▚ (EMs) Financial Spillovers to Emerging Markets

29 min readJun 29, 2023

≣Foreword :
The purpose of this paper is to estimate the bond market linkages between emerging market (EM) and advanced market (AM) yields by estimating yield equations for EMs as a function of AM yields and illustrating the quantitative macroeconomic effects on EMs of global yield shocks in a multi-country dynamic stochastic general equilibrium modeling model.

Keywords: Cross-border flows, international financial spillovers; macroprudential policy coordination; cost benefit analysis; international financial organizations.

➲ Key Points:

⇝Financial Globalization and Emerging Economies

⇝Factors For Financial Risk Management

⇝Spillover Effects and Financial Meltdown

Financial globalization has been a very dynamic component of the continued globalization experienced by the world in recent years. Capital flows to a large number of emerging economies are expanding rapidly.

Abstract: This paper discusses the scope for international macroprudential policy coordination in a financially integrated world economy. The particular case of currency unions is discussed, as is the issue of whether coordination of macroprudential policies simultaneously requires some degree of monetary policy coordination. Much of this analysis focuses on the potential for countercyclical policy coordination between major advanced economies and a group identified as systemic middle-income countries (SMICs). Consider practical ways to promote international macroprudential policy coordination. Following a discussion of Basel III’s principle of reciprocity and ways to improve it, the paper advocates a further strengthening of the current statistical, empirical, and analytical work conducted by the Bank for International Settlements, the Financial Stability Board, and the International Monetary Fund to evaluate and raise awareness of the gains from international coordination of macroprudential policies. The last section brings together some of the key policy lessons that can be drawn from the analysis.

Introduction

Over the past three decades, despite a slowdown coinciding with the global financial crisis (GFC), the degree of international financial integration has increased relentlessly.

International spillovers, especially those associated with monetary policy in advanced economies, are a source of concern for another reason. Even if monetary policy is optimally tailored to macroeconomic and financial conditions in the United States or the euro area — in the sense of being able to promote price and output stability domestically — other countries typically face different circumstances. This is a particularly important concern for large developing economies facing stronger inflationary pressures and greater risks to financial stability (Pereira da Silva (2013)). In a context where cyclical positions are not well synchronized, international monetary policy spillovers from advanced economies could well be destabilizing for the global economy. This has led observers and policymakers in several major middle-income countries (especially Brazil and India) to issue pleas for increased policy coordination. The argument, as it is usually presented (see, for instance, Mishra and Rajan (2016) and Shin (2015)), is that US and European policymakers must go beyond their mandate — which requires taking account of the external impact of their policies only insofar as they feed back onto their own economies, through spillback effects — and explicitly account for cross-border effects in their policy decisions. Calls for central banks in advanced economies to consider the effects of their decisions on the rest of the world have also been accompanied by greater reliance, Bagliano and Morana (2012), Bauer and Neely (2014), Fratzscher et al (2014), Aizenman et al (2016), Tillmann (2016), and MacDonald (2017) for a discussion of these spillover effects. Several of these contributions focus on the effects of the Federal Reserve’s large-scale asset purchase (LSAP) program. Broader reasons for operating a managed float in many middle-income countries include the impact of currency fluctuations on domestic inflation, the domestic currency value of foreign liabilities, and competitiveness. See Agénor and Pereira da Silva (2013) for a discussion. Financial market spillovers to advanced economies from the rest of the world are now commonly referred to as spillback effects and are discussed later on. BIS Papers No. 97 3 at the national level, on macroprudential policies, in both their structural and countercyclical dimensions.6 These policies (especially those of a time-varying nature) appear to have indeed been effective in helping recipient countries insulate themselves from global financial shocks and mitigate the systemic financial risks that international capital flows may create (see Ghosh et al., (2017)). Moreover, in response to these shocks, there have also been calls for greater coordination of these policies across countries. The purpose of this paper is to discuss, from an analytical and policy perspective, the role of, and scope for, international macroprudential policy coordination in a financially integrated world economy. Among the issues we address are the extent to which greater coordination of macroprudential policies may help mitigate the effects of cross-border financial spillovers and spillbacks; the magnitude of potential gains from international coordination; and the role supranational authorities may, or should, play in monitoring system-wide financial risks and promoting international coordination in the area of macroprudential regulation. At the outset, it is important to note that even though cross-border spillovers and spillbacks may be significant, and may indeed have increased in magnitude in recent years, it does not necessarily follow that they reduce global welfare or that cooperation is prima facie improving welfare. If the global economy is experiencing a recession, for instance, the coordinated adoption of an expansionary fiscal policy stance by a group of large countries may, through trade and financial spillovers, benefit all countries. The magnitude of this gain may actually increase with the degree to which countries are interconnected, the degree of business cycle synchronization, and the magnitude of spillovers. But if maintaining financial stability is a key policy objective, the propagation of financial risks through volatile short-term capital flows also becomes a source of concern. These risks may or may not materialize in the same manner across countries, even when they are highly integrated, because these flows are not necessarily driven by fundamentals or because countries can be at different stages of their business and financial cycles. When they do, however, they may be magnified by domestic financial market imperfections. To the extent that financial risks represent negative externalities that tend to increase with the magnitude of spillovers and spillbacks, which may in turn be exacerbated (through cross-country leakages) by uncoordinated national macroprudential policies, there is a case for macroprudential policy coordination.

Evaluating the potential gains from international macroprudential coordination in responding to these shocks, dwelling on both recent analytical contributions and quantitative studies based on multi-country dynamic general equilibrium models with financial market frictions.

The particular case of currency unions is also discussed, with a focus on whether macroprudential policy should be conducted at the level of a common (union-wide) financial authority or left instead under the responsibility of national authorities — a timely issue for the euro area and the performance of the Single Supervisory Mechanism introduced in November 2014. We discuss whether international coordination of macroprudential policies should simultaneously involve some degree of monetary policy coordination, given that these instruments may be complementary in jointly promoting macroeconomic and financial stability. The final section brings together some of the key policy lessons that can be drawn from the analysis.

⇝International Financial Spillovers:

transmission channels Understanding the nature and magnitude of financial spillovers and how they are transmitted across borders has been the subject of a large body of literature in recent years. From the perspective of this paper, such understanding is an essential step for International coordination between large economies and smaller economies may be less probable if the potential gains are likely to be small (Kincaid and Watson (2016)). However, small economies may indirectly benefit from the coordination between major advanced economies and SMICs, to the extent that it promotes global financial stability. In addition, coordination between large and smaller countries on the structural dimension of macroprudential policy — through implementation of the Basel III standards or (as discussed later) extensions of them — is of course desirable and potentially beneficial for the global economy as a whole. After a first draft of this paper was completed, we became aware of a contribution by Huidrom et al (2017) which takes a position related to ours — they suggest focusing on the largest emerging market economies, or EM7 (our group of SMICs minus South Africa), because of their importance in terms of global output and their potential for large cross-border spillover effects. However, their focus is on growth spillovers, whereas our focus is on financial spillovers. Moreover, they do not discuss the benefits of their proposed grouping in the context of policy coordination issues. Macroeconomic models that account for financial frictions, as well as a range of interactions between the real and financial sectors, are now commonly used in academic circles, central banks and research institutions to study the benefits of macroprudential regulation, independently and in combination with monetary policy.

This section begins by defining the nature of financial spillovers. It then describes the various channels, direct and indirect, through which they are propagated internationally. Given the focus of our analysis, particular emphasis is put on the role of cross-border banking and arbitrage incentives created by domestically focused financial regulation.

Nature of financial spillovers Cross-border financial spillovers are commonly defined as occurrences where fluctuations in the price of an asset in one country (or region) trigger changes in the prices of the same asset or other assets in another country (or region).These fluctuations can reflect both desirable effects (resulting, for instance, from the incorporation of news into forward-looking asset prices) and less desirable ones (such as the transmission of excess volatility due to financial frictions, especially financial accelerator effects).

This definition implies that the qualitative nature, and quantitative impact, of cross-border financial spillovers depend on several dimensions:

(a) the type of shock that generates fluctuations in asset prices in the source country;

(b) the channels, real and financial, through which the shock is transmitted internationally;

(d) the nature of the macroeconomic and macroprudential policy regime in source and recipient countries; and

(e) the scope for policymakers in recipient countries to respond in a timely fashion.

Transmission channels The cross-border transmission of financial shocks (triggered, for instance, by a temporary change in risk-free interest rates in major economies or a sudden shift in market risk perceptions) may occur through a number of conventional channels. Particularly important from the perspective of this paper, recent studies have emphasized the role of cross-border banking (both as a direct conduit for the propagation of financial shocks and an amplifying mechanism for these shocks) as well as leakages associated with differences in financial regulatory regimes across countries. Conventional channels The conventional channels through which financial spillovers are typically deemed to occur involve direct and indirect changes in financial prices, cross-border balance sheet exposures, information or confidence effects (including fundamentals-driven changes in expectations), trade linkages, and policy spillover.

Conventional channels of financial spillovers Spillovers via asset prices and portfolio effects. Asset prices represent the standard channel through which financial shocks are transmitted across borders. When financial markets are globally integrated, changes to prices on any asset market usually translate quickly into changes in asset prices and valuations in other economies, through interest rate parity and risk premia effects. For instance, when monetary policy is eased in a core country, it tends to lower longer-term yields and raise other asset prices in that country. Through portfolio balance effects among financially interconnected economies, this may lead to large capital flows to, and lower yields and higher asset prices in, periphery countries. This may, in turn, ease financial conditions there. Thus, this channel may operate solely through portfolio reallocation by investors operating in several markets across countries, that is, cross-border financial flows; it does not necessarily depend on the existence of shared fundamentals between core and periphery economies — a phenomenon referred to generally as contagion. Spillovers via cross-border balance sheet exposures. These occur through the impact of changes in asset prices on balance sheets. If collateral values depend on the behavior of asset prices (as is the case with house prices) and if changes in collateral values determine access to credit (because real estate is used to secure loans) these effects can be large and affect both consumption and investment. In addition, the wealth effects associated with changes in asset prices can affect household consumption. For banks, a balance sheet weakening can also affect lending capacity. Spillovers through trade linkages. These can occur even if trade flows are considerably less volatile than financial flows — thereby preventing rapid transmission and amplification of shocks through large changes or reversals. In general, trade linkages operate through an income effect and a competitiveness effect (relative price changes), which can work in opposite directions (see for instance Ammer et al 2016). To the extent that financial shocks affect changes in income (as noted earlier), they may also be amplified through changes in trade flows. Thus, a high degree of trade openness may facilitate the propagation of financial shocks across highly integrated economies. Spillovers through information or confidence effects. These occur when market participants’ perception or anticipation of changes in economic fundamentals are driven by policy announcements (or expectations of them) rather than the actual realisation of these changes. They are important for explaining contagion effects, in particular in the context of wake-up call effects, which happen when new information concerning a country (or region) induces markets to reassess the vulnerability of other countries (or regions). Policy spillovers. These occur when domestic monetary and fiscal decisions in source countries have the potential to affect foreign financial variables not only indirectly (through the channels outlined above) but also directly, if policymakers in recipient countries respond in the same direction. In particular, to the extent that shocks to world interest rates are accommodated by lower domestic rates, they may generate large spillover effects by inducing domestic banks to borrow more (increased leverage), which in turn would affect their capacity to lend. Thus, the magnitude of financial spillovers depends also on the nature of policy responses, which itself depends on the degree of financial interconnectedness. This discussion suggests that financial spillovers and spillbacks are not necessarily bad if they allow new information about changes in economic fundamentals to be reflected accurately in asset prices across different countries. However, they may be undesirable when they contribute to the propagation of shocks across countries — even in the absence of significant economic linkages among them. This is the case, for instance, if portfolio rebalancing considerations induce fund managers in a core country to sell assets in a periphery country, as a result of constraints on exposure they may face.

⇝What Is the Spillover Effect?

The spillover effect refers to the impact that seemingly unrelated events in one nation can have on the economies of other nations. Although there are positive spillover effects, the term is most commonly applied to the negative impact a domestic event has on other parts of the world, such as an earthquake, stock market crisis, or another macro event.

⇝How the Spillover Effect Works

Spillover effects are a type of network effect that increased since globalization in trade and stock markets deepened the financial connections between economies. The Canada-U.S. trade relationship provides an example of spillover effects. This is because the U.S. is Canada’s main market by a wide margin across nearly every export-oriented sector. The effects of a minor U.S. slowdown are amplified by Canada's reliance on the U.S. market for its own growth.

For example, if consumer spending in the United States declines, it has spillover effects on the economies that depend on the U.S. as their largest export market. The larger an economy is, the more spillover effects it is likely to produce across the global economy. Since the U.S. is a leader in the global economy, nations and markets can be easily swayed by domestic turmoil.

Since 2009, China has emerged as a major source of spillover effects as well. This is because Chinese manufacturers have driven much of the global commodity demand growth since 2000. With China becoming the number two economy in the world after the U.S., the number of countries that experience spillover effects from a Chinese slowdown is significant.

When China’s economy experiences a downturn, it has a palpable impact on the worldwide trade in metals, energy, grains, and many more commodities. This leads to economic pain through much of the world, although it is most acute in Eastern Europe, the Middle East, and Africa, as these areas rely on China for a larger percentage of their revenue.

⇝Special Considerations for Unconnected Economies:

There are some countries that experience very little spillover from the global market. These closed-off economies are getting rarer, as even North Korea—an economy nearly sealed off from world trade in 2019 — has begun to feel the spillover effects of intermittent Chinese slowdowns.

⇝Safe-Haven Economies

A few developed economies are vulnerable to certain economic phenomena that can overwhelm spillover effects, no matter how strong. Japan, the U.S., and the Eurozone, for example, all experience spillover effects from China, but this impact is partially counteracted by the flight to safety by investors into their respective markets when global markets get shaky.

Similarly, if one of the economies in this safe haven group is struggling, investments will usually go to one of the remaining safe havens.

This effect was seen with U.S. investment inflows during the EU’s struggles with the Greek debt crisis in 2015. When dollars flow into U.S. Treasuries, the yield goes down along with the borrowing cost for American homebuyers, borrowers, and businesses. This is an example of a positive spillover effect from the perspective of a U.S. consumer.

KEY TAKEAWAYS

The spillover effect occurs when an event in one country has a ripple effect on the economy of another, usually more dependent country.
Spillover effects can be caused by stock market downturns such as the Great Recession in 2008, or macro events like the Fukushima disaster in 2011.
Some countries experience a cushion from the spillover effect because they are considered “safe haven” economies, where investors park assets when downturns occur.

Evidence on international financial spillovers The empirical evidence shows that the importance of financial spillovers, and spillbacks, has grown significantly over the last two decades. Many of the recent studies have focused on the transmission of financial shocks across equity, foreign exchange, and sovereign bond markets, as well as interest rate and balance sheet effects. This section begins with a brief overview of these studies. In line with our earlier analytical discussion of the transmission channels of global financial shocks, we devote more attention to the evidence on the credit spillover channel and crossborder bank flows, as well as regulatory leakages and capital flows. Challenges in measuring financial spillovers are subsequently discussed. Asset price movements and bond spreads A common approach to measuring financial spillovers is in terms of the impact of domestic asset price movements on asset prices in other economies. Among the most recent studies of this type are those of the IMF (2016a,b,c). In IMF (2016a), spillovers are estimated using a vector autoregression (VAR) model of daily asset returns incorporating global control variables. The results indicate that over the last 20 years, spillovers of emerging market asset price shocks to equity prices and exchange rates in advanced and (other) emerging market economies have risen substantially, and now explain over a third of the return variation in these countries.

Recent evidence on international financial spillovers and spillbacks Recent econometric evidence on quantifying the cross-country transmission of financial spillovers has focused on (a) correlations in equity and foreign exchange returns; (b) correlations in returns on sovereign bonds; © correlations in house prices; (d) correlations in policy rates; (e) correlations in changes in confidence; (f) changes in policy and asset return uncertainty; (g) the role of domestic financial sector characteristics in the source and recipient countries in amplifying shocks; and (h) the degree of financial market integration. Correlations in equity and foreign exchange returns. Studies include Fratzscher et al (2014), Mishra et al (2014), and IMF (2016a,c,d). Focusing on the episode of unconventional monetary policy in Europe, Fratzscher et al find that ECB policies had positive spillovers on equity prices across a wide set of countries, but the impact on yields was limited to the euro area, especially Italy and Spain. Mishra et al focus on market reactions to the 2013–14 Federal Reserve announcements relating to tapering of asset purchases. Using daily data on exchange rates, government bond yields and stock prices for emerging markets, they find that countries with stronger macroeconomic fundamentals, deeper financial markets, and a tighter macroprudential policy stance in the run-up to the tapering announcements experienced smaller currency depreciations. However, there was less differentiation in the behavior of stock prices based on fundamentals. In order to identify financial market spillovers between countries, the IMF (2016a) uses a VAR model of daily asset returns with global control variables. The study defines a financial market spillover from country A to country B as the share of the variation in country B’s market return shocks that can be attributed to contemporaneous or preceding shocks in country A’s market returns. Using this methodology, the study finds that, globally, spillovers in equity and foreign exchange markets have risen significantly over the last two decades. For equity markets, the share of the variation in advanced and emerging economies’ returns attributable to other countries’ equity return variations rose from 50% to 80%. In foreign exchange markets, the corresponding increase was from 50% to 71%. The evidence also suggests that spillbacks (spillovers from emerging markets to advanced economies) now account for more than a third of the variation in equity and foreign exchange returns of advanced economies. In two complementary studies, the IMF (2016c,d) focuses on the size and nature of financial spillovers from China by looking at the impact of developments in that country on global financial markets, differentiated across asset classes. In particular, the IMF (2016d) estimates time-varying spillovers from China to advanced and emerging market economies. Results showed that the magnitude of China’s spillovers has steadily increased across countries during the last two decades, but remains limited. These effects are felt most significantly in foreign exchange and equity markets, and reflect primarily the central role the country plays in goods trade and commodity markets, rather than its financial integration in global markets and the direct financial linkages it has with other countries. Spillovers are larger for countries with deeper trade ties with China (especially Asian countries integrated in the global supply chain), countries that export mostly manufacturing goods, and net commodity exporters. The analysis also shows that the external impact of economic and financial developments in China on global financial markets is more pronounced for bad news than for good news, increases with the size of the shock, and works mainly through risk aversion and global commodity prices. A related literature provides evidence of spillover effects between sovereign and private risk, across equity markets. De Bruyckere et al (2013) focus on the risk spillovers between European banks and sovereigns over the period 2007–12, using credit default swap (CDS) spreads. They find significant evidence of spillover effects, in both directions. In addition, they find that risk spillovers are stronger between banks and their home country, and linked to bank capital ratios. In a related contribution, Lucas et al (2014) estimate euro area joint and conditional sovereign default probabilities using data on CDS prices over the period 2008–13. They find evidence of spillover effects influencing the likelihood of sovereign default and of significant time variation in risk dependence (which increases in times of stress) between countries.

Interest rate and balance sheet effects Fluctuations in interest rates in major advanced economies tend to affect other countries through changes in the cost of external borrowing. For major middle-income countries, whose corporations and banks borrow heavily abroad mostly in US dollars and with little hedging — unlike other advanced economies — changes in US interest rates are a critical channel for financial spillovers. Indeed, Figure 6 shows that SMICs have relatively high ratios of foreign currency debt to GDP. Financial spillovers may therefore amplify domestic leverage and generate large effects when borrowers face financial distress.

Cross-border bank flows and the credit spillover channel Evidence on the determinants and effects of cross-border bank flows and the credit spillover channel is provided in a number of recent contributions. Studies by Cetorelli and Goldberg (2012), Bruno and Shin (2015), Correa et al (2015), Tonzer (2015) and Cerutti et al (2017a) focus on aggregate banking flows, whereas Reinhardt and Riddiough (2014) focus on disaggregated (interbank and intragroup) flows. By and large, these studies have shown that cross-border bank capital flows are highly sensitive to changes in interest rates in advanced economies and changes in global risk perceptions, and that these changes tend to operate quickly — with potential consequences for financial stability in destination countries. Correa et al (2015) for instance provide empirical support for the existence of an international portfolio rebalancing channel, whereby tighter monetary policy in source countries leads to a decrease in the net worth and collateral values of domestic borrowers, which prompts banks to substitute away from domestic credit and towards foreign credit. Tonzer (2015) finds that countries that are linked to more stable banking systems abroad through foreign borrowing or lending positions are significantly affected by positive spillover effects. Thus, in times of financial volatility, linkages in the banking system can contribute to the propagation of shocks. In addition, the composition of bank funding also matters for financial stability. In a study focusing on disaggregated flows, Reinhardt and Riddiough (2014) find that intragroup funding appears to be unrelated to global or local cyclical factors, whereas interbank funding appears to respond procyclically. 3.4 Regulatory leakages and capital flows Studies focusing on how regulatory leakages (including macroprudential measures) affect cross-border capital flows, which therefore act as a conduit to financial spillovers, include Houston et al (2012), Bremus and Fratzscher (2014), Aiyar et al (2014a,b), Karolyi and Taboada (2015), Reinhardt and Sowerbutts (2016), Avdjiev et al (2017), Beirne and Friedrich (2017), Cerutti et al (2017a), Forbes et al (2017), Kang et al (2017) and Takáts and Temesvary (2017).24 Houston et al use data aggregated at the country level and survey data on global regulations to argue that cross-border banking flows move to circumvent regulations, thereby providing evidence for “race to the bottom” behaviour. In the same vein, Bremus and Fratzscher find that inflows and outflows of international capital through banks around the time of the GFC responded to the stance of regulation and supervision. Using a broader sample covering the period 2000–14, Avdjiev et al find that changes in macroprudential policy — in the form of loan-to-value limits and local currency reserve requirements — have a significant impact on cross-border bank lending. Similar results are obtained by Takáts and Temesvary. Also using a large sample of countries and a broader variety of empirical techniques, Kang et al find that while sectoral and liquidity-based macroprudential policy measures tend to generate large cross-border bank credit spillovers, that is not the case for capital-based measures.

Challenges in measuring financial spillovers The recent empirical literature discussed earlier provides convincing evidence of the increased importance of international financial market spillovers through bank and non-bank capital flows — especially those associated with portfolio reallocation or cross-border regulatory arbitrage. However, there are several dimensions in which the empirical literature can be improved. First, there is a need to examine domestic effects and international spillovers using more detailed micro-banking data, and relying on more precise measures of prudential regulation than were initially available to researchers studying cross-border spillovers. New databases on prudential instruments compiled by Cerutti et al (2017b) and Akinci and Olmstead-Rumsey (2018) for instance may prove useful in that regard, although more refined data (focusing in particular on the intensity with which, and not simply the direction in which macroprudential instruments are used) are needed.

⇝International macroprudential policy coordination:

Rationale and potential gains The scope for international macroprudential policy coordination to mitigate the adverse effects of cross-border financial spillovers and raise global welfare has been the subject of much interest in recent years. This section begins with a brief review of the link between systemic financial risks and the rationale for macroprudential regulation. The fundamental case for cross-border macroprudential policy coordination is discussed next. Empirical evidence on the gains from cross-border macroprudential policy coordination is then examined. The section concludes with a discussion of whether monetary and macroprudential policies should be simultaneously coordinated across borders to some degree to be effective, and of the particular case of macroprudential policy coordination in currency unions.

Systemic risks and the rationale for macroprudential regulation The goal of macroprudential policy is commonly described as promoting financial stability by mitigating systemic risks to the financial system.25 This contrasts with macroprudential supervision, which focuses on the financial health of individual financial institutions. Systemic risks fall into four broad categories: excessive credit growth (often associated with procyclical risk-taking by financial institutions) and associated asset price inflation; excessive leveraging or deleveraging; systemic liquidity risks; and large and volatile capital flows. These risk categories typically occur in combination with each other, and to varying degrees. For instance, SMICs have time and again been confronted with episodes of sudden floods in capital flows, rapid credit growth, asset price pressures, and excessive leveraging — followed by sudden stops in capital movements which throw the previous process into reverse (Agénor et al (2014, 2018a)). There is broad consensus that, from an operational standpoint, an aggregate that may serve as a proxy for financial stability is rapid credit growth or changes in the credit-to-GDP ratio. On that basis, credit can be viewed as a “summary” indicator or intermediate target, which can be used to calibrate the effect of macroprudential instruments and design policies to dampen destabilizing swings in the credit cycle. However, despite significant progress in recent years no consensus has yet emerged on the transmission mechanism and effectiveness of macroprudential policies, their complementarity with micro prudential policies, and the degree to which they should be coordinated with monetary policy — given that the regulatory regime may alter the monetary transmission mechanism and that changes in macroprudential instruments can affect activity and prices.Moreover, as documented in the previous section, cross-border activities of financial institutions pose challenges to macroprudential policies, with possibly unwelcome spillover effects weakening their policy impact.

Partial equilibrium models of international banking The banking and finance literature on international policy coordination includes Acharya (2003), Dell’Ariccia and Marquez (2006) and Kara (2016). Dell’Ariccia and Marquez study the incentives of national regulators to form a regulatory union in a two-country world, where a single bank from each country competes for loans in both markets in a Bertrand differentiated-products setting. Both regulators focus on the profitability of national institutions and compete with each other, but there is an exogenously specified asymmetry between them in terms of their preferences. The key result of the study is to show that the outcome in this setting could be a race to the bottom, in terms of prudential standards. By contrast, a coordinated structure with higher prudential standards is more likely to emerge if: (a) the impact upon profitability of prudential supervision is similar across countries; (b) the weights assigned by supervisors to financial stability and banking sector competitiveness are similar; and © the weight assigned to financial stability by the supervisors is larger than that assigned to profitability and competitiveness. Acharya (2003) focuses instead on practical issues that may impede cross-border regulatory coordination efforts. His key argument is that convergence in international capital adequacy standards cannot be effective unless it is accompanied by convergence in other aspects of financial regulation, such as bank closure policies. Thus, coordination in setting regulatory standards does not necessarily eliminate regulatory arbitrage. Both of the studies referred to above focus on the benefits of international coordination in financial regulation under externalities that operate through integrated loan or deposit markets in stable times. In contrast, Kara (2016) focuses on pecuniary externalities between national financial markets that operate through asset markets and asset prices during times of distress

Macroeconomic models Recent analytical contributions on the international coordination of macroprudential policies from a macroeconomic perspective include Korinek (2014), Bengui (2014) and Jeanne (2014). Korinek shows that international cooperation is not warranted if small countries can use prudential capital controls to respond to domestic externalities. Bangui studies the scope for international coordination in a model with public liquidity provision. He finds that the non-cooperative equilibrium between national regulators leads to an inefficiently low level of regulation, as national regulators do not internalize the benefits of their country’s provision of liquidity to the rest of the world. By contrast, Jeanne analyses the scope for international coordination in a model where both domestic macroprudential policies and prudential capital controls generate international spillovers through their impact on capital flows. The uncoordinated use of macroprudential policies may lead to a “capital war” that depresses global interest rates. However, international coordination of macroprudential policies is not warranted, unless there is unemployment in some countries, or one part of the world is in a liquidity trap, while the rest of the world accumulates reserves for prudential reasons.

Obstacles to policy coordination The banking-based and macro-based analytical literature reviewed earlier is somewhat mixed, in the sense that it suggests that coordinated macroprudential policies can potentially offer significant gains, even though this is not necessarily the case. Moreover, even if gains do exist, achieving and maintaining coordinated policies across countries in pursuit of these gains may prove difficult in practice. First, assuming that a cooperative outcome can indeed be achieved, and that regulators have agreed to coordinate, each of them almost invariably has an incentive to cheat. Indeed, once one of the countries’ regulators has set its instrument at the agreed level, the other typically can set its own instrument at a different value and attain an even lower policy loss or higher welfare. This incentive is stronger the smaller the perceived ex post cost of reneging on a cooperative agreement. Second, cooperative solutions may be inefficient in the presence of third-party effects: in a policy game with three or more players, the welfare contribution of a subgroup coalition generally cannot be determined a priori, and it is often the case that policy coordination worsens welfare (see Rogoff (1985) and Cai and McKibbin (2013)). This is important because, as discussed next, recent empirical contributions have generally been based on two-country models, in which a “core country” (which can be interpreted as an aggregate of major advanced economies) and a “periphery country” (which can be interpreted as the group of SMICs identified earlier) operate. However, while a two “country” structure may be appropriate to generate analytical insights, as well as broad estimates of the gains from coordination, it does not account for the fact that in practice these groups are not homogeneous and face coordination issues of their own. Among advanced economies for instance, these issues are equally important between the United States, Japan and the euro area — even though these countries have in the past cooperated sporadically (often in the context of emergency responses to heightened risks to the world economy) in setting macroeconomic policy. This issue is even more problematic in the case of SMICs, given their historical record in that area. Third, simple theoretical models assume that regulators across countries have the same targets and/or common national preferences, whereas in practice supervisory authorities may place diverging weights on similar goals or seek different objectives (see VanHoose (2016)). Fourth, theoretical models often assume that different countries share the same view of the world; however, in practice they often have fundamentally different models in mind. Regulators might therefore not be able to carry on a coherent discussion of the potential gains from coordination — which involves assessing the costs and benefits of alternative policy choices — and how to achieve them. Indeed, as shown by Frankel and Rockett (1988) in the context of the debate on monetary policy coordination, if models are incorrect international coordination could worsen outcomes — by moving policies in the wrong direction — instead of improving them. Moreover, model perceptions could be endogenous with respect to individual countries interests.

For all these reasons, maintaining a macroprudential policy coordination agreement is likely to be challenging in practice — even when mutual net gains from such coordination are potentially large.36 A common response to the first challenge to maintaining coordinated policies across countries is to ensure that appropriate and credible sanctions are in place to eliminate the temptation to renege. To address the fourth challenge a possible response might be for countries to entrust an assessment of the origin and nature of global shocks, and the need for a coordinated international response, to a group of multilateral institutions — in effect, a group of “honest brokers”. This could help not only to address the issue of model uncertainty and the magnitude of policy gains, but also to alleviate some of the collective action problems discussed earlier — inertia in policymakers’ reaction and the disadvantage of moving first — which combine to prevent a timely response to financial risks.

The case of currency unions A currency union, characterized by a very high degree of financial integration, faces particular challenges in deciding whether countercyclical macroprudential policy should be conducted at the national level or instead in coordinated fashion at the union level. One of them relates to the fact that, in a currency union where business cycles are not fully synchronized, national macroprudential policies may take on added importance from the perspective of stabilizing activity. This results from the absence of an independent monetary policy and the limited scope for fiscal policy to play an active countercyclical role in the presence of deficit and debt ceilings — as is the case in almost all existing unions. Another challenge relates to the tension that may arise between countercyclical macroprudential measures designed to inhibit excessive cross-border capital flows in order to maintain financial stability, and the broader long-term objective of promoting a single, integrated financial market. In effect, impeding capital mobility through discretionary macroprudential actions at the level of individual member countries may lead to a fragmentation of the union’s financial markets, thereby hampering the ability to share and diversify risks across jurisdictions. A third issue is the extent to which credit market heterogeneity among union members may mitigate the gains from centralized macroprudential policy coordination.

⇝Promoting international macroprudential policy coordination:

Regulatory standards and reciprocity principles As discussed earlier, in recent years increased interconnectedness of financial institutions and markets, and more highly correlated financial risks, have intensified the strength and speed of cross-border spillovers. At the same time, there has been increased recognition that differences in national macroprudential policy regimes across countries can themselves be a source of international spillovers. In particular, by triggering cross-border regulatory arbitrage, these differences may lead to large swings in capital flows and magnify the international transmission of real and financial shocks — which may exacerbate financial risks locally if credit is already growing rapidly in recipient countries. When systemic financial intermediaries can evade policy actions taken by national authorities, and financial cycles are not well synchronized across countries, the combination of national macroprudential policies may be suboptimal from the perspective of the world economy — even when each country’s macroprudential policy is optimal at the national level.

Minimum regulatory standards As noted earlier, national macroprudential policies that are designed to contain risks associated with a rapid expansion of domestic credit can be subject to leakages from an increase in cross-border borrowing, which in turn may weaken their effects. In addition, during a crisis or its immediate aftermath, a protectionist national financial policy response may favor local banks. When that occurs, fragmentation increases, with the best example being Europe, where the intertwined problems of banks and sovereign risks culminated in the 2010–12 euro area debt crisis (see Baldwin and Giavazzi (2015)). Global coordination may help to avoid these outcomes. The first example of such coordination is an internationally agreed-upon structural minimum standard on capital requirements to guard against regulatory arbitrage. For instance, the first Basel Accord was introduced in 1988 to harmonize capital regulation across jurisdictions. Reciprocity ensured that the same standard was imposed on all relevant credit exposures to borrowers in a given country — regardless of whether credit is provided by domestic or foreign entities. Of course, like any agreement, the Basel framework also had to evolve in accordance with the perception and measurement of risks and their international transmission. One direction taken, in 1996, was to consider using banks’ internal models for regulatory capital requirements for market risk. Under Basel II, banks got the option of using their own credit risk estimates under the internal ratings-based approach (IRB). The goal was to reduce the scope for arbitrage and provide banks with incentives for improved risk measurement and management. However, the GFC revealed inadequate and low-quality bank capital positions in many countries, excessive leverage, overly aggressive maturity transformation, and a tendency by the financial system to engage excessively in risky activities. In effect, the financial system de facto relied only on risk-weighted capital ratios to assess individual and systemic risks. As documented in numerous studies, the inadequate ability to assess financial risks was a contributing factor to the GFC.

⇝Summary and policy lessons :

The purpose of this paper has been to discuss the scope for international macroprudential policy coordination in a financially interconnected world economy, and assess how such coordination can be promoted in practice. Several key lessons have emerged from our analysis. First, with the advance in global financial integration over the last three decades, the transmission of shocks has become a two-way street — from advanced economies to the rest of the world, but also and increasingly from a group of large middle-income countries, which we refer to as SMICs, to the rest of the world, including major advanced economies. These increased spillbacks have strengthened incentives for advanced economies to internalize the impact of their policies on these countries, and the rest of the world in general. Although stronger spillovers and spillbacks are not in and of themselves an argument for greater policy coordination between these economies, the fact that they may exacerbate financial risks — especially when countries are in different phases of their economic and financial cycles — and threaten global financial stability is. Second, the disconnect between the global scope of financial markets and the national scope of financial regulation has become increasingly apparent, through leakages and cross-border arbitrage — especially through global banks. In fact, what we have learned from the financial trilemma is that it has become increasingly difficult to maintain domestic financial stability without enhancing cross-border macroprudential policy coordination, at least in its structural dimension. Avoiding the leakages stemming from international regulatory arbitrage and open capital markets requires cooperation, but addressing cyclical risks requires coordination. Third, divergent policies and policy preferences contribute additional dimensions to global financial risks. In the absence of a centralized macroprudential authority, coordination needs to rely on an international macroprudential regime that promotes global welfare. Yet, divergence in national interests can make coordination unfeasible. Fourth, significant gaps remain in the evidence on regulatory spillovers and arbitrage, and the role of the macroprudential regime in the cross-border transmission of shocks. In addition, research on the potential gains associated with multilateral coordination of macroprudential policies remains limited. This may be due in part to the natural or instinctive focus of national authorities on their own country’s objectives, or to greater priority on policy coordination within countries — an important ongoing debate in the context of monetary and macroprudential policies. This “inward” focus may itself be due to the lack of perception of the benefits of multilateralism with respect to achieving national objectives — which therefore makes further research on these benefits all the more important. This assessment suggests that, in a financially integrated world, international coordination of macroprudential policies may not only be valuable, but also essential, for macroprudential instruments to be effective at the national level. A first step towards coordination has been taken with Basel III’s principle of jurisdictional reciprocity for countercyclical capital buffers, but this principle needs to be extended to a larger array of macroprudential instruments.

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