: POLICY CHALLENGES AND REGULATORY RESPONSES II Preface he Committee on International Economic in global economic management and economic Policy and Reform is a non-partisan, indepen- governance. Each Committee report will focus on Tdent group of experts, comprised of academics a specific topic and will emphasize longer-term and former government and central bank officials. rather than conjunctural policy issues. Its objective is to analyze global monetary and financial problems, offer systematic analysis, and The Committee is grateful to the Alfred P. Sloan advance reform ideas. The Committee attempts to Foundation* for providing financial support and identify areas in which the global economic archi- to the Brookings Institution for hosting the com- tecture should be strengthened and recommend mittee and facilitating its work. Quynh Tonnu pro- solutions intended to reconcile national interests vided excellent administrative and logistical sup- with broader global interests. Through its reports, port to the Committee. it seeks to foster public understanding of key issues Committee Members Markus Brunnermeier, Princeton University José De Gregorio, University of Chile Barry Eichengreen, University of California, Berkeley Mohamed El-Erian, PIMCO Arminio Fraga, Gavea Investimentos Takatoshi Ito, University of Tokyo Philip R. Lane, Trinity College Dublin Jean Pisani-Ferry, Bruegel Eswar Prasad, Cornell University and Brookings Institution Raghuram Rajan, University of Chicago Maria Ramos, Absa Group Ltd. Hélène Rey, London Business School Dani Rodrik, Harvard University Kenneth Rogoff, Harvard University Hyun Song Shin, Princeton University Andrés Velasco, Columbia University Beatrice Weder di Mauro, University of Mainz Yongding Yu, Chinese Academy of Social Sciences *Brookings recognizes that the value it provides to any donor is in its absolute commitment to quality, independence and impact. Activities sponsored by its donors reflect this commitment and neither the research agenda, content, nor outcomes are influenced by any donation. BANKS AND CAPITAL FLOWS: POLICY CHALLENGES AND REGULATORY RESPONSES III Executive Summary n our previous report, Rethinking Central Bank- Our main conclusions and recommendations are ing, we made the case for a broader mandate for as follows: Icentral banks and for monetary policy coordination. In this report, we lay out a complementary • The policy maker’s goal is to reap the ben- framework for cross-border banking flows and for efits from cross-border capital flows while improved regulatory coordination. guarding against potential financial stability costs. Reaping the benefits requires, The traditional policy prescription for capital ac- first and foremost, resisting vested inter- count opening is that the benefits of capital flows ests that push for barriers to capital flows can be reaped by removing the impediments to as a way of avoiding necessary structural unfettered capital movements one by one. Some reforms and fiscal adjustments. Good allowance is made for emerging and developing macroeconomic and structural policies economies to liberalize more slowly, given their form the bedrock of financial stability. weak institutions. However recent experience, such as the capital flow reversals in Europe, has • Guarding against financial instabil- shown that even advanced economies may be vul- ity starts with keeping track of the com- nerable to the unintended consequences of capital plete matrix of gross cross-border capital account liberalization when the procyclicality in- flows and gross external asset and liabil- herent in capital flows is not adequately addressed. ity positions. Focusing on net flows is not enough. The detailed features of national The procyclicality of capital flows can in principle balance sheets, at the level of gross flows, be addressed through coordinated global regula- determine whether financial integration tion and globally coordinated monetary policy. promotes risk sharing across countries or However, in practice such coordination is not increases financial contagion. straightforward to design or implement, even • Persistent current account imbalances when the interests of countries overlap or are con- pose financial stability risks and have gruent. And even when coordination is globally implications for the sustainability of net optimal, it may generate tensions with the valued external asset positions. Discussions of prerogative of national governance. global rebalancing should be linked to the broader debate on capital flows, including Given the obstacles to global coordination, coun- specifically the connections between capi- tries may have little choice but to design frame- tal flows and financial stability, the procy- works that mitigate the risks of cross-border flows clical nature of such flows, and the role of at the national level. We provide a number of rec- monetary policy spillovers in magnifying ommendations from the perspective of national that procyclicality. policy makers. • Foreign direct investment and equity portfolio investment are conducive to BANKS AND CAPITAL FLOWS: POLICY CHALLENGES AND REGULATORY RESPONSES Iv increased international risk sharing and shows that the flaws with the incremental tend to be stabilizing. In contrast, credit First Best approach are not simply a result flows, which are not always conducive to of underdeveloped or inadequate domes- efficient risk sharing, have a greater poten- tic institutions, as traditionally argued tial to be destabilizing. Therefore, current in the emerging market and developing biases in favor of debt financing over eq- country context. uity financing should be reduced. • Given the difficulties of attaining a uni- • Most cross-border capital flows are chan- fied global regulatory framework and ef- neled through global banks and are heav- ficiently coordinating monetary policies ily procyclical. The procyclical nature of across countries, governments may need cross-border bank-intermediated credit to resort to a Second Best approach in flows has given rise to serious economic which they seek actively to manage capi- and financial instabilities. Effective regu- tal flows. Macro-prudential policies can lation of cross-border banking is essential play a key role in this process by imposing for domestic and global financial stability targeted regulations on banks engaged in in a highly financially integrated world cross-border activities. economy. • Macro-prudential policies should operate • The organizational and financial struc- on the asset side of a bank’s balance sheet, ture of global banks is important for the as do loan-to-value and debt-to-income transmission of imbalances and there- caps, and the liability side, through devic- fore requires careful regulatory attention. es such as levies on the non-core liabilities. Banks that are funded by stable deposits These policies should attempt to influ- or long-term funding pose the least risk. ence balance sheet management by banks In contrast, banks that rely on short-term through instruments like countercyclical wholesale funding represent a greater risk, capital requirements. irrespective of whether they are domesti- cally-owned or branches/subsidiaries of • For the euro area, the First Best outcome foreign banks. may still be attainable through sufficiently robust financial regulation together with • Globally-enforced financial regulation banking integration. A full banking union together with global monetary policy co- with a single regulator, as has been pro- ordination can reduce distortions suffi- posed recently by the European Commis- ciently to allow countries to reap the ben- sion, would be an effective means to this efits of capital flows while limiting risks to end. Alternatively, national banking sys- stability. In practice, though, political re- tems that are conservatively regulated at alities are likely to complicate multilateral the national level—for instance, through discussions of banking regulation, while macro-prudential measures that limit monetary policy tends to be conducted banks’ reliance on short-term wholesale with domestic rather than global impera- funding—would help moderate capital tives in mind. flows that could otherwise exacerbate procyclical behavior and generate risks. • The incremental liberalization of capital But the middle ground of fragmented fi- flows in the pursuit of the

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