The benefits of open capital markets are clear. They allow savers and investors to diversify portfolios beyond national borders, and provide a greater range of funding sources to fast-growing economies and businesses. In turn, this allows interest rates to be determined by global factors, generally raising the rates of return available to surplus countries, and lowering the cost of borrowing for economies where the greatest opportunities lie. Although cross-border bank flows have declined in recent years, this has been offset by the rise of international market-based finance, meaning capital markets are as open and interconnected now as they have ever been (Figure 1).
Figure 1 Global capital markets are as open as ever
However, open capital markets also come with risks. Evidence of a ‘global financial cycle’, which drives co-movements in asset prices, and pro-cyclical gross capital flows, has been well documented (Rey 2013, Forbes 2016). Global financial markets have become more correlated and common shocks play an important role. And the correlation of credit growth across countries has increased in recent decades (Figure 2).
Figure 2 Correlation of credit growth across countries has increased in recent decades
Consistent with this literature, research underway at the Bank of England finds that even when domestic credit growth is moderate, elevated credit growth abroad could result in financial instability at home, for example by boosting cross-border lending, through spillovers into domestic asset prices, or by creating the potential for contagion in the event of a banking crisis abroad (Cesa-Bianchi et al. forthcoming).1 This research suggests that a one standard deviation in foreign credit growth could have an impact on the probability of a crisis that is of the same order of magnitude as a similar shock to domestic credit growth. And that the effect of foreign credit growth on domestic financial stability is stronger for countries that are more financially open.
Were crises to spread from one country to another, it could lead to renewed pressure to reduce the openness of capital accounts, shrinking the opportunities available to global savers and borrowers alike. In turn, that would put further downward pressure on interest rates in advanced economies, and upward pressure on borrowing costs in faster growing economies with the most potential.
Taking all of this together underlines the need to think globally when setting macroprudential policy. At first blush, this may appear to sit awkwardly with the largely domestic nature of macroprudential tools that have been developed thus far. But there are number of ways in which international considerations could form part of the calibration of those tools.
Acting locally to address risks from cross-border banking flows
The most obvious way to take international considerations into account is by treating risks emanating from abroad as an important input when setting domestic macroprudential policy. At the Bank of England, for example, spillovers from the crystallisation of global risks play a key part of the design of the Bank’s annual stress tests, which are used to inform the Financial Policy Committee’s (FPC) decision on the countercyclical capital buffer applied to UK domestic banks.
But the effectiveness of macroprudential policies can be reduced by ‘leakages’ if lending by domestic banks is simply replaced by lending from overseas, thus reducing the resilience benefit of any given level of capital buffers. The existence of reciprocity – by which an increase in the countercyclical buffer in one country is applied to lending into that economy by banks in another country – is an effective way of mitigating the impact of leakages.
Because the build-up of credit in one economy can affect the probability of a crisis in another, policymakers applying the principle of reciprocity to cross-border lending will also have a positive impact on financial stability at home. Indeed, under a reasonable set of assumptions, reciprocity can be shown to improve the trade-off between output and stability available to macroprudential policymakers (Shafik 2016, Aikman et al. forthcoming). To borrow a phrase from the recent IMF-FSB-BIS report on elements of effective macroprudential policies, this feature of reciprocity can be thought of as a good example of “enlightened self-interest” (IMF-FSB-BIS 2016).
Reciprocity also helps address the old problem of asymmetric adjustment of global imbalances. Suppose a deficit country wishes to contain the supply of credit and build resilience in its financial system by raising the buffer. If a surplus country whose banks are lending to the deficit country reciprocates, its banks should be incentivised to lend less to the deficit economy, and more to their domestic economy. That should increase domestic demand in the surplus country, and hence demand for deficit country exports, reducing the overall level of imbalances.
Acting locally to address risks from market-based finance
What of market-based finance? Its growth adds welcome diversity to the financial system, particularly for emerging markets. In many ways these flows are less risky than bank flows – for example, the average maturity of international securities issued by emerging markets is ten years, reducing rollover risk and exposure to a sudden flight of capital.
But market-based flows have risks nonetheless. Portfolio flows to emerging markets have been just as volatile as bank flows once their relative sizes have been taken into account (Hoggarth et al. 2016). And portfolio debt flows to emerging markets are pro-cyclical, especially when denominated in foreign currencies. So as these gain in importance relative to bank flows, emerging markets could have greater volatility inflicted on them by global factors.
Of course, raising the countercyclical capital buffer for banks does little to reduce risks from, or build resilience in, the provision of market-based finance. And that is true of the majority of macroprudential tools developed to date, most of which are focused on banks or banking flows.
But there are steps that can be taken in the local interest of both sources and recipients of global capital flows that strengthen the resilience of market based finance. By building strong domestic institutional frameworks and deepening domestic capital markets, recipients of global flows can reduce their susceptibility to volatility in those flows. Central bank credibility, a robust macroprudential framework, and fiscal stability can all reduce the risk of a sudden stop, and liquid domestic capital markets make it easier to absorb larger inflows.
And by encouraging the use of responsible liquidity management, source countries can reduce the probability of a sudden rush for the exit. The FSB’s recent proposals to reduce structural vulnerabilities from asset managers are an excellent example of this. They include recommendations to enhance reporting to authorities, undertake more stress testing of funds and to extend the suite of liquidity management tools (such as gating and swing pricing) available to fund managers (FSB 2016). Implementation of these recommendations will help better align investors’ expectations of liquidity with reality, and hence ensure their flows to the rest of the world are less flighty and more sustainable.
The global benefits of local action
All of this leads me to conclude that, by acting in their local interest, domestic policymakers can reduce the risk of financial instability spilling across borders. By building domestic resilience, the countercyclical capital buffer can ensure that spillovers from bank lending are not amplified across borders, and reciprocity can improve the available set of outcomes. By reducing the likelihood of procyclical flows, recipients and sources of those flows can improve the resilience of market-based finance. Moreover, given the tendency for global credit growth to affect the probability of domestic crises, macroprudential policy taken in the interest of taming the local financial cycle can have positive externalities for the world.
Aikman, D, J Giese, S Kapadia and M McLeay (forthcoming), “Targeting Financial Stability: Macroprudential or Monetary Policy?”
Cesa-Bianchi, A,F Eguren Martin and G Thwaites (forthcoming), “Foreign Booms, Domestic Busts: The Global Dimension of Banking Crises”.
Forbes, K (2016), “Global economic tsunamis: Coincidence, common shocks or contagion?”, Speech at Imperial College, 22 September 2016.
FSB (2016), “Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” Consultative Document.
Hoggarth, G, C Jung and D Reinhardt (2016), “Capital inflows — the good, the bad and the bubbly”, Bank of England Financial Stability Paper No. 40.
IMF-FSB-BIS (2016), “Elements of Effective Macroprudential Policies – Lessons from International Experience”.
Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, paper prepared for a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 21-23 August 2013.
Shafik, M (2016), “Think Global, Act Local,” speech given at the joint Bank of England, IMF and Hong Kong Monetary Authority conference on Monetary, Financial and Prudential Policy Interactions in the Post-crisis World.
 In this research, domestic credit growth is defined as credit extended by domestic banks to the private non-financial sector in a given country. Foreign credit growth is defined as the average of the growth in credit extended by domestic banks to the domestic private nonfinancial sector in all other countries.